The State of State Taxation of Trusts and the U.S. Supreme Court Decision in Kaestner
Date
August 27, 2019
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25 minutes
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By Stuart J. Kohn and Steven L. Kriz
This article was originally published in Bloomberg Tax.
INTRODUCTION
A state’s taxation of a non-grantor trust’s income has historically been an important piece of the estate planning puzzle. Unfortunately, it’s been the puzzle piece that has many curves and prongs because if, and when, a state will tax a trust’s income varies from state to state. Currently, 43 states and the District of Columbia impose a tax on the income of a ‘‘resident’’ trust. The difference comes down to how the states define the term. Some states will tax the income of a trust if the settlor was a resident of the state at the time the trust was created. Others will tax the trust’s income if the trustee is a resident of the state. Still others will tax the trust’s income if a beneficiary is a resident of the state. Some states will tax the trust’s income if the trust is administered in the state. Finally, some states actually consider more than one of the foregoing factors when determining whether the trust is a ‘‘resident’’ trust for income tax purposes.
These differences in how and when a state will tax a trust’s income can provide planning opportunities and pitfalls for estate planning practitioners. For example, Illinois taxes the income of trusts created under a will of an Illinois decedent, or an inter vivos trust created by an Illinois resident.¹ New Mexico taxes the income from a trust with a resident trustee (even if there is a co-trustee in another state), or a trust administered in New Mexico.² California taxes the income of a trust with a resident beneficiary or with a resident trustee or fiduciary.³ Florida does not have an income tax, and therefore does not tax a trust’s income. Consequently, consider the following:
- A non-grantor trust created by an Illinois resident, with New Mexico and Florida co-trustees, administered in New Mexico, and one beneficiary who is a resident of California. Here, three states would tax the income on this trust.
- A non-grantor trust created by a California resident, with Illinois and Florida co-trustees, administered in Illinois, and a New Mexico beneficiary. The income of the trust would not be taxed by any state.
As this example illustrates with slight variations in the applicable factors, the state tax burdens on a trust can be significant or non-existent. As trusts continue to accumulate wealth and continue indefinitely (particularly dynasty trusts in light of states’ extension or repeal of the rule against perpetuities), trustees of those trusts, and the estate planners and accountants that advise those trustees, must understand the tax implications of changes in the trusteeship, movement of the beneficiaries, and the location of the trust’s assets.
This landscape has shifted from time to time, with a new shift in recent years as the constitutionality of the various states’ regimes for taxation of a trust’s income has been questioned. Several state courts, including in Illinois and Pennsylvania, have found that state statutes taxing a trust’s income solely on the basis of the settlor’s residence in that state were unconstitutional.4 Around the same time, a case was working its way through the state courts in North Carolina, addressing the constitutionality of that state’s statute taxing a trust’s income based solely on the fact that the beneficiary of the trust was a resident of North Carolina. That case, Kaestner 1992 Family Trust v. North Carolina Dept. of Revenue, climbed all the way to North Carolina’s highest court, and, ultimately, to the U.S. Supreme Court.
On April 16, 2019, the Supreme Court heard arguments in North Carolina Dept. of Revenue v. The Kimberley
Rice Kaestner 1992 Family Trust. The issue was whether North Carolina could tax the income of a trust based solely on the fact that a beneficiary of the trust was a resident of North Carolina. When the case was heard, many commentators and practitioners wondered whether the Supreme Court’s decision in Kaestner could have ripple effects on if, when, and how some states tax a trust’s income, and as a result, impact both the administration of existing trusts as well as planning around creation of trusts going forward.
On June 21, 2019, the Supreme Court released its 9-0 decision upholding the North Carolina court’s decision.5 With the decision, some narrow questions were answered, but several important questions remain unanswered.
The issue presented in the case was whether North Carolina could tax the income of a trust based solely on the fact that a beneficiary of the trust is a resident of North Carolina. The Supreme Court found in favor of the Kimberley Rice Kaestner 1992 Family Trust (Trust). Specifically, the Supreme Court held that the North Carolina tax statute violated the Trust’s constitutional right to due process because: (1) the Trust’s only connection to North Carolina was that the Trust’s beneficiaries were residents of North Carolina; (2) no distributions had been made to the beneficiaries from the Trust; (3) the beneficiaries did not have a right of withdrawal; and (4) the trustee had absolute discretion to make distributions or not, and to make them to any beneficiary to the exclusion of the other beneficiaries.
