A trust beneficiary’s residence in a state doesn’t establish enough of a connection for the state to tax the trust, the U.S. Supreme Court ruled June 21 in a unanimous opinion.
The case centers on whether a trust can be taxed by a state based on where beneficiaries live. Income not yet distributed can’t be taxed when it is uncertain whether a beneficiary will receive it, the court said in its opinion. Trusts earn about $120 billion in yearly income in the U.S.
A ruling for the state would have meant havoc for trust administration, “forcing trustees to track the travel and temporary residence of all contingent beneficiaries, and opening trusts up to duplicative taxation in potentially all fifty states,” said David H. Bernstein, a Debevoise & Plimpton LLP partner who has been trustee of the Kaestner Family Trust since 2005.
The state of North Carolina argued that it had the right to tax the Kimberley Rice Kaestner 1992 Family Trust on income the trust earned from 2005 to 2008. However, the income wasn’t generated in North Carolina or distributed to Kaestner’s children, and the trust was originally created in New York.
The trust paid more than $1.3 million in taxes to North Carolina, but sued for a refund. It argued that Kaestner wasn’t guaranteed to receive the funds.
A minimum connection is necessary under the due process clause, and the trust argued Kaestner’s residency in North Carolina didn’t establish that link. The high court agreed, saying that “the Kaestners’ in-state residence was too tenuous a link between the State and the Trust to support the tax.”
The court also ruled that the beneficiary hadn’t yet received any benefits from the trust and it wasn’t guaranteed that would ever happen.
The state said that agreeing with the trust’s position would “lead to opportunistic gaming of state tax systems.” But the high court said that “mere speculation about negative consequences” isn’t enough to be considered a minimal connection.
“The ruling emphasizes the Constitution’s most profound guarantee: The government cannot order a citizen to do something that is fundamentally unfair, and that includes forcing someone who has nothing to do with a State to pay taxes for services they didn’t use,” David A. O’Neil, a partner at Debevoise & Plimpton LLP in Washington who represented the trust, said in an email.
Brian Galle, a law professor at Georgetown Law, said the opinion effectively created a small tax shelter by saying that if you have a beneficiary who doesn’t have any control over assets, the state where that beneficiary lives can’t tax the trust based solely on the location.
That was disappointing, Galle said, because it “opens an avenue for a well-advised wealthy family to transmit wealth without being taxed.”
For example, if a beneficiary is living in a high-tax state like California but the trustee is living in a low-tax state like Nevada, the trustee can earn investment income in the trust and it won’t be taxed in California, Galle said. Once the beneficiary wants to receive the income, they could move to the low-tax state to receive the distribution.
Matthew W. Sawchak represented the North Carolina Department of Revenue. The office said in an email that it appreciates the court’s “careful consideration.”
The case is N.C. Dep’t of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, U.S., No. 18-457, 6/21/19.