Do you live in a high-tax state? Would you be better off having assets in a trust in a state with no taxes? The U.S. Supreme Court just answered the second question with a resounding “Yes” in the Kaestner case. States cannot tax out-of-state trusts. A case summary of this important decision follows:

ISSUE

Can a State lawfully tax the income of a trust merely because a beneficiary of the trust lives in the State?

APPLICABLE LAW

In North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, ____________ U.S. _________,___________S.Ct.________, 2019 WL 2552488 (decided June 21, 2019), the United States Supreme Court unanimously conclude that the North Carolina state residence of a trust beneficiary did not supply the minimum connection with North Carolina to support the State’s imposition of tax on trust income, and thus the State’s tax as applied to the trust violated the Due Process Clause of the United States Constitution.

The Decision in Kaestner

Justice Sotomayor delivered the opinion for a unanimous Court, and Justice Alito filed a concurring opinion, in which Justices Roberts and Gorsuch joined.

The court stated that this case was about the limits of a State’s power to tax a trust, and observed that North Carolina imposes a tax on any trust income that “is for the benefit of” a North Carolina resident. The court noted that the North Carolina courts interpret this law to mean that a trust owes income tax to North Carolina whenever the trust’s beneficiaries live in the State, even if—as was the case here—those beneficiaries received no income from the trust in the relevant tax year, had no right to demand income from the trust that year, and could not count on ever receiving income from the trust.

However, the Court pointed out that, even the North Carolina courts held the tax to be unconstitutional when assessed in such a case, because the State lacked the minimum connection with the object of its tax that the Constitution requires. The Court agreed, and affirmed the decision of the North Carolina courts, because, as applied in these circumstances, the Court concluded that the State’s tax violated the Due Process Clause of the Fourteenth Amendment.

The Facts in Kaestner

Originally, the precursor of the trust in question was formed nearly 30 years ago when New Yorker Joseph Lee Rice III formed a trust for the benefit of his children. Rice decided that the trust would be governed by the law of his home State, New York, and he appointed a fellow New York resident as the trustee, who was later succeeded by a Connecticut resident as trustee.

The trust agreement provided that the trustee would have “absolute discretion” to distribute the trust’s assets to the beneficiaries in such amounts and proportions as the trustee might from time to time decide. When Rice created the trust, no trust beneficiary lived in North Carolina. That changed in 1997, when Rice’s daughter, Kimberley Rice Kaestner, moved to the State. She and her minor children were residents of North Carolina from 2005 through 2008, the time period relevant for this case.

A few years after Kaestner moved to North Carolina, the trustee divided Rice’s initial trust into three subtrusts. One of these subtrusts—the Kimberley Rice Kaestner 1992 Family Trust (the “Kaestner Trust”)—was formed for the benefit of Kaestner and her three children. The same agreement that controlled the original trust also governed the Kaestner Trust. Critically, this meant that the trustee had exclusive control over the allocation and timing of trust distributions.

North Carolina admitted in the state-court proceedings that the State’s only connection to the Trust in the relevant tax years was the in-state residence of the Trust’s beneficiaries. From 2005 through 2008, the trustee chose not to distribute any of the income that the Trust accumulated to Kaestner or her children, and the trustee’s contacts with Kaestner were “infrequent”; there were only two meetings between Kaestner and the trustee I those years, both of which took place in New York.

The trustee also gave Kaestner accounts of trust assests and legal advice concerning the Trust. The Trust was subject to New York law; the grantor was a New York resident; and no trustee lived in North Carolina. The trustee kept the Trust documents and records in New York, and the Trust asset custodians were located in Massachusetts.

The Trust also maintained no physical presence in North Carolina, made no direct investments in the State, and held no real property there. The Trust agreement provided that the Kaestner Trust would terminate when Kaestner turned 40, after the time period relevant here. After consulting with Kaestner and in accordance with her wishes, however, the trustee rolled over the assets into a new trust instead of distributing them to her. This transfer tool place after the relevant tax years.

Between 2005 and 2008, North Carolina required the Connecticut trustee to pay more than $1.3 million in taxes on income earned by the assets in the Kaestner Trust. North Carolina levied this tax solely because of Kaestner’s residence within the State.

Course of Proceedings in Kaestner

The Court noted that North Carolina taxes any trust income that “is for the benefit of” a North Carolina resident, and that the North Carolina Supreme Court interprets the statute to authorize North Carolina to tax a trust on the sole basis that the trust beneficiaries reside in the State. Applying this statute, the North Carolina Department of Revenue assessed a tax on the full proceeds that the Kaestner Trust accumulated for tax years 2005 through 2008 and required the trustee to pay it. The resulting tax bill amounted to more than $1.3 million.

