The U.S. Supreme Court ruled in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust that states cannot tax the income of out-of-state trusts based only on in-state resident beneficiaries. The case involved a North Carolina law that allows the state to tax trust income that “is for the benefit of” a resident. North Carolina applied the law to tax the income of an out-of-state trust based on beneficiaries who lived in the state.
A unanimous Court concluded that the law as applied to the out-of-state trust violated the Due Process Clause of the U.S. constitution. The presence of in-state beneficiaries alone does not allow states to tax trust income if:
- the trust has not distributed the income to the beneficiaries; and
- the beneficiaries have no right to demand that income and are uncertain ever to receive it.
Origins of Kaestner
The grantor formed the Kaestner trust in his home state of New York for the benefit of his children. New York law governed the trust and a New York resident served as its first trustee. A Connecticut resident served as trustee at the time of the dispute. The trustee had absolute discretion over trust distributions.
The grantor’s daughter and her children lived in North Carolina. The trustee did not distribute any income from the trust to the daughter or her children during this time.
The trustee kept the trust documents and records in New York. Custodians located in Massachusetts managed the trust’s assets. The trust had no physical presence, held no real property, and made no direct investments in North Carolina.
North Carolina issued a tax assessment of $1.3 on the income of the Kaestner trust for the tax years in question. The trustee paid the tax under protest and then sued in state court for a refund. The North Carolina courts found the link between the state and the trust too tenuous to meet due process requirements.
Minimum Contacts Analysis
The Court applies a two-step analysis to determine if a state tax satisfies the Due Process Clause. First, some definite link or minimum connection must exist between a state and the person, property or transaction it seeks to tax. Second, a rational relationship must exist between the income subject to tax and the values connected with the state.
When looking at the state trust taxes, the Court has focused on the relationship between:
- the settlor, trustee, or beneficiary; and
- the trust assets that the state seeks to tax.
For beneficiary contacts, it has examined the in-state beneficiary’s right to:
- enjoy; or
- receive trust assets.
The Kaestner beneficiaries did not have any minimum connection to support the North Carolina’s tax on the trust. The beneficiaries:
- did not receive any income distributions from the trust;
- had no right to demand trust income or otherwise control, possess, or enjoy the trust assets; and
- could not count on receiving any specific amount of income from the trust in the future.
The Court made it very clear that its decision is narrow in scope. It noted that North Carolina is one of a small number of states that rely only on beneficiary residency as a basis for trust taxation. Tennessee has a law like North Carolina, but it is phasing out its income tax. California applies its tax based on the residency of noncontingent beneficiaries.
The decision also did not address the validity of state laws that:
- consider the in-state residency of a beneficiary as one of a combination of factors; or
- turn on the residency of a settlor.
So, the Kaestner ruling leaves open many unanswered questions about the limits on a state’s power to tax trust income.
By Tim Bjur, J.D.