By: Andrew Bechel, Esq., LL.M.
On June 21, 2019, the U.S. Supreme Court, in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust (“Kaestner ”), held that states cannot tax a trust’s income when the only connection to that state is the residency of a beneficiary when certain specific criteria are met: 1) the resident beneficiary did not receive any income from the trust in the year in question, 2) the resident beneficiary had no right to demand trust income or control, possess, or enjoy the trust assets in the year in question, and 3) the resident beneficiary had no right to ever demand or receive distributions from the trust (i.e., distributions from the trust are fully discretionary at all times with regards to the resident beneficiary). Consequently, the holding in Kaestner is quite narrow and will not reach many existing trusts, but is important nonetheless because it provides a blueprint for how to avoid taxation when a state attempts to tax trusts based solely on the residency of a beneficiary.
The trust at issue in Kaestner was formed by a New York resident, with a New York trustee, under New York law. The New York trustee was eventually replaced by a Connecticut trustee. All beneficial interests under the trust were fully discretionary and the beneficiaries had no right to receive any distributions and no guarantee that they would ever receive any distributions. Eventually, separate subtrusts were formed for each of the settlor’s children, but at all times distributions from each trust were fully discretionary. The beneficiary of one such separate trust was a North Carolina resident. North Carolina attempted to tax the trust as a resident trust due to the beneficiary’s North Carolina residency. At no point while the beneficiary was a resident of North Carolina were any distributions made to such beneficiary.
The Supreme Court held that it was unconstitutional for North Carolina to tax the trust based on these facts and taking into account the specific criteria laid out above. Due to the narrowness of this ruling, however, the ruling may not be as impactful as the estate planning community hoped. For example, it is still an open question how the trust would be taxed in a year that a distribution is made or if the beneficiary had withdrawal rights or would receive mandatory distributions at any time during the trust’s existence. However, the ruling does provide a roadmap for designing a trust that minimizes state tax law implications if a beneficiary of the trust does live in a state that taxes trusts based on beneficiary residence. Consequently, while there are many open issues that still need to be addressed in the wake of Kaestner , this is an important first step in limiting a state’s ability to tax a trust based solely upon the residency of a beneficiary of the trust.
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