Trust Income, know the Tax laws

Legitimate Taxation or “Confiscation?”
Taxing Trust Income

Which states can tax a trust’s income? This exact question was taken up by the Supreme Court in their recent opinion North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust. North Carolina was of the opinion that they could tax the trust income of any and all trusts with at least one beneficiary residing in their state. The Supreme Court, however, disagreed.

North Carolina courts had interpreted local law to mean that a trust owes income tax to North Carolina whenever at least one beneficiary lives in North Carolina. According to North Carolina’s highest court, it didn’t matter whether those beneficiaries living in North Carolina received any distributions, or even whether they had a right to demand distributions from the trust. North Carolina was going to tax the trust income no matter what.

Between the years of 2005-2008, the Kaestner Trust paid more than $1.3 million dollars in state income taxes to North Carolina, despite the facts that (1) the beneficiaries living in North Carolina received no income from the trust during those years and (2) the beneficiaries had no right to demand trust income during those years. The Kaestner Trust challenged the North Carolina law as being an unconstitutional violation of the Fourteenth Amendment’s Due Process Clause.

The Supreme Court began its analysis by noting that the Due Process Clause is centrally concerned with the fairness of government activity. According to the Court, the power to tax is “essential to the very existence of government,” but the legitimacy of the taxing power requires drawing a line between real taxation and mere unjustified “confiscation.” Critically, the difference between a legitimate tax and an illegitimate tax lies in whether the person or object (in this case, a trust) being taxed has certain “minimum connections” with the state such that the state is justified in taxing them.

Ultimately, the Supreme Court found that North Carolina could not tax a trust which is only connected to North Carolina by the in-state residence of the beneficiaries. The Court made clear, however, that its holding was limited to the facts of the case. The outcome may have been different if the North Carolina beneficiaries received income from the trust or even if they had a right to receive income from the trust. Also, if the Kaestner Trust’s trustees resided in North Carolina or if trust administration took place in North Carolina, the court may have upheld the taxation.

This case makes clear that mere in-state residence of beneficiaries is not a sufficient ground for taxing a trust. However, it underscores the myriad factors that go into whether a state can tax trust income. Estate attorneys and those wishing to settle a trust need to carefully consider all of these factors to avoid unwanted tax consequences. Please do not hesitate to contact the attorneys Bart Chepenik, J.D. LL.M. (Taxation) 305-613-3548 or Brad Trushin, Esq. 305-981-8889 of Chepenik Trushin LLP, who are ready, willing, and able to assist with your estate planning, trust administration, and probate litigation needs.


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