The U.S. Supreme Court recently ruled that a state does not have the right to tax a beneficiary's income from an out-of-state trust solely based on the fact that the beneficiary lives in the state.

In June, the high court affirmed state court decisions that "in-state residence was too tenuous a link between the State and the Trust to support the tax." It also agreed that the tax, as applied, was unconstitutional because it violated the Fourteenth Amendment's Due Process Clause (North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457, U.S. Sup., June 21, 2019).

Beneficiary Relocates

When New York resident Joseph Lee Rice III created a trust in the state to benefit his children, he appointed a New York resident to serve as the trustee. The trouble started after Rice's daughter, Kimberley Rice Kaestner, moved to North Carolina.

The state of North Carolina levied a tax on the Kimberley Rice Kaestner 1992 Family Trust of more than $1.3 million under a statue allowing North Carolina to tax any trust income that benefits a state resident.

The trustee paid the tax but then sued the North Carolina tax authority, arguing the tax on the trust was unconstitutional. The trustee pointed out that the tax applied to years 2005 through 2008, when Kaestner received no distributions. Further, the trustee argued that the trust did not have a physical presence in North Carolina, make any direct investments in North Carolina entities, or hold property located in North Carolina.

State courts sided with the trustee and, ultimately, the case landed before the U.S. Supreme Court.

Minimum Connection

Under the Due Process Clause, states may only impose taxes that are fiscally related to "protection, opportunities and benefits given by the state," the high court said. There must be a definite link or minimum connection between the state and the individual, property, or transaction it taxes.

For trust beneficiaries, that link or minimum connection must be more than the fact that the beneficiary is a resident of the state. So, an inquiry must be made into what the trust beneficiary controls or possesses and how that interest to be taxed relates to the purpose of the state tax, said the high court. So, Kaestner's North Carolina residency on its own was not enough, it noted.

The high court rejected North Carolina's argument that ruling in favor of the trust will undermine state tax regimes. The court pointed out that only a few states use the residency of trust beneficiaries as the sole basis for trust taxation, with an even fewer number relying on state residency regardless of whether the beneficiary is certain to receive trust assets. Pennsylvania does not fall into either one of these categories.

Income Tax

The Kaestner decision demonstrates that state income tax issues can be critical to good trust and estate planning.

In most states, the definition of a "resident trust" -- whether by statute, tax regulations, or other guidance -- determines whether a trust's trustee must pay the state income tax. Trustees of resident trusts must pay taxes on ordinary income and capital gains, while trustees of non-resident trusts are usually taxed on income that is attributable to real property, tangible personal property, or business activities conducted in the state, noted a podcast by the American College of Trust and Estate Counsel (ACTEC) on the Kaestner ruling.

Factors other than residency may also be considered, depending on the state. For example, in Fielding v. Comm'r of Revenue (916 N.W.2d 323 [July 18, 2018]), the Minnesota Supreme Court held that the resident trust definition as applied to four trusts was unconstitutional. The court looked at a host of factors to evaluate the connection between the trust and the state of Minnesota and decide whether the income being taxed was rationally related to the benefits being conferred on the trust by the state.

Relevant factors included the domicile of the trustee and the location of the trust's administration and records. Factors deemed irrelevant included the grantor's connections with Minnesota and the use of Minnesota law as the choice of law in the trust agreement.

Pennsylvania Connections

Pennsylvania is fairly unique, it is one of only four states where a beneficiary's residence is used to determine if a trust is considered a resident trust. (The other states are Connecticut, Iowa, and Nebraska.)

In Pennsylvania, a resident trust is defined as any inter vivos or testamentary trust created by a Pennsylvania resident or a deceased Pennsylvania resident. Whether the trust's fiduciary and beneficiaries live in the state or not is irrelevant to the issue of income tax in Pennsylvania, however. A 3.07 % personal income tax is levied on Pennsylvania resident trusts, usually depending on the residency of the trust's grantor.

But not always.

The Pennsylvania Commonwealth Court held in McNeil v. Commonwealth that, even though the grantor was a Pennsylvania resident when he set up the trust, the trust was not sufficiently connected to the state. Therefore, the court concluded the assessment of the personal income tax was unconstitutional.

In its 2013 decision, the court used a four-pronged test established in 1977 by the U.S. Supreme Court in Complete Auto Transit v. Brady (to determine if the application of the Pennsylvania state income tax was constitutional):

  1. the taxpayer must have a substantial nexus to the state;

  2. the tax must be fairly apportioned;

  3. the tax being imposed upon the taxpayer must be fairly related to the benefits being conferred by the state; and

  4. the tax may not discriminate against interstate commerce.

The Commonwealth Court concluded that the application of state's personal income tax violated the first prong in particular, because the McNeil trust had no Pennsylvania-based assets, was not governed by Pennsylvania law or administered inside the state, and did not conduct business within Pennsylvania.

As Kaestner demonstrates, where the trust, grantor, and beneficiaries are located can have varying effects for tax purposes. It would be wise to consider the facts and circumstances of each trust and the personal income tax regulations of any state that may be implicated to help address questions or disputes down the road.