Taxation of trusts

Supreme Court Overrules Taxation of Trust

Last month the United States Supreme Court ruled (unanimously) that North Carolina’s approach to taxation of trusts was impermissible. If it was a 9-0 decision, though, the obvious questions are:

  1. Whoever thought North Carolina’s approach to taxation of trusts would be acceptable in the first place? and
  2. What difference will this decision actually make for people who establish — or administer — trusts?

First, though, let us make an initial observation. It’s not very often that the US Supreme Court takes up cases that affect trust and estate planning or administration. In this term, for instance, landmark decisions addressed the role of race in criminal trials, partisan gerrymandering by state legislatures, and the possible inclusion of a citizenship question on the census. And those are just a smattering of the decisions issued after the one on taxation of trusts. [Want to see the whole term? Here’s a link to the Supreme Court’s website. Enjoy browsing.]

The North Carolina case

To understand the Supreme Court decision, start with the trust it involved. New York resident Joseph Lee Rice III established the trust in his home state in 1992. It was for the benefit of his three children. The trustee was a New York resident. The trust was governed by New York law.

Three things changed in the intervening years. In order:

  1. Shortly after the trust was created a Connecticut resident became trustee. The trust was administered in Connecticut through all the relevant time periods.
  2. In 1997, Rice’s daughter Kimberley Rice Kaestner moved to North Carolina.
  3. After Ms. Kaestner relocated to North Carolina, the trustee divided the trust into separate shares for each of Rice’s children (and their respective issue).

The trust did not require the trustee to make any distributions to its beneficiaries. In fact, no the trustee did not distribute anything during the relevant years.

Depending on circumstances, a trust may have to pay federal and state income tax. North Carolina demanded that the trust pay income tax because one of the beneficiaries lived in that state. The amount of tax was not trivial: the final tax bill exceeded $1.3 million. The trustee paid that tax and then appealed.

The North Carolina courts — all the way up to the state Supreme Court — order the state to return the tax money. Those state courts agreed taxation of trusts depended on some meaningful relationship between the state and the trust.

North Carolina appealed to the US Supreme Court. Last month’s decision upheld those state court rulings. North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, June 21, 2019.

Why did North Carolina think it could tax the Kaestner trust?

Different states take different approaches to taxation of trusts. Seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming — do not tax trust income at all. Most of the other states impose a tax based on some theory. North Carolina and Tennessee are particularly aggressive about taxation of trusts.

Four states — California, Georgia, North Carolina and Tennessee — tax trusts if a beneficiary lives in those states. But Ms. Kaestner was just a “contingent” beneficiary — the trustee was not required to make, and had not made, any distributions. Such a trust would be subject to taxation only in North Carolina and in Tennessee — though Tennessee is phasing out its income tax altogether, and will tax no income beginning in 2021.

There are obvious problems with having various interpretations of state income taxation of trusts. Can a given trust be subject to taxation in multiple states? Yes. Can the same income be taxed more than once? Yes.

To be clear: if the Kaestner trust had actually made distributions to Ms. Kaestner, the income she received would be subject to taxation in North Carolina. If the trustee moved to North Carolina, that state might require a tax return and impose a tax on the entire trust’s income. The Supreme Court decision does not address those issues.

What does this decision mean for taxation of trusts?

First of all, the new Supreme Court case won’t mean much for your revocable living trust. Income tax rules ignore that kind of trust.

But if you are planning on naming successor trustees from North Carolina or California, particularly, you might want to reconsider. In fact, you might want to think about choosing a trustee in one of the no-tax states (though that won’t always make a difference).

There are other issues to consider, as well. Was the trust established by a resident of a state that imposes income taxes on such trusts? It is not clear that this is permissible, but future litigation will likely resolve the dispute. Can a trust beneficiary move to another, non-taxing state just before receiving distributions? Perhaps — just as they do with sale of appreciated assets.

The unanimous decision in Kaestner helps clear up some of the most aggressive state taxing attempts. Income taxation of trusts remains a complicated, legally fraught area of concern. For more, talk with your trust administration/estate planning attorney.


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