Oftentimes, a family business will be owned in part or entirely by one or more irrevocable trusts. Whether those trusts are subject to state income tax depends on the location of any one or more of: (1) the Settlor/Grantor/Trustor (the person who created the trust), (2) the Trustee(s) and where the trust is administered, (3) the trust assets and/or source of income, and/or (4) the trust beneficiaries.
On June 21, 2019, the U.S. Supreme Court issued a unanimous opinion striking down North Carolina’s attempt to tax undistributed income held by a New York trust solely because beneficiaries of the trust resided in the state. North Carolina urged the Court to adopt a categorical rule, “When a trust beneficiary resides in a state, so does her trust.” The Court rejected this approach, holding that the “minimum connection” standard for jurisdiction must take into account the quality of the relationship between the trust and beneficiary. Mere in-state residency of a contingent beneficiary who did not receive, and might never receive, income from the trust does not meet the test.
DWT filed an Amicus Brief in this case on behalf of an advocacy group, Washington State Tax Practitioners. It was the only brief (out of 15) to invite the Supreme Court to consider that its estate tax cases also validate the focus on the nature of the beneficiary’s claims to trust property or income, and the Court’s opinion adopted this view. DWT’s brief also was one of four that called the Court’s attention to the problem that the state’s rule did not respect the variety of trust purposes or legal rights held by beneficiaries in relation to their trusts – and this point was the Court’s main rejoinder to North Carolina’s argument in Part IV of the opinion. “The State’s argument fails to grapple with the wide variation in beneficiaries’ interests.”
The Court’s synthesis of the governing legal principle also repeated verbatim the core phrase of the summary proposed in DWT’s brief. Per the Court, “When a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax that asset.” DWT had argued, “Whether the in-state beneficiary or trustee has possession, control, or enjoyment of the property or income is the key to these direct-tax decisions.” It is simple to deduce this formulation from the Court’s old cases, but the Court had not used this straightforward expression before.
This decision is a very narrow one, in that only North Carolina and Tennessee use a trust beneficiary’s residency as the sole basis for subjecting the undistributed income of irrevocable trusts to income taxation, and the beneficiary in this case was a contingent beneficiary. And, if other facts had been present to establish some degree of possession, control or enjoyment in the trust beneficiary, it is possible the case may have been decided differently.
Kaestner does, however, point to the importance of taking into consideration all relevant factors when creating an irrevocable trust to own family business interests (and other assets) and of drafting flexibility into the trust terms for such income tax planning should the residency of trustees and beneficiaries change over time, as is often now the norm. As the Court itself noted, “Settlors who create trusts in the future will have to weigh the potential tax benefits of [depriving beneficiaries of income rights, input on investments, or powers of appointment] against the costs to the beneficiaries of lesser control over trust assets.”
The Kaestner case also discusses other factors used by other states in taxing the income of irrevocable trusts.