The trustee paid the tax under protest and then sued in state court, arguing that the tax as applied to the Kaestner Trust violated the Due Process Clause of the Fourteenth Amendment. The trial court decided that the Kaestner’s residence in North Carolina was too tenuous a link between the State and the Trust to support the tax and held that the State’s taxation of the Trust violated the Due Process Clause.

The North Carolina Court of Appeals affirmed, as did the North Carolina Supreme Court. A majority of the State Supreme Court reasoned that the Kaestner Trust and its beneficiaries “have legally separate, taxable existences” and thus that the contacts between the Kaestner family and their home State cannot establish a connection between the Trust “itself” and the State. The Court granted certiorari to decide whether the Due Process Clause prohibits States from taxing trusts based only on the in-state residency of trust beneficiaries. 

The Rationale in Kaestner

Initially, the Court noted that, in its simplest form, a trust is created when one person (a “settlor” or “grantor”) transfers property to a third party (a “trustee”) to administer for the benefit of another (a “beneficiary”). As traditionally understood, the arrangement that results is not a distinct legal entity, but a fiduciary relationship between multiple people.

The trust comprises the separate interests of the beneficiary, who has an equitable interest in the trust property, and the trustee, who had a legal interest in that property. In some contexts, however, trusts can be treated as if the trust itself has a separate existence from its constituent parts, and that trusts are treated as distinct entities for federal taxation purposes. 

The court noted that the Due Process Clause provides that “[n]o State shall…deprive any person of life, liberty, or property, without due process of law.” The Court pointed out that the Clause centrally concerns the fundamental fairness of governmental activity; and that in the context of state taxation, the Due Process Clause limits States to imposing only taxes that bear fiscal relation to protection, opportunities, and benefits given by the state. The Court observed that the power to tax is essential to the very existence of government, but cautioned that the legitimacy of that power requires drawing a line between taxation and mere unjustified confiscation. 

The Court concluded that the boundary turns on the simple but controlling question whether the state has given anything for which it can ask return. In this regard, the Court applied a two-step analysis 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 connected with the taxing State. 

To determine whether a State has the requisite “minimum connection” with the object of its tax, the Court borrowed from the familiar test of International Shoe Co. v. Washington, 326 U.S. 310, 66 S.Ct. 154, 90 L.ED. 95 (1945). Thus, a State has the power to impose a tax only when the taxed entity has certain “minimum contacts” with the State such that the tax does not offend “traditional notions of fair play and substantial justice.” The Court stated that the “minimum contacts” inquiry is flexible and focuses upon the reasonableness of the government’s action. Ultimately, only those who derive benefits and protection from associating with a State should have obligations to the State in question.

The Court noted it had already held that a tax on trust income distributed to an in-state resident passes muster under the Due Process Clause, as does a tax based on a trustee’s in-state residence (this is a planning opportunity for creating Nevada based trusts, where there are no state taxes). The Court also suggested that a tax based on the site of trust administration was constitutional. However, the Court carefully distinguished the Kaestner Trust upon the following grounds: (1) the Kaestner Trust made no distributions to any North Carolina resident in the years in question; (2) the trustee resided out of State; (3) the Trust administration was spilt between New York (where the Trust’s records were kept) and Massachusetts (where the custodians of its assets were located); (4) the trustee made no direct investments in North Carolina in the relevant tax years; and (5) the settlor did not reside in North Carolina. The Court emphasized that of all the potential kinds of connections between a trust and a State, North Carolina sought to rest its tax on just one—the in-state residence of the beneficiaries.

For these reasons, the Court held that the presence of in-state beneficiaries alone did not empower a State to tax trust income that had not been distributed to the beneficiaries where the beneficiaries had no right to demand that income and were uncertain ever to receive it. In limiting its holding to the specific facts presented, the Court did not imply approval or disapproval of trust taxes that were premised on the residence of beneficiaries whose relationship to trust assets differed from that of the beneficiaries here.

In discussing its holding, the Court noted that, in the past, it had analyzed state trust taxes for consistency with the Due Process Clause by looking to the relationship between the relevant trust constituent (settlor, trustee, or beneficiary) and the trust assets that the State sough to tax. In the context of beneficiary contacts specifically, the Court noted that it had focused upon the extent of the in-state beneficiary’s right to control, possess, enjoy or receive trust assets. The Count pointed out that its emphasis on these factors emerged in the following two early cases: (1) Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83, 50, S.Ct. 59, 74 L.Ed. 180 (1929) (rejecting Virginia’s attempt to tax a trustee on the whole corpus of the trust estate, and explaining that nobody within Virginia had the present right to the trust property’s control or possession, or to receive income therefrom); and (2) Brooke v. Norfolk, 277 U.S. 27, 48 S.Ct. 422, 72 L.Ed. 767 (1928) (rejecting a tax on the entirety of a trust fund assessed against a resident beneficiary because the trust property was no within the State, did not belong to the beneficiary, and was not within her possession or control).

