On July 21, 2019 the U.S. Supreme Court ruled unanimously that North Carolina could not tax the income of a New York trust where the only connection to North Carolina was a discretionary beneficiary who had not received and could not demand distributions. While the court’s opinion was applied narrowly to the facts, it provides support for planning with trusts to avoid or defer state income tax such as NINGs.
FACTS OF THE CASE
Decades ago, a father established a trust for the benefit of his children in New York. Some time later, the trust was subdivided into separate trusts, one for the benefit of his daughter Kimberley and her children and called the trust The Kimberley Rice Kaestner 1992 Family Trust (the “Kaestner Trust”). Kimberly moved to North Carolina at some point.
The North Carolina Department of Revenue assessed a $1.3 million tax for 2005-2008 because The Kaestner Trust was “for the benefit of” a North Carolina resident. The taxing authority relied on North Carolina statutes and a North Carolina Supreme Court case which found that a beneficiary residing in the state was sufficient to assess the tax. The Trustee paid the tax then appealed in the North Carolina courts. The appeal claimed that the Due Process Clause of the U.S. Constitution prevents North Carolina from assessing a tax where the only link to North Carolina was that a beneficiary resided in the state. All of the North Carolina courts agreed, holding “that the Kaestners’ in-state residence was too tenuous a link between the State and the Trust to support the tax.” The North Carolina Department of Revenue appealed to the U.S. Supreme Court.
The North Carolina Department of Revenue’s argument failed again at the highest court in the land. The State argued that a “trust and its constituents” (e.g. a trustee or beneficiary) are “inextricably intertwined,” and supports state taxation, and an in-state beneficiary is sufficient to tax the trust. The court acknowledged that while a beneficiary is central to a trust, there is such “wide variation in beneficiaries’ interests” in any trust and wouldn’t adopt such a hard-line rule to tax solely on that basis. Likewise, the State’s arguments that ruling in favor of the Trust would “undermine numerous state tax regimes” and could “lead to opportunistic gaming of state tax systems” failed.
The US Supreme Court considered the Due Process Clause of the U.S. Constitution. Ultimately, a minimum connection between the State and the trust is required to assess a tax. It was a purely discretionary trust. Distributions to or for the benefit of a beneficiary were in the sole discretion of a Trustee who was not in the State of North Carolina. The ruling was that the mere residence of the beneficiary in North Carolina was not sufficient to tax the trust because: 1. The beneficiary did not receive any income from the trust during the years in question, 2. The beneficiary had no right to demand trust income or to control, possess, enjoy, or receive trust assets, and 3, The beneficiary couldn’t count on receiving distributions from the trust at any known point in the future.
What does this case tell us? Although the ruling was limited to the narrow facts of this case, it gives us an excellent view of how the U.S. Supreme Court interprets States’ authority to tax trusts. It supports the idea that a trust can be established in another state and avoid/defer income tax in the state of the trust beneficiary. Establishing a non-grantor trust (a trust which is a separate income tax payer) in a state without state income tax (sometimes called ING Trusts). These types of trusts can be excellent tools in the right situation to minimize tax liabilities so long as they are structured properly.