Kaestner: States Cannot Tax Trusts Based Solely on Residency of Beneficiaries

The U.S. Supreme Court recently released its opinion in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, largely vindicating the understanding of most estate planners: A state cannot tax the income of a trust where the only connection to the state is the presence of the trust’s discretionary beneficiary.

Facts in Kaestner

The facts in Kaestner, in brief, are as follows. Joseph Lee Rice III formed a trust for his children’s benefit in his home state of New York, with a New York resident as trustee. The trustee had absolute discretion to distribute the trust’s assets to beneficiaries. In 1997, Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina. At a later date, the trustee divided Mr. Rice’s trust into several subtrusts, one of which was the Kimberley Rice Kaestner 1992 Family Trust (the “Trust”), the beneficiaries of which were Kaestner and her children.

North Carolina sought to tax the entirety of the Trust’s income,[1] even though, during the relevant period for which the state assessed taxes of more than $1.3 million, Kaestner did not receive any distributions from the Trust. Moreover, the Trust did not have a physical presence in North Carolina, nor did it make any direct investments or hold any real property in the state. The Trustee’s contacts with Kaestner were infrequent, the Trust was subject to New York law, its grantor was a New York resident, the Trust’s documents and records were kept in New York, the Trust’s asset custodians were located in Massachusetts, and no Trustee lived in North Carolina.

The Trust paid the tax under protest and sued the state in North Carolina’s courts. The state courts held in favor of the Trust, concluding that the Trust beneficiaries’ in-state residence was too tenuous a link to support the imposition of tax.

The Supreme Court’s Holding

The U.S. Supreme Court agreed with North Carolina’s state courts, holding in a unanimous decision authored by Justice Sotomayor that the in-state beneficiaries’ right to control, possess, enjoy, or receive Trust assets did not rise to the level of establishing a “definite link” or “minimum connection” (that is, nexus) to justify taxation.

The Court relied on three key facts: (1) the beneficiaries did not receive any income from the Trust during the years in question; (2) they had no right to demand Trust income or otherwise control, possess, or enjoy the Trust assets during that time; and (3) they could not count on receiving any specific amount of income from the Trust in the future.

The Court emphasized that their holding is limited to the facts in the case and that they neither approve nor disapprove of trust taxes premised on the residence of beneficiaries whose relationship to trust assets differs from that in the case.

Going Forward

Most states do not attempt to tax trust income as aggressively as North Carolina sought to do in Kaestner. And certain rules regarding the extent of state taxation of trust income are well-established. Thus, a state may tax trust income distributed to an in-state resident. A state also may tax a trust if the trustee is a resident of that state or if the trust is being administered in that state.

By way of example, in Michigan, Revenue Administrative Bulletin 2015-15 describes the Michigan Department of Treasury’s position on the taxability of income to estates, trusts, and beneficiaries. The Bulletin differentiates between resident and non-resident trusts. Resident trusts are those created by the Will of someone who died while domiciled in Michigan or those created by or consisting of the property of someone domiciled in Michigan at the time the trust becomes irrevocable. Non-resident trusts are all those trusts that do not meet the definition of a resident trust, as well as those trusts that do meet that definition but for which all of the following are true: (i) the trustee is not a Michigan resident, (ii) the trust assets are not held, located or administered in Michigan, and (iii) all of the beneficiaries are non-residents.

Trusts that are considered resident in Michigan are taxable on all of their income from any source, except for income attributable to another state according to the allocation or apportionment provisions of the Michigan Income Tax Act.

Non-resident trusts are subject to Michigan income tax on income sourced to Michigan that is not taxable to beneficiaries.

While the Supreme Court’s opinion in Kaestner affirms that, on its own, the simple presence of a trust beneficiary in a state provides an insufficient nexus to allow the state to tax the trust’s income, the decision ultimately is of limited applicability. Most states have adopted rules for taxing trusts that are more akin to Michigan’s rules than the relatively aggressive ones in North Carolina that were at issue in the case.

For more information, please contact any member of Dykema’s Taxation or Estate Planning Practice Groups or your Dykema relationship attorney.

¹ N.C. Gen. Stat. Ann. Sec. 105-160.2 allows North Carolina to tax any trust income that is “for the benefit of” a North Carolina resident. The North Carolina Supreme Court has interpreted this statute to authorize the state to tax a trust on the sole basis that the trust’s beneficiaries reside in the state.