As such, the decision is limited in its effect. The Supreme Court admittedly did not address other factors that may be more commonly found in the drafting and administration of irrevocable trusts and could impact the taxation of a trust’s income. At the same time, the Supreme Court did provide some hints (non-binding, of course) as to how it might resolve the case under different facts. Before reviewing the factors, however, a thorough review of the facts in Kaestner and the Supreme Court’s opinion is warranted.
BACKGROUND
In 1992, Joseph Lee Rice created a trust for the benefit of his children, including Kimberley Rice Kaestner, the named appellee (Kimberley). The settlor and the initial trustee were both New York residents and, at the time the trust was created, none of the primary and contingent beneficiaries were residents of North Carolina. None of the assets were located in North Carolina.
In December 2002 the original trust divided into separate trusts for each of the settlor’s children. At that time, Kimberley and her family were residents of North Carolina. The assets held by the Trust were administered in Boston; the trustee was still a resident of New York; the trust’s books and records were kept in New York City; and the tax returns and accountings were all prepared in New York City. In 2005, the initial trustee was replaced by a successor trustee who was a resident of Connecticut.
Per the trust document, the trustee of the Trust (Trustee) was given broad discretion to make — or not to make — distributions of income or principal to the beneficiaries. The Trust also required the Trustee to distribute the trust assets to Kimberley when she reached age 40. In 2009, before her 40th birthday, Kimberley had conversations with the settlor and the Trustee about whether she wished to receive the trust assets. As a result of those conversations, the Trustee ultimately transferred, presumably through decanting, the assets to a new trust, thereby extending the term of the trust.
The North Carolina tax code imposes a tax on trusts ‘‘on the amount of taxable income of the . . . trust that
is for the benefit of a resident of [North Carolina].’’6 To comply with North Carolina’s statute, the Trustee
filed North Carolina income tax returns on behalf of the Trust, and paid the applicable income tax, for tax
years 2005 through 2008.
During the tax years in question, the current beneficiaries resided in North Carolina but the Trustee made
no distributions to those beneficiaries. North Carolina taxed the Trust’s accumulated, but not distributed, income based solely on the fact that the beneficiaries of the Trust were residents of North Carolina, disregarding the fact that the beneficiaries did not receive, and might not ever actually receive, a distribution from the Trust. As a result, having previously paid the income tax for tax years 2005 through 2008, the Trustee subsequently sought a refund of those taxes— totaling $1.3 million—in 2009. The North Carolina Department of Revenue (Department of Revenue) denied the request for a refund.
In 2012, the Trustee filed suit in the North Carolina Business Court (Business Court),7 seeking a refund of the income taxes paid from 2005 through 2008. The Trustee argued that the tax violated the Due Process Clause of the U.S. Constitution as well as the similar provision of the North Carolina Constitution because the trust did not have sufficient minimum contacts with North Carolina, and, thus, was unconstitutional. The Trustee also argued that the tax on the Trust’s income violated the Commerce Clause as the tax was not applied to an activity with a substantial nexus to the taxing state. The Business Court agreed with the Trustee, finding that taxation of the Trust based solely on the residence of the beneficiaries deprived the Trust of property without due process of law under both the federal and North Carolina constitutions and also violated the Commerce Clause.
The Department of Revenue appealed to the North Carolina Court of Appeals, and later to the North Carolina Supreme Court. Both courts agreed that the state’s taxation of the trust income as applied to the facts in the case deprived the Trust of property without due process of law. The Court of Appeals found it unnecessary to address the Commerce Clause argument because it found that the Trust had been deprived of due process. After both failed appeals, the Department of Revenue appealed to the U.S. Supreme Court.
THE SUPREME COURT’S DECISION
Section 1 of the Fourteenth Amendment to the U.S. Constitution contains the Due Process Clause providing that all persons are guaranteed the right of due process of law before a state may deprive a person of life, liberty, or property. The Constitution does not tell us what exactly that means, so to determine whether property was deprived without due process of law in any instance requires an analysis of over 150 years of jurisprudence.
The Supreme Court in Kaestner analyzed how the Due Process Clause is applied in the context of state taxation as follows: the ‘‘Due Process Clause limits States to imposing only taxes that bear fiscal relation to protection, opportunities and benefits given by the state.’’8 To determine whether a tax bears fiscal relation to protection, opportunities, and benefits given by the state, the tax must meet the two requirements set forth in Quill Corp.9 First, there must be ‘‘some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’’10 Second, ‘‘the income attributed to the State for tax purposes must be rationally related to ‘values connected with the taxing State.’ ’’11 A state must meet both of these elements in order for the proposed tax to pass the due process analysis. In its opinion in Kaestner, the Supreme Court did not address the second requirement because North Carolina could not meet the minimum connection requirement.
