Many trustees, beneficiaries, and settlors are aware of the U.S. Supreme Court’s recently-issued opinion relating to state taxation of trust income. While this case made headlines, many are still asking, “How does Kaestner affect my trust and me?”
Joseph Rice III was a New York resident who set up a trust for his three children, giving the trustee “absolute discretion” to distribute the assets to the children. Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina in 1997, and later, the trustee divided the original trust into three separate subtrusts, one for each of the children. North Carolina law allowed the state to tax the income from a trust that “is for the benefit of” a state resident.
From 2005-2008, North Carolina imposed $1.3M tax liability on the subtrust created for Kimberley Rice Kaestner. During this time, Kaestner had no right to, and did not receive, any distributions from the trust. In fact, if Kaestner suffered a premature death, she conceivably could never receive any trust distributions. Additionally, the trust did not have physical presence, make investments, or own real property in North Carolina.
The trust paid the tax then sued the North Carolina Department of Revenue, arguing North Carolina’s law violated the 14th Amendment’s due process clause. North Carolina courts agreed with the trust, holding in-state residence of a beneficiary was too tenuous a link for the state to levy an income tax against the trust.
In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, the U.S. Supreme Court upheld the North Carolina courts’ decisions in a unanimous 9-0 opinion. The Court held:
“The presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain to receive it.”
Impact on Trusts
While Kaestner is a major decision in state income taxation case law, its impact is applicable only in very narrow circumstances. In fact, Kaestner may only be relevant if all of the following apply:
- State law taxes trust income solely on the basis of beneficiary state residency,
- The trust has no other connection with the state, including trust administration, in-state investments or property,
- The beneficiary has no ability to demand distributions from the trust,
- The beneficiary does not receive distributions, and
- The beneficiary could not necessarily count on receiving any distributions in the future.
Although Kaestner was decided by unanimous Court, three justices joined by a concurring opinion, which may signal a divide on the underlying issues addressed by the Court, perhaps to be played out in future opinions. For now, trusts that have paid taxes under these circumstances in the small handful of states with laws like North Carolina should file protective refund claims now, in order to preserve the trust’s right to collect previously remitted taxes, which are now deemed to be unconstitutional.
If you have questions about Kaestner or whether/how your trust should file state protective refund claims, please contact John Ure or one of our experienced individual or trust and estate tax advisors at 301.231.6200.