SCOTUS Makes It More Difficult For States to Tax Trusts

SCOTUS Makes It More Difficult For States to Tax Trusts

The United States Supreme Court welcomed the first day of summer by issuing its decision in North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust.  This decision clarifies and supports a line of cases that set out when a state can and cannot subject an irrevocable trust to its taxes.   Under this line of cases, it is clear that the Due Process Clause under the Fourteenth Amendment to the U.S. Constitution requires, among other things, a minimum connection between the state and the person, entity, or transaction, the state is seeking to tax.

In the Kaestner case, a father (who was a New York resident) established an irrevocable trust for his daughter.  The trustee of the trust was also a New York resident; the trust was administered in New York and the assets were held in Massachusetts.  After the trust was established, the daughter who was the beneficiary, moved to North Carolina.  The trust gave the trustee wide discretion over making (or not making) distributions to the daughter; and in fact during the years in question, the daughter did not receive any distributions from the trust.  North Carolina subjected the trust to its state taxes, even though the only tie was that the beneficiary, to whom distributions could be made, lived in North Carolina.  Kaestner makes it clear that is not enough of a minimum connection to allow a state to tax a trust.

The Minnesota Supreme Court recently decided a similar case, Fielding v. Commissioner of Revenue.  Minnesota’s law was different from North Carolina’s.  Under Minnesota law, if the settlor of a trust was a Minnesota resident at the time it became irrevocable, the trust would forever be subject to Minnesota taxes, regardless of where the trustee or beneficiaries lived or where the trust was administered.  The Minnesota Supreme Court struck the law down as unconstitutional, for much the same reason as the Court in Kaestner struck down the North Carolina law – neither of those factors alone (the residency of the beneficiary nor the residency of the grantor) was enough of a “minimum connection” to the state.¹

It is important to note that the Court’s holding in Kaestner is very narrow.  The Court has said in the past that income which is actually distributed to a beneficiary does have that minimum connection to the beneficiary’s state of residency, and can be subject to taxation.  However, for trusts that no longer have significant ties to its state of taxation, Kaestner and Fielding should open a new dialogue.  Trustees and the legal/tax advisors should be taking a fresh look at trusts to determine if the historical taxation of a trust is still appropriate, and if changes should be made to take a trust out of a high tax state to a lower tax state.  Our experienced Trust and Estates attorneys can assist you in determining how the decision may impact your current plan.

¹ The Fielding case has been appealed, but the United States Supreme Court has not yet granted a writ of certioriari.  After the Kaestner decision, it would appear less likely that they would hear the Fielding case.  Although the two cases have different facts and are applying different state laws, the Due Process analysis would appear to be very similar.