Minimum Connection
A long line of cases has shaped the Supreme Court’s analysis of whether a minimum connection between the state and the person, property, or transaction it seeks to tax exists.12 In applying the International Shoe analysis to the minimum contact test for the taxation of trusts, the Supreme Court has stated it will analyze ‘‘the relationship between the relevant trust constituent (meaning, the settlor, trustee, or beneficiary) and the trust assets that the State seeks to tax.’’13 When looking at a tax based on an in-state beneficiary, the Supreme Court has said it is ‘‘focusing on the extent of the in-state beneficiary to control, possess, enjoy, or receive trust assets.’’14
The Supreme Court in Kaestner did not invalidate the North Carolina statute. It did not find that state taxation of trust income based upon the location of beneficiaries is unconstitutional on its face. It merely applied the International Shoe analysis and found that there were not sufficient contacts between the Trust and North Carolina. The Supreme Court held 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.’’15 As a result, this statute as applied to trusts with other facts might satisfy the minimum contacts analysis.
The decision outlines the following four reasons why the facts, as applied here, did not rise to the level that would meet the minimum connection test: (1) The Trust’s only connection to North Carolina was that the Trust’s beneficiaries were residents of North Carolina; (2) no distributions had been made to beneficiaries from the Trust; (3) the beneficiaries did not have a right of withdrawal; and (4) the Trustee had absolute discretion as to making distributions. Practitioners are left to wonder whether, if any one of these reasons were slightly different, the Supreme Court may have found differently.
North Carolina’s Only Connection to The Trust was the In-State Residence of the Trust’s Beneficiaries
In discussing the connection to the beneficiaries, the Supreme Court stated that ‘‘[f]rom 2005 through 2008, the Trustee chose not to distribute any of the income that the Trust accumulated to [Kimberley] or her children, and the Trustee’s contacts with [Kimberley] were ‘infrequent.’ ’’16 The Supreme Court pointed out that the Trust was subject to New York law, the grantor was a New York resident, no trustee lived in North Carolina, the documents and records were kept in New York, the custodians of the assets were located in Massachusetts, and the Trust
maintained no physical presence in North Carolina, made no direct investments in North Carolina, and held no real property there.17 The language the Supreme Court used to describe the connections the Trust had to North Carolina suggest that even slightly different facts could have resulted in a finding in favor of North Carolina.
What facts would sway the Supreme Court to find that a beneficiary’s connection alone is enough to satisfy a due process analysis? After all, this Court did state that ‘‘One can imagine many contacts with a trust or its constituents that a State might treat, alone or in combination, as providing a ‘minimum connection’ that justifies a tax on trust assets.’’18
No Trust Distributions Were Made to the Beneficiaries
The next few points are related, but distinct enough to separate them. In fact, the Supreme Court also separated them in its discussion. The first, whether a distribution was actually made to the beneficiary, targets the result of an action while the latter two — the absolute discretion of the trustee to make distributions and the right of the beneficiaries to demand distributions—target the ability of the trustee or beneficiaries to take action.
The Supreme Court spent little time addressing actual distributions, aside from pointing out that if the beneficiaries did receive any income from the trust, it would have been taxable to them. While the language is relatively straightforward, we live in a world of possibilities, and strange things happen. What if a trust earned income in one year and distributed principal in the next? If the tax were challenged, would the actual distribution in the following year sway the Supreme Court’s decision to find that the income was taxable in the prior year? It is unclear from the opinion how the Supreme Court would rule. Arguably, while no distributions would have been made during the year in question, a subsequent principal distribution made to the North Carolina beneficiary could certainly have been the undistributed income of the preceding year.
What about similar facts to Kaestner where the trust document provides that all principal would be distributed to a beneficiary on her 40th birthday? The Supreme Court noted that the Trustee determined that the assets would continue to be held in trust even after Kimberley’s 40th birthday. Although the Supreme Court said this was irrelevant to their decision, what if no modification had been made and all principal was actually distributed to the beneficiary? What if the governing state did not allow a trust to be decanted? Under those facts, would the Supreme Court consider a future, definite trust termination?
