The latest Supreme Court decision limiting trust taxation heightens the threat to taxes on trusts in New York and the District of Columbia, and may also jeopardize a California mechanism for taxing certain out-of-state trust income.
That’s according to several practitioners who said that the decision in North Carolina Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, while very narrow, confirmed that the court sees constitutional concerns around state taxation based on slight or uncertain connections to trusts.
“Kaestner sharpens the constitutional limits on state taxation of trust income,” said Richard Nenno, managing director and trust counsel at Wilmington Trust Co.
“I think what it means is the prospects for successful challenges to state taxation of trust income have improved,” he said.
The high court’s unanimous July decision said that the North Carolina tax on an out-of-state trust based on the in-state residency of a beneficiary who didn’t have a right to anything in the trust violated the Constitution’s guarantee of “due process.” The state wasn’t sufficiently connected to the trust it was trying to tax, the court said.
But the justices narrowly tailored their ruling to the specifics of the North Carolina case, holding that a state can’t tax a trust’s income based solely on the in-state residency of a beneficiary who hasn’t received anything, can’t demand anything, and may never get anything from the trust. The court made clear that it was expressing “no opinion” on various other approaches to state trust taxation.
The deliberately narrow decision suggests that the court wasn’t eager to make broad constitutional pronouncements, but also confirms the court’s concern about taxation where states are loosely connected to trusts.
D.C. Taxation Based on Trust’s Creator
A trust is created when someone, a grantor, places assets under the care of a third party, a trustee, who is given instructions on how to manage the assets for the benefit of a beneficiary. Depending on how the assets are managed, such trusts can generate significant income, and states may tax that income if they are sufficiently connected to the trust.
Multiple state rulings—including in New York and Virginia—have cast doubt on one basis of trust taxation, where a state claims the right to tax trust income indefinitely because the grantor was a state resident when the trust became irrevocable.
But Washington, D.C. still applies that tax.
A 1997 District of Columbia Court of Appeals decision upheld the city’s policy in a particular context—when the trust was created through the will of someone who died as a D.C. resident. The court reasoned that the city, in this context, created a legal environment that allowed the trust to come into being, established the trust through administering the will, and provided court access to interested parties.
But a footnote to that decision, which didn’t have legal effect, explicitly questioned the tax when a D.C. resident created the trust during his or her life—creating what’s known as an “intervivos trust.” The court noted that the city’s laws and courts aren’t responsible in the same way for the trust’s existence and so the trust “does not have the same permanent tie to the District.”
Nenno, at Wilmington Trust, saw the footnote as cause for optimism for someone considering challenging that particular tax.
“The court specifically did not decide that question for intervivos trusts, so I think D.C. residents could clearly explore creating intervivos trusts and win a constitutional argument if challenged,” he said.
Nenno also questioned the 1997 ruling, and he wasn’t alone.
“My personal view is once all of the connections with D.C. are broken because there are no longer trustees, a creator, or certain kinds of beneficiaries in the city, then the city loses its constitutional basis to tax the trust,” said Natanya Allan, an attorney at Cochran Allan who focuses on estate planning in the D.C. area.
Ultimately, a constitutional test depends on someone deciding to sue and possibly also on which judges end up hearing the case.
And here there may be practical roadblocks to challenging the 1997 decision on trusts created through wills. Nenno pointed to how rarely the Supreme Court reviews any cases, assuming D.C. courts maintain their position, while Allan spoke of the potential practical challenge of finding a motivated plaintiff who’s able to sue.
“My clients who care most about this issue cannot bring a case because D.C.'s ability to tax their trusts cannot be challenged until they die,” she said.
A spokesperson for the D.C. Office of Tax Revenue confirmed the district’s trust tax policy but didn’t respond to questions about its constitutionality.
New York’s ‘One-Dollar Rule’
Practitioners also expressed skepticism about a New York tax on trusts, which mirrors the D.C. tax but adds a further requirement.
New York’s policy taxes all the income a trust generates in a tax year if the trust’s creator resided in New York when the trust became irrevocable and even a small amount of the trust’s income comes from New York state sources. Because a single New York-sourced dollar could theoretically trigger the tax, some refer to the policy as the “one-dollar rule.”
“This is becoming an issue especially for corporate trustees because they often have complex investment strategies, and somewhere along the line one of these investment funds has a minor interest in New York real estate that generates one dollar of source income,” said Michael Canfield, a fiduciary tax senior manager at Deloitte.
“One could argue that is overly broad,” he said.
Jonathan Rikoon, a partner at Loeb & Loeb who focuses on trust and estate issues, said he had heard in past years of the New York Tax Department sometimes offering to compromise when the amount of New York-sourced income, as a percentage of the total trust income, is minuscule and when the New York-sourced income is coming indirectly through a pooled investment fund.
“They have informally been willing to compromise those cases because they don’t want to risk having the current exemption structure overturned,” he said.
New York’s Department of Taxation and Finance didn’t respond to requests for comment.
California’s Throwback Rule
A California tax known as the throwback rule could also face a constitutional challenge.
The rule will come into play in cases where California wasn’t able to tax trust income in previous years because its only connection to the trust was the California residence of a beneficiary who didn’t have the right to demand the income. In these cases, the rule enables California to tax the beneficiary on such income later on, when the California beneficiary finally can demand the funds or actually receives them.
Nenno said he didn’t think practitioners should concede that the throwback rule is constitutional in light of the Kaestner decision and how income is computed on an annual basis in the tax system.
“I think there are good arguments to say that California shouldn’t be able to tax that income at all, because they are trying to tax beneficiaries who weren’t entitled to anything, and this is for the past years’ income,” he said. “That’s exactly what Kaestner said North Carolina couldn’t do.”
Ellen Harrison disagreed, saying there isn’t any constitutional constraint once the income goes to the beneficiary.
“There’s nothing that shocks the conscience about saying that a beneficiary’s taxable on the receipt of income that was accumulated in a prior year—the crucial point is that the beneficiary actually received it,” she said. Harrison is a partner at McDermott Will & Emery in Washington, D.C., where she focuses on estate planning and other tax issues.
California’s Franchise Tax Board declined to comment.