By Camille Smith
Quietly working its way through the US Supreme Court is a tax case that could possibly upend how trusts are structured and taxed. In the case of North Carolina Department of Revenue(NC) v. Kimberly Rice Kaestner 1992 Family Trust, NC asserts that it should be able to tax the trust’s income in the current year, based only on the beneficiaries’ residency in that state.
State taxation of trusts revolves around situs, trustee administration, and the beneficiaries’ residency. It is most common for states to tax trust income based upon situs or administration, under the theory that the state has extended legal protections/benefits to the trust. Currently, Georgia, North Carolina, and Tennessee tax the income of a trust based solely on the beneficiaries’ residency.
North Carolina’s only connection to the Kaestner trust is the beneficiaries’ residency in that state. The trust was formed in New York and administered in Connecticut. Given that the beneficiaries have neither access to nor control over the assets in the trust, North Carolina would traditionally not be considered to have sufficient connection to the trust to tax its income until it is distributed to the beneficiaries.
However, North Carolina asserts that the economic reality is that the income from the trust ultimately belongs to the beneficiaries. That “economic reality” combined with the beneficiaries’ NC residency gives the state sufficient nexus to tax the trust income in the current year, regardless of distributions (or the lack thereof).
Why not simply wait until the beneficiaries receive distributions? NC argues that the “gamesmanship” common to trusts will deprive it of its ability to tax the income; prior to the trustee making distributions, the beneficiaries will move to a state without income tax. In essence, North Carolina seeks to tax the beneficiaries’ future distributions now, under the presumption that it will not be able to do so later.
The defense contends that the “economic reality” argument is insufficient to create NC nexus to the trust. While the trust is for the benefit of the Kaestners, the assets are owned neither legally nor in practice by them. Income and assets are only distributed at the trustee’s discretion. Moreover, taxation of future distributions now would not be equitable, as it is impossible to know when any future distributions would be made or how they would be structured. North Carolina’s proposed pro-rata tax would tax any future distributions not made in a pro-rata manner.
Given the ability to tax trust income on the basis of beneficiary residency, we could expect other states to follow suit if the Supreme Court rules in favor of the North Carolina Department of Revenue. Please contact your tax advisor if you have further questions on the case.
Update: The Supreme Court issued a decision in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust—and it’s unanimous. The Court ruled that a trust beneficiary’s residence alone is not sufficient grounds for a state to tax a trust’s undistributed income.