Trust Taxation – Latest Developments

Trust Taxation – Latest Developments

By Melissa Faith Davis, CPA

A significant development in fiduciary taxation took place recently with the decision that North Carolina was not able to tax undistributed income from a non-grantor trust, which was governed under the laws of New York, solely on the basis of the beneficiaries’ place of residence, North Carolina.  It has been decades since the Supreme Court has examined a case like North Carolina Department of Revenue versus Kimberley Rice Kaestner 1992 Family Trust (Kaestner), which brings to the forefront the constitutionality of state taxation of trusts.

States currently utilize many factors to determine the applicability of an income tax including:

  1. Is the trust created by a resident of the state?
  2. Is the trust administered in the state?
  3. Is the trust’s trustee a resident of the state?
  4. Where does the trust’s beneficiary reside?

In Kaestner, the Supreme Court unanimously affirmed the lower court’s decision that it was unconstitutional for North Carolina to tax a trust solely on the basis that a beneficiary resided within the state.  The specific set of facts on which this ruling was based included the following:

  1. The beneficiaries received no income from the trust.
  2. The beneficiaries had no rights to demand the trust income.
  3. The beneficiaries had no expectations of receiving income in the future.

The Kimberly Rice Kaestner 1992 Family Trust was taxed more than $1.3 million dollars over the 2005-2008 tax years.  The trust paid this tax but subsequently filed to claim a refund on the basis that the North Carolina’s imposed tax violated the Fourteenth Amendment’s Due Process Clause.   In this case, the trustee, who was a non-resident of North Carolina, had absolute discretion over the distributions made to the beneficiaries and the investments, which were not located in North Carolina, held under the trust. The Court placed emphasis on the beneficiary’s right to control, possess, enjoy or receive trust assets when making its final decision.

The Court stated that it is important to note that the decision in Kaestner was specific to North Carolina as were the facts listed above; however, the significance lies in the taxpayer’s ability to challenge the fairness of a governmental authority and state taxation based on the functions of a beneficiary, settlor or trustee. As states are becoming more aggressive in recent years to find funding, it is important to consider this case as guidance in making estate planning decisions. For example, one should always be mindful of how a trustee’s domicile impacts the state taxation of a trust.

Please consult your tax advisor for further discussion on your estate planning decisions.

Melissa Davis

Melissa Faith Davis Tax Manager, CPA

NC License #33188