Can a state tax a trust based on the beneficiary’s residency?

By Frances Schafer, J.D., and Eileen Reichenberg Sherr, CPA, CGMA

On Tuesday, the U.S. Supreme Court heard oral arguments in the case of North Carolina Dep’t of Rev. v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S.). The case involves a North Carolina statute (N.C. Gen. Stat. §105-160.2) that allows a trust to be taxed solely because it has a North Carolina beneficiary, which was held to be unconstitutional by the North Carolina Supreme Court for violating the Due Process Clause of the 14th Amendment to the U.S. Constitution (Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Dep’t of Rev., 814 S.E.2d 43 (N.C. 2018), aff’g 789 S.E.2d 645 (N.C. Ct. App. 2016), aff’g 12 CVS 8740 (N.C. Sup. Ct., Wake Cty. 4/23/15)).

Trusts generate more than $120 billion in earnings every year, so the question of which state is entitled to tax that income is a significant one. According to the states’ amici brief supporting North Carolina, of the 44 states that impose an income tax on trusts, 12 “use the location of the trustee as the primary consideration in determining residency”; 27 provide for taxation “based on either the location of the beneficiary or the location of the grantor, without reference to the location of the trustee”; and six use multiple factors.

Matthew Sawchak, the North Carolina solicitor general, argued that the trust assets are owned by the beneficiaries of the trust and that North Carolina taxes only the pro rata portion of the trust’s current income based on the number of beneficiaries who are North Carolina residents. As a discretionary beneficiary of this trust, the North Carolina resident is currently eligible for distributions, so she is a current beneficiary of the trust. He said that during the time that a trust accumulates income and does not make distributions, the state of North Carolina is providing protection for the trust assets that are owned by the beneficiaries and should be entitled to tax a proportionate share of the trust’s income.

Several justices asked the solicitor general pointed questions. Because the trustee has discretion to make distributions to the North Carolina resident and also to her children who are not North Carolina residents, Justices Ruth Bader Ginsburg and Sonia Sotomayor inquired how the amount passing to the North Carolina resident will be determined since there is no way to know what she will ultimately receive.

Justice Stephen Breyer inquired whether present value concepts should apply because current income is being taxed that may not be distributed for many years. Sotomayor asked if North Carolina was in essence changing the trust instrument because, if there are five beneficiaries and one of those beneficiaries is a North Carolina resident, then North Carolina taxes 20% of the income because the trustee should be giving 20% to her even though she may not get anything. She also asked how the trust is present in the state in order to give North Carolina jurisdiction over the trust to tax it. Sawchak responded that the true owners of the trust assets are the beneficiaries and one of them resides in North Carolina.

David O’Neil, the attorney for the trust, argued that the North Carolina beneficiary has no right to demand assets from the trust and, as a discretionary beneficiary, may in fact never receive any assets from the trust. Therefore, there is nothing that should be subject to North Carolina tax as long as the income is accumulated and not distributed.

O’Neil suggested that a state could enact throwback rules similar to those for distributions to U.S. beneficiaries from foreign trusts. Thus, when a North Carolina resident actually receives a distribution, the state could tax the accumulated income that is part of the distribution as well as the current income. But Justice Brett Kavanaugh chimed in that the North Carolina resident could move to a nontax state prior to receiving the distribution to avoid such a tax.

Justice Elena Kagan seemed to have the most concerns with the trust’s argument. She established three possible locations for the trust income to be taxed: where the trustee lives, where the trust is administered, or where the beneficiaries live. She stated that since the trustee is not the beneficiary of the income growth, the state where the trustee lives has little relevance. The assets in the trust are working for the beneficiary who resides in North Carolina, so North Carolina has by far the greatest interest in the trust.

Most of the other justices’ questions seemed to reflect their concerns about letting states tax a trust based on resident beneficiaries who may never receive any income. The Court will issue its decision by the end of June.

Frances Schafer, J.D., is a former managing director in the National Tax Office of Grant Thornton LLP and a member of the AICPA Trust, Estate and Gift Tax Technical Resource Panel. Eileen Reichenberg Sherr, CPA, CGMA, MT, is a senior manager–AICPA Tax Policy & Advocacy. To comment on this article or to suggest an idea for another article, contact Alistair Nevius, the JofA’s editor-in-chief, tax, at Alistair.Nevius@aicpa-cima.com.

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