The Trustee had Absolute Discretion to Make or not Make Distributions
The Supreme Court pointed out several times that the trust document provided that the Trustee had ‘‘absolute discretion’’ to make distributions to the trust beneficiaries. Because the Trustee had ‘‘absolute discretion,’’ the Supreme Court pointed out that the beneficiaries could not ‘‘demand trust income or otherwise control, possess, or enjoy the trust assets in the years at issue.’’19 What if the trustee was required to make distributions of income, but not required to make principal distributions? What if the trust was not a spray trust (i.e., only had one beneficiary) and required the trustee to distribute all principal to the beneficiary at age 40? Would the Supreme Court find under those circumstances that the trustee did not have absolute discretion?
Discretionary Distributions
The Kaestner trust document provided that the Trustee was to view the trust ‘‘as a family asset and to be liberal in the exercise of the discretion conferred,’’ and included language indicating that goal of the trust was to meet the beneficiaries’ needs. Citing the Restatement (Third) of Trusts, the Supreme Court also observed that ‘‘the trustee of a discretionary trust has a fiduciary duty not to ‘act in bad faith or for some purpose or motive other than to accomplish the purposes of the discretionary power.’ ’’20 That being said, the Supreme Court still concluded that the Trustee had sole discretion with respect to distributions, and that the beneficiaries had no entitlements otherwise.
Many estate planners think of ‘‘absolute discretion’’ in this context as the familiar ‘‘best interests’’ standard. Most practitioners would agree that the incorporation of the best interests standard in a trust document is meant to provide the trustee with absolute discretion. The trust document in Kaestner did, however, go a bit further in indicating that the goal of the Trust to was provide for the beneficiaries’ needs. What if the language of the Trust, while still granting the Trustee discretion, instead included the typical ascertainable standards of health, education, maintenance, and support? Also, what if the language required distributions for support rather than discretionary distributions for support — would the result in Kaestner have been different? Indeed, in countering
the Department of Revenue’s arguments, the Supreme Court noted in this case that ‘‘a beneficiary may have only a ‘future interest,’ an interest that is ‘subject to conditions,’ or an interest that is controlled by a trustee’s discretionary decisions.’’21
In either event, the Supreme Court said that the instructions must give the trustee liberal discretion. This finding is consistent with the overall theme that one cannot foresee what distributions a trustee may or may not make if left to the trustee’s discretion. One could discern that the Supreme Court perhaps wanted to make a point that if the standard was an ascertainable one, the question of distributions would no longer have been ‘‘if’’ the distributions would occur but ‘‘when’’ they might occur as distributions under ascertainable standards would have been more reasonably certain to have occurred. On the other hand, a question arises whether limitations on distributions for health, education, maintenance, and support are, at their essence, conditions—they are conditions upon which the trustee must make a distribution. This would seem to suggest that being subject to conditions would not rise to the level so as to satisfy due process.
Investment Decisions
The Supreme Court also makes a point of adding that the Trustee, and not the beneficiaries, is authorized to make investment decisions regarding the Trust’s property. This is typical. Most trust documents provide that a trustee has all of the discretion for making investment decisions. Sometimes, however, a settlor might want a beneficiary who is not acting as a trustee to make investment decisions. Would the Supreme Court’s decision have been different if the beneficiaries had some say in investment decisions? Such a power might mean that the trustee does not have absolute discretion. Note that, if the trust assets are administered in a state, such activity could be enough to meet the minimum contacts to allow the state to tax the income of the trust. It really does not matter that the person administering the assets in the example above is a beneficiary—the connection to the state is there regardless.
Powers of Appointment
While the beneficiaries in Kaestner did not have a power of appointment, the Supreme Court’s opinion suggests that, if they did, the result may have been different. The Supreme Court stated that ‘‘the Trust agreement prohibited the beneficiaries from assigning to another person any right they might have to the Trust property . . . thus making the beneficiaries’ interest less like a ‘potential source of wealth [that] was property in [their] hands.’ ’’22 The Supreme Court reasoned that if a beneficiary could exercise their powers of appointment, such a power is a ‘‘potential source of wealth’’ to the beneficiary.23 It seems logical that if a person has a general power of appointment, it is a potential source of wealth because the person can exercise the power in favor of any person or organization, including, potentially, the beneficiary holding the power. What if a power of appointment can only be exercised in favor of a limited class of persons determined by the settlor? Would that still be considered a potential source of wealth, even though the beneficiary does not have absolute discretion? While admittedly, the trustee would not then have absolute discretion, the more limited the power of appointment, the less likely it seems that the power is a potential source of wealth to the beneficiary.
