Merely Having an In-State Income Beneficiary Insufficient to Allow a State to Tax All Trust Income

The U.S. Supreme Court appears to be making June 21 its annual tax opinion day.  Or, at least, they’ve issued the major tax opinion of the term on June 21 for the past two years.  While last year’s issue related to sales taxes (Wayfair), this year the issue is whether a state can tax a trust solely based on the trust having a resident current income beneficiary, even if that beneficiary has no right to force a current distribution of such income, no such distribution is made, and there’ s no guarantee the beneficiary will ever receive such a distribution.

A unanimous Supreme Court decided that the answer is no, a state cannot impose its tax in that situation, in the case of North Carolina Department of Revenue v. The Kimberly Rice Kaestner 1992 Family Trust, United States Supreme Court, Case No. 18-457.[1]  Justice Sotomayor wrote the main opinion on behalf of the Court.

The Court was to decide if the North Carolina Supreme Court had correctly ruled that the imposition of this tax violated the Due Process Clause of the Fourteenth Amendment to the U.S. Constitution.  The opinion explains that, in the context of state taxation, two tests must be met by the state to not run afoul of the Due Process clause:

  • There must be a definite link between the state and the item 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.[2]

With regard to the first test that the Court decides this case upon, the opinion provides the following discussion of how that test is applied:

To determine whether a State has the requisite “minimum connection” with the object of its tax, this Court borrows from the familiar test of International Shoe Co. v. Washington, 326 U. S. 310 (1945). Quill, 504 U. S., at 307. A State has the power to impose a tax only when the taxed entity has “certain minimum contacts” with the State such that the tax “does not offend ‘traditional notions of fair play and substantial justice.’” International Shoe Co., 326 U. S., at 316; see Quill, 504 U. S., at 308. The “minimum contacts” inquiry is “flexible” and focuses on the reasonableness of the government’s action. Quill, 504 U. S., at 307. Ultimately, only those who derive “benefits and protection” from associating with a State should have obligations to the State in question. International Shoe, 326 U. S., at 319.

The opinion notes that the Supreme Court has found that such a minimum connection has existed in the trust context in the following situations:

  • Income is distributed to an in-state beneficiary;

  • The tax is based on the in-state residence of the trustee of the trust; and

  • The state is the site of trust administration (though the opinion in this case states the prior opinions “suggest” this result)[3]

None of those situations applied to the Kaestner Trust.  No distributions were made to Kimberly Kaestner or her children (the beneficiaries who lived in North Carolina) during the years in question, the trustee resided in Connecticut, the records of the trust were kept in New York, the custodians of the trust assets were located in Massachusetts, the trust had no property in North Carolina and the settlor of the trust did not reside in North Carolina.  Rather, North Carolina claimed the right to tax all undistributed income of the trust based solely on the residency of Kimberly Kaester, the trust’s potential income beneficiary who received no distributions in the years in question.

The Court wastes no time stating the ultimate holding it will make, immediately telling the reader:

We hold that the presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain ever to receive it. In limiting our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.[4]

The opinion notes that in previous opinions where the question of a beneficiary’s status and a state’s ability to impose a tax has arisen, the Court focused on “extent of the instate beneficiary’s right to control, possess, enjoy, or receive trust assets.”[5] 

The opinion notes that the same question regarding power and control have arisen when the Court has decided this issue based upon the residence of settlors and trustees.  The opinion states:

In Curry, for instance, the Court upheld a Tennessee trust tax because the settlor was a Tennessee resident who retained “power to dispose of ” the property, which amounted to “a potential source of wealth which was property in her hands.” 307 U. S., at 370. That practical control over the trust assets obliged the settlor “to contribute to the support of the government whose protection she enjoyed.” Id., at 371; see also Graves v. Elliott, 307 U. S. 383, 387 (1939) (a settlor’s “right to revoke [a] trust and to demand the transmission to her of the intangibles . . . was a potential source of wealth” subject to tax by her State of residence).

