On June 21, the U.S. Supreme Court issued a unanimous decision in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust (Kaestner), holding that a trust is not subject to fiduciary income tax in a state where the trust’s only contacts to the state are the presence of discretionary beneficiaries.
In Kaestner, the settlor, a New York resident, created a trust in New York and named a New York resident as trustee. The trustee had the absolute discretion to distribute (or not distribute) the trust’s assets to the beneficiaries of the trust. After one of the beneficiaries, Kimberley Rice Kaestner, moved to North Carolina, the trustee divided the trust into three separate subtrusts, one of which was for the benefit of Kaestner and her children (the Kaestner Trust).
The trustee, the assets and the administration of the Kaestner Trust remained outside of North Carolina. The Kaestner Trust’s only contact to North Carolina was the residency of the discretionary beneficiaries, who did not have a right to demand the distribution of trust income, and no trust income was distributed to the beneficiaries during the relevant time period.
North Carolina’s trust income tax statute imposes a tax on any trust income that “is for the benefit of” a North Carolina resident. Applying this statute, North Carolina assessed an income tax on the undistributed income of the Kaestner Trust based solely on the residence of the beneficiaries.
The Supreme Court concluded that the presence of in-state discretionary beneficiaries alone does not give a state the power to tax undistributed trust income when the beneficiaries have no right to demand the income, have not received it, and may never receive it. The Court reasoned that, under these circumstances, the minimum connection required by the Due Process Clause of the Fourteenth Amendment between North Carolina and the trust income it sought to tax was not satisfied. The Court limited its holding to the specific facts presented, stating that “we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries [of the Kaestner Trust]”.
While the holding of Kaestner is limited in its scope, we recommend that the administration and taxation of existing trusts be reviewed to confirm that they are being taxed properly for state income tax purposes. If you have questions regarding Kaestner or would like to discuss the impact Kaestner may have on your estate plan or existing trusts, please contact a member of Pepper’s private clients group.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.