It’s not every day that taxes are the talk of the town, but every so often they garner some attention. On June 21, 2019 interest about a state’s power to tax a trust was ignited by the Supreme Court when it unanimously ruled the presence of in-state beneficiaries alone is insubstantial for a state to tax the income of a trust. The court considered this tax to be unconstitutional because it violates the due process clause of the fourteenth amendment.

What’s the background of the case?

In 1992, Joseph Lee Rice III set-up a trust for the benefit of his children. A few years later his daughter, Kimberley Rice Kaestner, moved to North Carolina. At a glance, Kimberley’s change in residency might not have suggested a significant change in the state taxation of the trust because almost every aspect of the trust had ties outside of North Carolina. Specifically:

• The grantor and trustee were residents of other states.
• The trust was administered in another state.
• There was no North Carolina source income.

Nonetheless, North Carolina assessed a tax of $1.3 million from 2005-2008 because North Carolina Gen. Stat. Ann. §105–160.2 states that trusts and estates can be taxed on income “that is for the benefit of this State.” During this period the trustee had “absolute discretion” over distributions and no distributions were ever made to beneficiaries. The tax was paid under protest and the trustee sued arguing this imposition of tax was a violation of the due process clause.

What happened next?

The trustee first sued in North Carolina state court. In 2015, the Superior Court of Wake County ruled that it “does not believe that the residency of the beneficiaries in North Carolina standing alone, can be viewed as the Trust’s purposeful activity in the state.” Both the Court of Appeals of North Carolina and Supreme Court of North Carolina affirmed the rulings that the tax was unconstitutional because the trust did not have the minimum contacts with the State. In 2018, the State filed a writ of certiorari request the U.S. Supreme Court to hear the case. The petition was granted, which set the stage for the U.S. Supreme Court to give another ruling with potentially big state tax implications one year after the Court’s pivotal decision in Wayfair v. South Dakota. Check out our blog on this- Supreme Court Rules that States can Collect Sales Tax on Online Purchases.

What was the U.S. Supreme Court’s ruling?

In a 9-0 ruling, the Court ruled in favor of the taxpayer, that North Carolina Gen. Stat. Ann. §105–160.2 is unconstitutional. Judge Sotomayor delivered the Court’s opinion and emphasized that the presence of a resident beneficiary alone is not sufficient to provide the minimum connection to sustain the state’s tax on the trust’s assets. Some additional factors cited in the ruling were:

• The trust did not make any distributions to the beneficiaries at any time.
• “The beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue.”
• The trustee had absolute discretion in whether and to whom distributions were made.

What does this mean?

The court emphasized that their ruling was limited to the specific facts of this case, and that it does not imply approval or disapproval of a state tax of a trust under different circumstances. That said, the decision serves as a prudent reminder to review the different factors that dictate state taxation of trusts, such as:

• State residence of settlor.
• State residence of trustee.
• Location of physical trust assets and custodian of trust assets.
• Location of trust administration

Clients should work closely with their tax advisor and estate planning attorney to ensure they are complying with their state tax obligations, and when appropriate, taking advantage of tax planning to reduce state taxes owed by their trust.

Have questions?

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