In a closely-watched decision, the U.S. Supreme Court unanimously ruled that a beneficiary’s residence within a state alone does not subject a trust to such state’s income tax. In North Carolina Dept. of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. Jun. 21, 2019), North Carolina attempted to tax the income of the Kimberley Rice Kaestner 1992 Family Trust because the trust’s beneficiaries were all North Carolina residents, even though the grantor was a New York resident, the trust was governed by New York law and there was no requirement that the trustee distribute the trust’s income to the beneficiaries.
In an opinion authored by Justice Sonia Sotomayor, the Supreme Court held that North Carolina’s attempt to tax the trust’s income violated the due process clause of the 14th Amendment to the U.S. Constitution because North Carolina (1) lacked the minimum connection between the taxpayer (i.e. the trust) and the state, and (2) there was no rational relationship between the income and North Carolina. The court’s opinion hinged on a determination as to whether a beneficiary’s presence in a state alone would be sufficient to meet the requisite minimum connection. The court determined that since no trust income was distributed to the in-state beneficiaries, and such beneficiaries had no right to demand any income, such beneficiaries lacked the requisite control or possession of the trust’s assets to establish a connection to North Carolina.
In addition, in its opinion, the Supreme Court indicated that this test could be applied to any “position” in a trust, stating:
“In sum, when assessing a state tax premised on the in-state residency of a constituent of a trust – whether beneficiary, settlor, or trustee – the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee.”
Although the Supreme Court attempted to keep the scope of the ruling narrow, Kaestner could pave the way for future attempts to challenge the taxation of trusts by states. In fact, many states tax trust income based on the grantor’s residence when creating the trust, the location of the beneficiaries and/or the location of the trustees.
New Jersey taxes both non-exempt resident trusts and the New Jersey source income of non-resident trusts. In New Jersey, an irrevocable trust created by a New Jersey domiciliary or under the Will of a New Jersey domiciliary will be considered a New Jersey resident trust for income tax purposes. See NJSA 54A:1-2(o)(2). However, New Jersey case law provides that a New Jersey resident non-grantor trust is exempt from New Jersey tax if it (i) does not have tangible assets in New Jersey, and (ii) does not have any trustees who are residents of New Jersey. See Pennoyer v. Director, 5 NJ Tax 386 (Tax 1983), Potter v. Director, 5 NJ Tax 399 (Tax 1983), and Kassner Residuary Trust A v. Director, 27 NJ Tax 68 (Tax 2013).
Similarly, New York taxes both non-exempt resident trusts and New York source income of non-resident trusts. In New York, an irrevocable trust created by a New York domiciliary or under the Will of a New York domiciliary will be considered a New York resident trust for income tax purposes. See New York Tax Law 605(b)(3). Under New York tax law, a resident non-grantor trust can become exempt from New York income tax if the following conditions are met: (i) all of the trustees are domiciled outside of New York, (ii) all of the property held in the trust is located outside of New York, and (iii) the trust cannot receive any New York source income. See New York Tax Law 605(b)(3)(D)(i).
Note that with “incomplete gift non-grantor trusts,” New York will tax the trust as if it were a grantor trust. See New York Tax Law 612(b)(41).
The Kaestner ruling, as well as New Jersey’s case law and New York’s statute, demonstrates the importance of consulting with practitioners when establishing trusts or changing trust fiduciaries. A careful analysis of the laws of different jurisdictions should be made to ensure that the trust’s income does not incur unexpected state taxes.