In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust,1 the U.S. Supreme Court provided guidance as to the minimum contacts required to protect a state’s taxation of a trust’s income against a due process challenge. The article by Beckett G. Cantley and Geoffrey C. Dietrich provides an excellent description of the limited nature of that guidance and a helpful set of planning principles which, if followed, could minimize the exposure of a trust to state income tax.
State income taxes are an important source of revenue for most states. Forty-two states and the District of Columbia impose a tax on the income of their resident individuals and resident trusts, with rates ranging from a low of 2.9% in North Dakota to a high of 13.3% in California. Each state has its own method of determining the residency of individuals, usually based on domicile or on some degree of physical presence within the state.
The residency of a trust is a more elusive concept. Although a common law trust is treated as if it were an entity for tax purposes, it’s neither a person nor an entity for any other state law purposes. It has no physical presence anywhere and doesn’t owe its existence to the laws of any particular state. A trust is simply an ownership arrangement that confers legal title to property on a trustee with fiduciary obligations as to the management of that property and that confers a set of equitable rights with respect to the property on beneficiaries.
Neither Congress nor the Supreme Court has established any guidelines for determining the state residency of a trust. The absence of guidance has left states free to establish their own residency standards. Although there’s little uniformity from state to state, the authors point out that the residency of a trust for tax purposes is typically determined by the presence of one of more of the factors listed below:
In the case of testamentary trusts, the residency of the settlor at the time of the settlor’s death;
- The state where the trust is administered;
- The residency or place of business of the trustee;
- The location of the trust assets; and
- The residency of one or more trust beneficiaries.
To that list, I suggest adding the residency of the settlor of a trust at the time it becomes irrevocable.
The Kaestner case addressed a due process challenge to North Carolina’s trust residency statute. The statute, NC. Gen. Sat. Ann. Section 105-160.2 (2017), taxes trust income that “is for the benefit of” a North Carolina resident. North Carolina treats this law as applying to any trust with a North Carolina resident beneficiary. The trust in Kaestner was created and funded by a New York resident, had a Connecticut resident trustee and was administered in New York and Massachusetts. All of its beneficiaries in the tax years in question were North Carolina residents, but none had ever received any distributions from the trust nor was there any trust provision that would guarantee any of them any future distributions. The only connection the trust had with North Carolina was the residency of these contingent beneficiaries.
For a state income tax imposed on a trust to survive a due process challenge, it must satisfy the two prongs of the due process clause. There must be: (1) some minimum connection between the state and the trust; and (2) a rational relationship between the income attributed to the state and values connected to the state. The Supreme Court concluded that the North Carolina taxing statute, when applied to the trust in Kaestner, failed the first prong. As the authors point out, the Supreme Court had previously upheld state trust taxing statutes that were based on: (1) trust income actually distributed to trust beneficiaries, Maguire v. Trefry;2
(2) the situs of trust administration, Curry v. McCanless;3 and (3) the trustee’s residence, Greenough v. Tax Assessors.4 It had rejected a Virginia statute that attempted to tax a Virginia resident on the income of a Maryland-based trust that wasn’t distributed to the resident, Brooke v. Norfolk,5 and one that had attempted to tax a trust with contingent beneficiaries living in Virginia but no assets or trustees in Virginia, Safe Deposit & Trust Co. of Baltimore v. Virginia.6
Applying the precedents established by these previous decisions, the Supreme Court adopted the following minimum contacts test for the state taxation of trusts when the basis for taxation is the residence of a trust beneficiary:
When a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset. . . . Otherwise the State’s relationship to the object of its tax is too attenuated to create the ‘minimum connection’ that the Constitution requires.7
The authors acknowledge the narrow scope of the Kaestner holding. The decision didn’t conclude that the North Carolina statute was unconstitutional on its face. It held only that it was unconstitutional when applied to the particular facts applicable to the trust in Kaestner in the tax years at issue, including the following 10 facts:
- The trustee made no distributions to the beneficiaries;
- The trustee’s contacts with the beneficiaries were infrequent;
- The trust was subject to New York law;
- The settlor was a New York resident;
- The trustee wasn’t a resident of North Carolina;
- The trust records were kept in New York;
- The trust asset custodians were located in Massachusetts;
- The trust had no physical presence in North Carolina;
- The trust made no direct investments in North Carolina; and
- The trust owned no real property in North Carolina.
Given the Supreme Court’s heavy reliance on the facts peculiar to Kaestner, it’s not surprising that North Carolina hasn’t repealed or changed its statute. As the authors point out, North Carolina has instead advised trustees to:
carefully analyze [the entity’s connections to the state] to determine if the connections are sufficient for the State to tax the entity’s undistributed taxable income under the Due Process Clause. Income that is exempt from North Carolina tax under the . . . holding in Kaestner Trust is excluded from North Carolina taxable income . . . .
The authors conclude the article with a discussion of the steps planners should consider when advising a client on the creation of a trust. They first suggest the avoidance of testamentary trusts. When a trust is created under a will, the court in which the will is admitted to probate generally retains some degree of supervisory authority over the trust. That connection may be sufficient to satisfy the due process clause. Trustees should be residents of states that don’t impose income tax on trusts based on the residence of trustees and should be administered in states that don’t impose income tax based on the place of administration. If a trust’s beneficiaries are residents of a state that uses the residence of beneficiaries as a factor in determining trust residence, avoid giving the beneficiaries fixed rights to receive trust distributions and limit their powers over the trustees. The trust instrument’s choice-of-law provisions should avoid states that use the choice of their laws as a factor in determining the residence of a trust.
Finally, because states that are tax friendly today may not always be so, the authors recommend drafting trust instruments that will permit the trustees or other advisors to make modifications to the instruments or other aspects of trust administration to respond to changes in state law.
Endnotes
1. North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, 139 S. Ct. 2213 (2019).
2. Maguire v. Trefry, 253 U.S. 16 (1920).
3. Curry v. McCanless, 307 U.S. 357 (1939).
4. Greenough v. Tax Assessors, 331 U.S. 486 (1947).
5. Brooke v. Norfolk, 277 U.S. 27 (1928).
6. Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83 (1929).
7. Supra note 1, at p. 2222.