Both of these cases invalidated state taxes premised on the in-state residency of beneficiaries, and in each of these cases, the challenged tax fell on the entirety of a trust’s property, rather than on only the share of trust assets to which the beneficiaries were entitled. On the other hand, the Court noted that the same elements of possession, control, and enjoyment of trust property had let it to uphold state taxes based upon the in-state residency of beneficiaries who did have close ties to the taxed trust assets, and where the trust income actually was distributed to an in-state beneficiary. The Court states that, in those circumstances, the beneficiary owned and enjoyed an interest in the trust property, and the State could exact a tax in exchange for offering the beneficiary protection. 

The Court observed that its past cases reflected a common governing principle, i.e., when a State seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax. Although the Court stated that its resident-beneficiary cases were most relevant here, similar analysis also appeared in the context of taxed premised on the in-state residency of settlors and trustees; and that a focus on ownership and rights to trust assets also featured in the Courts; ruing that a trustee’s in-state residency can provide the basis for a state to tax trust assets.

In summary, the Court concluded that, when assessing a state tax premised on the in-state residency of a constituent of a trust—whether beneficiary, settlor, or trustee—the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee. However, when a tax is premised on the in-state residence of a beneficiary, 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; otherwise, the State’s relationship to the object of its tax is too attenuated to create the “minimum connection” that the constitution requires.

Applying these principles to the Kaestner Trust, the Court concluded: (1) the residence of the Kaestner Trust beneficiaries in North Carolina alone did not supply the minimum connection necessary to sustain the State’s tax; (2) the beneficiaries did not receive any income from the trust during the years in question (if they had, such income would have been taxable); (3) the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue; (4) the decision of when, whether, and to whom the trustee would distribute the trust’s assets was left to the trustee’s “absolute discretion”; (5) the Trust agreement explicitly authorized the trustee to distribute funds to one beneficiary to the exclusion of others, with the effect of cutting one or more beneficiaries out of the Trust; (6) the Trust Agreement authorized the trustee, not the beneficiaries, to make investment decisions regarding Trust property, thus making the beneficiaries’ interest less like a potential source of wealth that was property in their hands; (7) not only were Kaestner and her children unable to demand distributions in the tax years at issue, but they also could not count on necessarily receiving any specific amount of income from the Trust in the future; (8) Kaestner and her children had no right to control or possess the trust assets or to receive income therefrom; and (9) Kaestner and her children received no income from the Trust, had no right to demand income from the Trust, and had no assurance that they would eventually receive a specific share of Trust income.  The Court concluded that, given these features of the Kaestner Trust, the beneficiaries’ residence could not, consistent with due process, serve as the sole basis for North Carolina’s tax on trust income.  For these reasons, the Court affirmed the judgment of the Supreme Court of North Carolina.

Justice Alito’s Concurring Opinion

Justice Alito noted that he joined the opinion of the Court because he believed that it properly concluded that North Carolina’s tenuous connection to the income earned by the trust was insufficient to permit the State to tax the trust’s income.  However, he cautioned that, because this connection was unusually tenuous, the opinion of the Court was circumscribed. He stated that he wrote separately to make clear that the opinion of the Court merely applies its existing precedent and that its decision not to answer questions not presented by the facts of this case did not open for reconsideration any points resolved by its prior decisions.

Justice Alito observed that, although states have broad discretion to structure their tax systems, in a few narrow areas the Federal Constitution imposes limits on that power.  The Due Process Clause creates one such limit. It imposes restrictions on the persons and property that a State can subject to its taxation authority. The Due Process Clause requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.  North Carolina assesses this tax against the trustee and calculates the tax based on the income earned by the trust. Therefore, it is necessary to look at the connections between the assets held in trust and the State.

Justice Alito pointed out that it is easy to identify a State’s connection with tangible assets.  A tangible asset has a connection with the State in which it is located, and generally speaking, only that State has power to tax the asset.  However, intangible assets–stocks, bonds, or other securities–present a more difficult question.  In the case of intangible assets held in trust, Justice Alito noted that the Court previously had focused upon whether a resident of the State imposing the tax has control, possession, or the enjoyment of the asset.  Because a trustee is the legal owner of the trust assets and possesses the powers that accompany that status–power to manage the investments, to make and enforce contracts respecting the assets, and to litigate on behalf of the trust–the trustee’s State of residence can tax the trust’s intangible assets.  On the other hand, the Court now was being asked whether the connection between a beneficiary and a trust is sufficient to allow the beneficiary’s State of residence to tax the trust assets and the income they earn while the assets and income remain in the trust in another State.

