• Colin Doyle CFO

Tax Strategy A deep dive into Kaestner

We do not get a lot of tax cases decided by the Supreme Court, so when we get one, it is worth examining — even if it appears to be a very narrow ruling based on somewhat unusual facts.

Some trusts may be able to file claims for refunds based on the recent decision in Kaestner. Others may wish to restructure their trust terms to come within the facts involved in the decision. Some states may need to review their laws to come within the guidelines of the decision.

North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust (S. Ct. June 21, 2019), involved a North Carolina statute that subjects a trust to taxation in North Carolina based solely on the residence of a beneficiary of the trust within North Carolina. The statute subjects to tax any trust income for the benefit of the resident beneficiary. Neither the settlor of the trust, the trustee, nor trust assets were located in North Carolina — only the beneficiary. Under the terms of the trust, there was no automatic right of the beneficiary to distributions from the trust and the beneficiary had no power to require distributions. Also, there had in fact been no distributions to the beneficiary during the time period at issue and no assurance of future distributions.

Under these facts, a unanimous Supreme Court held for the taxpayer, citing to the Due Process Clause of the Constitution requiring some particular relationship between the North Carolina resident and the trust assets that the state seeks to tax. Under these facts, and limited to these facts, the court found an insufficient relationship between a discretionary beneficiary and the trust assets for the state to tax the trust. The same result had been reached by the North Carolina Supreme Court and lower courts in North Carolina, from which decision the Department of Revenue had appealed.

The court’s decision states specifically that the court does not decide what degree of possession, control or enjoyment would be sufficient to support taxation by North Carolina based on the residence there of the beneficiary. The court also indicated that the result might have been different depending upon whether a settlor, a trustee or a beneficiary was a resident in the state.

Implications for other states

The North Carolina statute was somewhat usual both in its focus solely on the residence of the beneficiary and no additional requirements to subject the trust to tax. More states focus on the residence of the settlor, the trustee, or where the trust is administered. Under a minimum-contacts Due Process analysis, it is likely that all three of these categories may have a closer relationship to the trust assets than the beneficiary may.

Fourteen states focus on the residence of the trustee, with about half of those states requiring some additional connection to the state, such as the settlor or the beneficiary.

Ten states have statutes focusing on where the trust is administered, with a couple of those states also requiring an additional connection to the state.

The most common basis of state taxation of trusts is for the statute to focus on the residence of the settlor of the trust at the time that the trust became irrevocable — 21 states plus the District of Columbia. Some of these statutes also require the in-state residence of a beneficiary. A few states fall into more than one of these categories.

In addition to North Carolina, only Georgia and Tennessee have similar statutes focusing solely on the residence of the beneficiary. However, Tennessee is phasing out its income tax by 2021, and Georgia’s statute is in dispute. California has a similar statute; however, it is limited to non-discretionary beneficiaries.

Tax planning

The North Carolina Department of Revenue raised the concern that to hold for the taxpayer would permit tax avoidance planning by locating the trust in a state that does not tax trust income and delaying distributions to a beneficiary until they locate to a state that does not have an income tax. The Supreme Court opinion acknowledges this possibility but also states that it would also require giving the beneficiaries less control over trust assets than may commonly be the case.

For states that focus on the residence of the beneficiary, trusts may want to consider restricting the rights of the beneficiary with respect to distributions similar to what was done in the Kaestner trust. Trust drafters should also be alert to the possibility of a beneficiary subsequently moving to such a state.

For states that focus on the residence of the settlor, the best focus for trusts would appear to be to try to eliminate any other contacts with the state. It may frequently be the case, for an irrevocable trust, that the settlor no longer has any control over or right to the trust assets.

A few states may have to revise their trust taxation statutes in line with the Kaestnerdecision.

Other implications

Some observers thought that, following the Supreme Court’s decision in Wayfair (Wayfair v. South Dakota, 138 S. Ct. 2080 (2018)) on taxation of online sales, the court here might also stake out new ground on the Due Process Clause nexus test, but the court stuck close to the analysis it had undertaken in the earlier Quill (Quill v. North Dakota, 504 U.S. 298 (1992)) decision and did not break new ground.

The trial court in North Carolina had also held that the statute violated the Commerce Clause as well as the Due Process Clause of the Constitution. However, the North Carolina appellate courts and the Supreme Court focused only on the Due Process Clause.

It remains unclear whether and to what extent any rights of the beneficiary to trust assets might still avoid the minimum contacts requirement, such as the right to assign income or assets or the right to future distributions from the trust. If the trust does not benefit in some way from a particular state in a given year, there may be an argument that the necessary minimum contacts do not exist.

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