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U.S. Supreme Court Sets Limits On State's Power To Tax A Trust

On June 21st, 2019, the U.S. Supreme Court released its unanimous opinion in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, No. 18-457, 586 U.S. ___ (2019), holding that the presence of in-state beneficiaries alone did not empower North Carolina to tax trust income that had not been distributed to said beneficiaries (and, in this case, where the beneficiaries had no right to demand that income and there were no guarantees they would receive it).

Nearly 30 years ago, Joseph Lee Rice III, of New York State, created a trust for the benefit of his children. The trust was managed by a New York trustee and governed under New York law. At the time that the trust was created, no beneficiaries lived in the State of North Carolina. That changed in 1997 when Kimberley Rice Kaestner, the daughter of the grantor, moved to that state with her children. A few years later, the trustee divided Mr. Rice's trust into three subtrusts that were still controlled by the original trust agreement. One of these was the Kimberley Rice Kaestner 1992 Family Trust, formed for the benefit of Ms. Kaestner and her own three children. However, the trustee in New York had exclusive control over the allocation and timing of trust distributions. Ms. Kaestner had no authority to request trust proceeds at any time.

North Carolina statute provides that any trust income that "is for the benefit of" a North Carolina resident can be taxed. As a result, the North Carolina Department of Revenue assessed a tax on the full proceeds that the Kaestner Trust accumulated from tax years 2005 to 2008 and required the trustee to pay it. The tax bill was over $1.3 million. The trustee paid the tax under protest but sued for a refund in North Carolina state court, arguing that the tax as applied to the Kaestner Trust violates the Fourteenth Amendment Due Process Clause ("[N]o State shall... deprive any person of life, liberty, or property, without due process of law.").

The state trial court decided that Ms. Kaestner's residency in North Carolina was "too tenuous a link" between the State and the Trust to support taxation and agreed that the Department of Revenue's tax assessment violated the Due Process Clause. Both the North Carolina Court of Appeals and the North Carolina Supreme Court affirmed the decision. North Carolina then appealed this decision to the United States Supreme Court.

The Court applies a two-step test to decide if a state tax abides by the Due Process Clause:

  • First, there must be "some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax."
  • Second, the "income attributed to the State for tax purposes must be rationally related to values connect with the taxing State."

The U.S. Supreme Court had previously upheld "minimum contacts" to justify a tax on trust assets where there were actual distributions to in-state residents, where the trustee was based in-state, or where the site of the trust administration was in-state. Furthermore, the U.S. Supreme Court previously held 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 the asset." In this case, the Trust has not actually made any distributions to Ms. Kaestner or any North Carolina resident in the tax years in question. The grantor, trustee and trust records were all out of state. The ONLY connection between North Carolina and the Trust was the fact that the beneficiaries lived in that state. Even more compelling, the fact that the beneficiaries could not count on receiving any specific income in the future makes it uncertain to determine how much North Carolina could even tax. As a result, the justices agreed that presence of beneficiaries alone does not empower a State to tax trust income that has not been distributed or where the beneficiaries have no right to demand it.

North Carolina contends that a trust and its beneficiaries are "inextricably intertwined" and that any legal action to recover taxes from a trust is, in reality, a legal action regarding the beneficiary's money. At some point, the State argues, the trust assets will be in the hands of the in-state beneficiary and the only question was when it would happen. However, the justices responded that there are "wide variations in beneficiaries' interests". In some cases, the relationship between the trust and the beneficiaries is "beyond separation" such as when the beneficiary actually receives assets. In other cases, a beneficiary may only have a "future interest", or "an interest that is subject to conditions", or an "interest that is controlled by a trustee's discretionary decisions". In this case, the trustee has the sole discretion over distributing income to Ms. Kaestner or any other beneficiary in the tax years affected, so to say that her relationship to the assets was "beyond separation" does not comport with the reality. The tax, as applied to the Kaestner Trust, is invalid.

This decision does not prevent states from tax trust assets distributed to in-state beneficiaries from other states, but rather establishes limits to taxation when the in-state beneficiary does not yet receive trust income or lacks the right to demand that income from the out-of-state trust. North Carolina is in the minority of states that look to the beneficiary's in-state residency as the sole determination for trust taxation in its statute. Many other states consider residency as one of many factors to decide if a trust should be taxed. The court's opinion considers the residency question alone to be a violation of the Fourteenth Amendment Due Process Clause, but does not invalidate statutory schemes where this is just a single consideration in the totality of circumstances. North Carolina can amend its laws to allow the Department of Revenue to consider a variety of factors for trust taxation so its scheme can pass constitutional muster.

How would Michigan's trust taxation scheme be affected by this decision? MCL 206.30(1) provides that "taxable income" means the "adjusted gross income for a person other than a corporation, estate, or trust, as defined in the Internal Revenue Code...". A "person" under Michigan law includes a beneficiary of a trust. The Internal Revenue Code (Sections 671 through 679) requires that a beneficiary of a trust includes in his or her gross income the amount of income required to be distributed by a trust, whether actually distributed or not, plus all other amounts that are properly paid, credited or required to be distributed to the tax. It does not matter if the trust is a resident trust or non-resident trust.

Further, MCL 206.51(7) allows a tax credit for a resident beneficiary in the current tax year in an amount that is "all or a proportionate part of any tax paid by the trust under this part for any preceding taxable year that would not have been payable if the trust had in fact made distribution to its beneficiaries at the times and in the amounts specified in... the internal revenue code." This way, Michigan beneficiaries are not paying taxes twice for the same income, once for the year they should have gotten it and once for the year they did get it. For an out-of-state beneficiary of a Michigan trust, the beneficiary pays state income taxes to his or her state of residency, not Michigan.

Unlike North Carolina, Michigan only taxes the in-state beneficiary IF the beneficiary actually receives trust income in that tax year OR the beneficiary is required to receive trust income that year even if he or she does not actually receive it. Michigan does not tax trust beneficiaries solely on the basis of in-state residency. Therefore, Michigan's trust taxation statutes are not affected by the Kaestner Trust decision.

If you have further questions about Michigan's taxation of trusts, do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC today.

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