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Trust Income: SCOTUS to Consider State Tax Nexus Case Based on Beneficiary’s Residence

Last year, the U.S. Supreme Court decided South Dakota v. Wayfair upending 51-years of precedence holding that a state could require an out-of-state seller with no physical presence in the state to collect and remit sales taxes on goods the […]


Last year, the U.S. Supreme Court decided South Dakota v. Wayfair upending 51-years of precedence holding that a state could require an out-of-state seller with no physical presence in the state to collect and remit sales taxes on goods the seller ships to customers in the state. In January, the U.S. Supreme Court announced that it will hear another state tax nexus case, Kaestner 1992 Family Trust v North Carolina. Kaestner will address whether the due process clause prohibits states from taxing trusts based on the in-state residency of a beneficiary.  In light of last year’s Wayfair decision and the Court’s apparent reluctance to take up nexus cases, the result is expected to have broad implications.

Background

In Kaestner, the trust’s only connection with the taxing state during the tax years at issue was a resident beneficiary. The Kimberly Rice Kaestner 1992 Family Trust, was created in New York and governed by New York Law. The Trust documents, financial books and records, and legal records were kept in New York and all tax returns and Trust accountings were prepared in New York. At the time it was created, neither the settlor nor any of the beneficiaries resided in North Carolina. The trustee was a Connecticut resident, and the trust held financial instruments located in Massachusetts. The beneficiary had no absolute right to the Trust’s assets or income, as distributions were made at the sole discretion of the trustee. No distributions were made to the beneficiary during the years at issue. The terms of the Trust provided that the trustee was to distribute the assets to Kimberly Kaestner when she reached a specified age, which did not occur until after the tax years at issue.

State Law

North Carolina tax law imposes a tax on the taxable income of trusts. The statute provides, in part: “The tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State.” Adding to this, the North Carolina Department of Revenue issued administrative guidance interpreting the statute application based on the “beneficiary’s state of residence on the last day of the taxable year of the trust.” At this point it should be noted that Michigan law differs from that of North Carolina. In Blue v Department of Treasury, the Michigan Court of Appeals held that Michigan may not tax trust income if all trustees, beneficiaries and trust administration occurs outside of the state (even if there is non-income producing property in the state – including real property).

The Dispute

At first the trust in Kaestner paid the tax for tax years 2005 through 2008, but later filed a refund claim on the basis that the taxing statute is unconstitutional as the presence of a resident beneficiary was not a sufficient connection with North Carolina for the state to impose its income tax on the trust.  The North Carolina Department of Revenue denied the claim and the underlying refund suit followed.

In a divided opinion, the North Carolina Supreme Court ruled in the trust’s favor finding that the presence of an in-state beneficiary alone was not enough to establish tax jurisdiction. The court reasoned that the trust is an entity separate from individual beneficiaries and distinguished cases in Connecticut and California that reached contrary results under similar facts. The dissent, argued that the trust had subjected itself to North Carolina’s taxing power because it, in the dissent’s view, purposely availed itself to the state through the in-state beneficiary.

Reasons to Watch

Trusts are a common planning tool and subjecting them to state income taxation based only upon an in-state beneficiary could have significant consequences. The states that have faced this issue are split on this question. The split is among nine states – four have said “Yes”; California, Missouri, Connecticut, and Illinois allow taxing a trust based on the presence of an in-state beneficiary, and five states have said “No”; New York, New Jersey, Minnesota, Michigan, and now, North Carolina. Nearly every state taxes trust income. As a result, the outcome of the Kaestner case could have important implications for tax planning and state tax policy. Some commentators have surmised that from the states’ perspective, a loss in Kaestner could nudge them away from extending the economic nexus reach of Wayfair into the area of state income taxation. All of this remains to be seen and deserves a close watch.


Fraser Trebilcock attorney Paul V. McCord has more than 20 years of tax litigation experience, including serving as a clerk on the U.S. Tax Court and as a judge of the Michigan Tax Tribunal. Paul has represented clients before the IRS, Michigan Department of Treasury, other state revenue departments and local units of government. He can be contacted at 517.377.0861 or pmccord@fraserlawfirm.com.