By Patricia A. Giarrantano, CPA
Caler, Donten, Levine, Cohen, Porter & Veil, P.A.
State Income Taxation of Trusts
How far can a state reach to subject a trust to taxation? The Kaestner Case highlights the issues relating to state taxation of trusts and the importance to consider state taxation of trusts when drafting, decanting and/or reviewing trusts.
In 1992, Joseph Lee Rice created a trust for the benefit of his children, including his daughter Kimberley Rice Kaestner. Mr. Rice and the trustee were both New York residents at the time the trust was created and none of the primary or contingent beneficiaries were residents of North Carolina and none of the trust assets were located in North Carolina.
In 2002, the original trust was divided into separate trusts for each of Mr. Rice’s children. At this time, Kimberley Kaestner was a resident of North Carolina. The assets of the trust were administered in Boston, the trustee was still a New York resident and the books and records were kept in New York City. Subsequently in 2005, the initial trustee was replaced with a trustee who was a resident of Connecticut. Pursuant to the trust document the trustee was given broad discretion to distribute trust assets and/or income to the beneficiary. The trust also required the trustee to distribute the trust assets to the beneficiary when she reached 40 years old. Prior to Kimberley turning 40, she had discussions with Mr. Rice and the trustee and expressed that she would prefer not to receive the assets of the trust. As a result of the conversation, the trust assets were transferred to a new trust thereby extending the trust term. During the years in question there were no distributions made to Kimberley. However, North Carolina taxed the Trust’s accumulated income based solely on the fact that the beneficiaries were residents of North Carolina, disregarding the fact that the beneficiary never received distributions from the trust. The Trust paid income tax to North Carolina totaling $1.3M from 2005 through 2008. In 2009, the Trust sought a refund from North Carolina but the North Carolina Department of Revenue denied the refund. In 2012, the trustee filed suit in the North Carolina Business Court, seeking a refund of the income taxes paid from 2005 through 2008. The trustee argued that the tax violated the Due Process Clause of the U.S. Constitution because the trust did not have sufficient minimum contacts with North Carolina, and thus was unconstitutional. The trustee also argued that the tax on the Trust’s income violated the Commerce Clause since the tax was not applied to an activity with a substantial nexus to the State of North Carolina. The Business Court agreed with the Trustee, holding that taxation of the Trust based solely on the residence of the beneficiaries deprived the Trust of property without due process of law under both federal and North Carolina constitutions.
The Department of Revenue appealed to the North Carolina Court of Appeals and later to the North Carolina Supreme Court. The Department of Revenue lost their appeal and appealed to the U.S. Supreme Court. The Supreme Court analyzed the Due Process Clause in context of state taxation stating that Due Process only allows individual states to impose taxes that bear fiscal relation to protection, opportunities and benefits given by the state. Furthermore, the tax must meet two requirements set forth in Quill Corp. There must be “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax” and” the income attributed to the State for tax purposes must be rationally related to values connected with the taxing State.” A state must meet both of the elements above in order for the proposed tax to pass the due process standard. The Supreme Court held that North Carolina had no minimum connection with the Trust citing that the Trust’s only connection to North Carolina was that the Trust’s beneficiaries were residents of North Carolina, there were no distributions made to the beneficiaries, the beneficiaries did not have a right of withdrawal and the trustee had absolute discretion when making distributions to the beneficiaries.
What might have happened if one of the above mentioned factors was slightly different? Apparently it is not enough of a “minimum connection” merely if the beneficiary is a resident of the taxing state, is it enough if the resident beneficiary has some right of withdrawal? Is it enough if all of the trustees are residents of the taxing state (as California seems to be claiming)? The Kaestner case highlights the importance of understanding individual state trust taxation and the issues that may arise which could subject a trust unknowingly to state taxation.
Patricia A Giarratano, CPA is a Tax Director at Caler, Donten, Levine, Cohen, Porter & Veil, P.A. located in West Palm Beach.