Supreme Court to Review Case Regarding When a State May Impose Its Income Tax on a Trust

The US Supreme Court has agreed to look at under what circumstances a state can impose its income tax on a trust by granting certiorari in the case of North Carolina Dept. of Revenue v. Kaestner Family Trust, Case No. 18-457.

Last July the North Carolina Supreme Court decided that the state had no right to impose its income tax on a trust that, while it had a North Carolina beneficiary, was established in New York, did not have a North Carolina trustee and had no property in North Carolina.  (See the prior article on Current Federal Tax Developments that discussed the original case along with another case on state taxation of trusts at Two States Find Their State’s Statutes for Taxing Trusts Violate Due Process Clause.)

As noted at the time, the North Carolina Supreme Court found that there were not sufficient contacts in this case to the state, with the imposition of the tax violating the due process clause:

For taxation of a foreign trust to satisfy the due process guarantee of the Fourteenth Amendment and the similar pledge in Article I, Section 19 of our state constitution, the trust must have some minimum contacts with the State of North Carolina such that the trust enjoys the benefits and protections of the State. When, as here, the income of a foreign trust is subject to taxation solely based on its beneficiaries’ availing themselves of the benefits of our economy and the protections afforded by our laws, those guarantees are violated. Therefore, we hold that N.C.G.S. § 105-160.2 is unconstitutional as applied to collect income taxes from plaintiff for tax years 2005 through 2008. Accordingly, we affirm the decision of the Court of Appeals that affirmed the Business Court’s order granting summary judgment for plaintiff and directed that defendant refund to plaintiff any taxes paid by plaintiff pursuant to section 105-160.2 for tax years 2005 through 2008.

The July 2018 article cited above also discussed the Minnesota Supreme Court’s ruling in the case of Fielding v. Commissioner of Revenue.  That case similarly decided that the state could not tax a true due to lack of minimum contact.  In the Minnesota case, the state claimed the right to tax the trust because the original grantor was a Minnesota resident when the trust became irrevocable, even though in the year in question no trustee resided in Minnesota, there were no Minnesota beneficiaries, and there was no property in Minnesota. 

The Minnesota Department of Revenue is also asking the Supreme Court to review this decision.  In that petition the Department notes that state high courts have issued conflicting rulings in this area:

Some state appellate courts have held that a state may impose an income tax on a trust even when the trustee resides out-of-state, so long as the grantor resided in-state when the trust became irrevocable. Other courts have required, on top of grantor residence, that the trust have some additional contacts with the state during the tax year. One other state high court has held that a state may tax a trust as a resident if a beneficiary of the trust resided in the state during the tax year. Under any of those rules, Minnesota could have taxed the trusts at issue here. Other state appellate courts, however, have focused on the residence of the trustee and held that the Due Process Clause bars states from taxing resident trusts administered out-of-state despite significant in-state contacts. The Minnesota Supreme Court's decision here deepens that conflict.

The Supreme Court has not yet announced if it will take up this case as well.

In an article covering the Supreme Court’s grant of cert, Andrea Muse of Tax Analysts cited attorney Michael Lurie’s view that the Court took this case to deal with differing holdings among the states in this area that Minnesota cites.  The article notes Mr. Lurie’s view of the potential consequences of this case:

Lurie said a decision by the Court in favor of the trust could open states that have ruled that such taxation of trusts is constitutional (including California, Missouri, and Connecticut) to refund claims.[1]

The North Carolina Department of Revenue argues in its November 30 brief, likely looking to bring in some of the considerations the Supreme Court raised in the Wayfair sales tax case, that allowing the North Carolina Supreme Court ruling to stand would allow taxpayers to create trust-based devices to avoid state income taxes completely:

The Trust’s brief also reveals this case as an example of how trusts are exploiting a judicially created tax shelter. The Trust engaged a trustee in Connecticut, conducted its business in New York, and existed solely for the benefit of a resident of North Carolina. Yet if the Trust succeeds in this case, none of those states (or any other) will have taxed the full extent of the Trust’s income during the tax years at issue.

That analysis does capture one important feature of state trust income taxation, namely that the states have varied rules for when the state will impose its income tax on a trust.  It certainly is possible in many cases to achieve a structure where tax is avoided, especially if the location of the grantor when the trust becomes irrevocable is found not to be a basis upon which the state may impose its tax (which was the holding of the Minnesota Supreme Court).

Of course, the Supreme Court could decide this case on a basis that isn’t as broad as the above analyses might suggest. However, advisers who work with trusts should keep a close watch on this case and the eventual opinion issued by the Court.

[1] Andrea Muse, “Supreme Court Agrees to Hear Trust Taxation Case,” Tax Notes Today, 2019 STT 9-1, January 14, 2019