No Right of Withdrawal
Similarly, the opinion states that the beneficiaries were unable to demand distributions in the tax years, nor count on any distribution of a specific amount of income anytime in the future.24 If a trust document allows for rights of withdrawal for the beneficiary the applicable portion of the trust corpus is no longer subject to the trustee’s discretion. In this respect, a right of withdrawal is also a potential source of wealth for the beneficiary because the beneficiary can make the determination as to the distribution of the trust corpus.
MORE GUIDANCE?
As noted at the outset of this article, there have been a number of state court decisions in recent years that have addressed the constitutionality of a state’s taxation of a trust’s income. Those cases involved statutes imposing a tax on a trust’s income solely based on the settlor’s residency in the state. Unfortunately, at this point, the Supreme Court has spoken on the topic of the taxation of trust income by the states, and it does not appear that it will be addressing the topic again any time soon. On June 28, 2019, the Supreme Court denied certiorari on Fielding v. Commissioner of Revenue — a Minnesota case that addressed the state’s taxation of trust income solely based on the fact that the trust settlor was a Minnesota resident at the time the trust became irrevocable.
Earlier this year, the Minnesota Supreme Court decided Fielding v. Commissioner of Revenue in favor of four related trusts.25 In 2009, Reid MacDonald, the grantor, created four trusts. At the time the trusts became irrevocable for Minnesota purposes the grantor was still a Minnesota resident, so the trusts were considered ‘‘resident trusts’’ under Minnesota law. Minnesota law provided that resident trusts are taxed on their income and gains from intangible property. When the trusts became irrevocable, their trustee was a Colorado resident; later, in 2014, the trustee was changed to a Texas trustee. In that same year, the trusts sold stock, resulting in a gain.
The trustee filed 2014 taxes under protest alleging that the Minnesota statute was unconstitutional as applied to the trusts and deprived the trusts of due process. The Commissioner denied the trustee’s request for refund. The trustee appealed to the Minnesota Tax Court, which found in favor of the trusts. The Commissioner then appealed to the Minnesota Supreme Court.
The Minnesota Supreme Court also found in favor of the trusts. In clarifying that they were not redefining a ‘‘resident trust,’’ the Minnesota Supreme Court determined that all relevant facts need to evaluated when considering whether the application of a statutory definition would be consistent with due process.
The court found that the residency of the grantor was not relevant to the relationship between the trust income that the state sought to tax and the ‘‘protection and benefits [the state] provided to the [trust’s] activities that generated the income.’’26 The court stated that the relevant connection to the state is its connection to the trustee, not the connection to the grantor. The court was also swayed that the trusts did not own any physical property in Minnesota. Any contacts between the trust and state that pre-dated the tax years in question, were, according to the court, irrelevant.
During the years in question, only one of the four beneficiaries of the trusts was a Minnesota resident. The trustee had almost no contact with Minnesota. All trust administration activities occurred outside of Minnesota.
The Minnesota Supreme Court did not address whether distributions were made to the beneficiaries or whether the beneficiaries had rights of withdrawal or any powers of appointment, but from the facts, we can conclude that the trusts certainly were not administered in Minnesota.
For now, it is clear that courts in recent years have considered whether the Due Process Clause has been satisfied when reviewing a state tax on trust income and have leaned toward a more strict reading of the Due Process Clause in those cases.
PLANNING CONSIDERATIONS IN LIGHT OF RECENT CASES
While most estate planning practitioners are not actually thinking day-to-day about whether the requirements of the Due Process Clause have been met when drafting wills and trusts, it is apparent that we all must continue to consider the taxing statutes of the state of residence of the settlor, trustee, and beneficiaries, as well as the state in which the trust is administered. While we may not have options regarding the identity of the settlor or beneficiaries, we may have flexibility as to the identity of the trustee or the state in which the trust is administered. As a result, we may be able to impact which state(s) will tax the trust’s income.
In addition, the applicable taxing authorities and statutes must be considered when drafting the trust document. As discussed in Kaestner, many of the trust provisions that practitioners draft on a daily basis, such as the discretion given to the trustee to make distributions, whether a beneficiary is given authority to manage trust assets, whether beneficiaries are given rights of withdrawal, or even whether the beneficiaries are given powers of appointment, could have changed the Supreme Court’s decision.