A focus on ownership and rights to trust assets also featured in the Court’s ruling that a trustee’s in-state residence can provide the basis for a State to tax trust assets. In Greenough, the Court explained that the relationship between trust assets and a trustee is akin to the “close relationship between” other types of intangible property and the owners of such property. 331 U. S., at 493.

The trustee is “the owner of [a] legal interest in” the trust property, and in that capacity he can incur obligations, become personally liable for contracts for the trust, or have specific performance ordered against him. Id., at 494. At the same time, the trustee can turn to his home State for “benefit and protection through its law,” id., at 496, for instance, by resorting to the State’s courts to resolve issues related to trust administration or to enforce trust claims, id., at 495. A State therefore may tax a resident trustee on his interest in a share of trust assets. Id., at 498.

For beneficiaries, the opinion holds:

When a tax is premised on the instate 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. Cf. Safe Deposit, 280 U. S., at 91–92.8 Otherwise, the State’s relationship to the object of its tax is too attenuated to create the “minimum connection” that the Constitution requires. See Quill, 504 U. S., at 306.[6]

In this fact pattern, the Court concludes it’s clear the beneficiaries do not have sufficient rights with regard to trust property to allow the state to impose its tax on trust income.

The Court refused to accept North Carolina’s view that a trust and its constituents are “inextricably intertwined” so that if, say, the fact that trustee residence would support taxation, the same must be true for the residency of the beneficiary.[7]  The opinion finds that the rights of beneficiaries vary too widely to allow the Court to accept the position that North Carolina’s view should be adopted as an absolute rule.

The Court also found that overturning North Carolina’s law would not serve to undermine a large number of state taxation schemes trusts.  The opinion notes that North Carolina is part of a very small minority states that claim the right to tax all income of a trust based on a resident beneficiary who received no distributions.[8]

Finally, the Court did not accept the state’s view that not allowing it to tax the trust’s income would inevitably lead to gaming of state tax systems.  The Court found that it was far from clear that would happen.  And even if that were the case, “mere speculation about negative consequences cannot conjure the ‘minimum connection’ missing between North Carolina and the object of its tax.”[9]

The Court specifically notes that this opinion does consider the validity of a state tax regime that considers the residency of a beneficiary as one factor in determining the taxation of  trust of trust income. One such state that has this sort of test is California.[10]

Justice Alito, joined by Chief Justice Roberts and Justice Gorsuch, wrote a concurring opinion to emphasize that this opinion is based on North Carolina’s “tenuous connection” to the trust and merely applies existing precedent to that narrow issue.  The opinion, in the view of the three who joined in this opinion, does not open up any prior opinion for reconsideration.

So what does this opinion add to our knowledge of the conditions under which a state can tax the income of a trust?  Not much, actually.  It seems possible, under the ruling, that trusts other than those with the unique characteristics of the Kaestner Trust might still find themselves subject to tax on all income of the trust by North Carolina based on the residence of a beneficiary so long as that person has sufficient rights to control, possess, enjoy, or receive assets of the trust.

All we really know is Kimberly Kaestner and her children have been found, under these facts, to not possess such rights.  And, therefore, North Carolina cannot impose its tax on this trust’s income at this time.  What other situations create similarly tenuous conditions that bar a state’s ability to tax will have to await future cases and decisions.

The opinion does recite other situations that do justify a state taxing all trust income, including simply have a trustee who resides in the trust (a test the state of Arizona uses to determine if it will claim the right to tax all of a trust’s undistributed income).

[1], Retrieved June 21, 2019

[2] Ibid, pp. 5-6

[3] Ibid, p. 6

[4] Ibid, p. 7

[5] Ibid

[6] Ibid, p. 10

[7] Ibid, p. 14

[8] Ibid, p. 15

[9] Ibid, p. 16

[10] Ibid, pp. 15-16