Jared R. Adams

Jared R. Adams
Associate

On Friday, the U.S. Supreme Court unanimously affirmed the North Carolina Supreme Court’s decision in Kaestner Family Trust. That decision struck down a North Carolina statute that taxed trust income if a trust beneficiary is a North Carolina resident.

N.C. Dept. of Revenue v. Kaestner Family Trust

The North Carolina statute in question, N.C. Gen. Stat. Ann. § 105-160.2, imposed a tax on any trust income that “is for the benefit of” a North Carolina resident. This meant that North Carolina could tax any trust, even if it is administered out-of-state and has no other connection to North Carolina, on the sole basis that trust beneficiaries reside in the State.

Trust Income Tax Violates Due Process Clause

Justice Sotomayor wrote for the Court, holding the State’s tax violates the Due Process Clause of the Fourteenth Amendment. The Kaestner Family Trust was established by a New York resident, subject to New York law, had a New York trustee, kept Trust documents and records in New York, and had trust custodians in Massachusetts. The only connection to North Carolina was one of the beneficiaries being a resident of the State. The Trust had no direct investments in the State and held no real property there.

In assessing the case, the Court focused on “the extent of the in-state beneficiary’s right to control, possess, enjoy or receive trust assets.” Here, Kimberly Rice Kaestner, the beneficiary of the Kaestner Family Trust, and her children were residents of North Carolina during the tax years in question. During these years, Kaestner received no distributions from the Trust, had no right to demand income or distributions from the Trust, and could not count on ever receiving either. The Trust gave its trustee the absolute discretion and exclusive control over the timing and amount of distributions to its beneficiaries.

To satisfy Due Process, there must be sufficient minimum contacts with the taxing state. The Court previously held a tax on income distributed to in-state residents, on trust income where the grantor or trustee is an in-state resident, and where the trust is administered are all sufficient connections to the taxing state.

Here, the Court held, “When a tax is premised on the in-state 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.” If the in-state beneficiary lacks such possession, control, or enjoyment of the trust property, the State’s relationship is “too attenuated to create the ‘minimum connection’ that the Constitution requires,” and the tax fails to satisfy Due Process.

Unclear Whether Assignment Rights Demonstrate Sufficient Control

The Court refused to answer whether a beneficiary’s right to assign a potential interest in trust property would afford sufficient control, possession, or enjoyment over such property to justify taxation otherwise based solely on the beneficiary’s in-state residency. This will be a question to watch over the coming years as the Supreme Court’s jurisprudence continues to develop in the taxation of trusts and estates.

Out-of-State Trusts and Virginia Law

Both Justices Sotomayor and Alito referenced previous Supreme Court cases involving taxes imposed by Virginia. Justice Alito’s concurring opinion focused heavily on the previous decisions in Brooke v. Norfolk, 277 U.S. 27 (1928), and Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83 (1929).

In Brooke, the Court struck down a Virginia tax assessed on the entirety of a trust’s assets when the beneficiary was a resident of the State. The Court noted even though the beneficiary had a present and ongoing right to receive trust income, Virginia could not tax undistributed assets that remained in the out-of-state trust.

Further, the Court in Safe Deposit held a beneficiaries’ residence in Virginia did not by itself allow the State to tax assets that remained in trust. In that case, the beneficiaries satisfied an age condition and became equitable owners of intangible trust property. However, the Court ruled such an equitable ownership of undistributed assets was not enough to connect the assets to Virginia and subject it to tax.

As we wrote last month, in its latest session, the Virginia General Assembly amended the definition of “resident estate or trust” to remove the ability to impose an income tax on trusts that have a Virginia trustee. Though the Supreme Court reaffirmed the constitutionality of states imposing such a tax, it’s possible Virginia legislators saw that such a provision would be ripe for challenge and took this step out of an abundance of caution.

As the taxation of out-of-state trusts continues to develop, please reach out to Woods Rogers’ Trusts & Estates attorneys with any questions.