Justice Alito stated that the following two cases provide a clear answer: (1) Brooke, supra; and (2) Safe Deposit, supra.

  1. In Brooke, supra, Virginia assessed a tax on the assets of a trust whose beneficiary was a resident of Virginia. The trustee was not a resident of Virginia and administered the trust outside the Commonwealth. Under the terms of the trust, the beneficiary was entitled to all the income of the trust and had paid income taxes for the money that had been transferred to her. But the Court held that, despite the beneficiary’s present and ongoing right to receive income from the trust, Virginia could not impose taxes on the undistributed assets that remained within the trust because the property was not within the State, did not belong to the petitioner, and was not within her possession or control.  Even though the beneficiary was entitled to and received income from the trust, the Court observed that she was a stranger to the assets within the trust because she lacked control, possession, or enjoyment of them.
  2. In Safe Deposit, supra, Virginia again attempted to assess taxes on the intangible 

assets held in a  trust whose trustee resided in Maryland.  The beneficiaries were children who lived in Virginia.  Under the terms of the trust, each child was entitled to one half of the trust’s assets (both the original principal and the income earned over time) when the child reached the age of 25.  Despite their entitlement to the entire corpus of the trust, the Court held that the beneficiaries’ residence did not allow Virginia to tax the assets while they remained in trust, and noted that nobody within Virginia had the present right to the assets’ control or possession, or to receive income therefrom, or to cause them to be brought physically within her borders. The Court concluded that the beneficiaries’ equitable ownership of the trust did not sufficiently connect the undistributed assets to Virginia as to allow taxation of the trust, and that the beneficiaries’ equitable ownership yielded to the established fact of legal ownership, actual presence, and control elsewhere.

Justice Alito pointed out that in Kaestner, as in Brooke and Safe Deposit, the resident beneficiary had neither control nor possession of the intangible assets in the trust.  She did not enjoy the use of the trust assets. The trustee administered the trust and held the trust assets outside the State of North Carolina.  Justice Alito stressed that, under Safe Deposit and Brooke, that was sufficient to establish that North Carolina could not tax the trust or the trustee on the intangible assets held by the Kaestner Trust.

In summary, Justice Alito concluded that the Due Process Clause requires a sufficient connection between an asset and a State before the State can tax the asset.  For intangible assets held in trust, the Court’s precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry.  Justice Alito stated that the opinion of the Court rightly concluded that the assets in the Kaestner Trust and the Trust’s undistributed income could not be taxed by North Carolina because the resident beneficiary lacked control, possession, or enjoyment of the Trust assets.  Justice Alito emphasized that the Court’s discussion of the peculiarities of the Kaestner trust did not change the governing standard, nor did it alter the reasoning applied in the Court’s earlier cases.  On that basis, he concur with the Court’s opinion. 

BRIEF DISCUSSION

The gist of Kaestner was that a State cannot tax trust income merely because a beneficiary of the trust lives in that State; however, the discussion in Kaestner also provides some indication as to when it may be permissible for a state to tax the income of a trust.  The following is a list of some of the factors to be considered:

  1. Income Distributed to an In-State Resident.  

The Court noted that the in-state beneficiaries in Kaestner did not receive any income from the trust during the years in question; and that, if they had, then such income would have been taxable.  The Court further noted that it had already held that a tax on trust income distributed to an in-state resident passes muster under the Due Process Clause.  The court emphasized that, not only were Kaestner and her children unable to demand distributions in the tax years at issue, but they also could not count on necessarily receiving any specific amount of income from the Trust in the future; they had no right to control or possess the trust assets or to receive income therefrom; they received no income from the Trust; they had no right to demand income from the Trust; and they had no assurance that they would eventually receive a specific share of the Trust income.  

  1. Residence of Trustee.  

The Court noted that a tax based on a trustee’s in-state Residence also passes muster under the Due Process Clause.

  1. Site of Trust Administration.  

The Court suggested that a tax based on the site of trust administration was constitutional.

  1. Residence of Grantor/Settlor.  

The Court concluded that, although the residence of the grantor/settlor of a trust is an important factor to be considered, the mere fact that the grantor/settlor of a trust lives in the taxing state may not, in and of itself, be sufficient to support taxation of the trust. 

  1. Control, Possession, and Ability to Use or Enjoy Intangible Asset.

The Court noted that the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue.  Justice Alito’s concurring opinion also emphasized that, for intangible assets held in trust, the Court’s precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry.  

  1. Trustee’s Exclusive Control.  

The Court noted that the Trust agreement provided that the Trustee would have “absolute discretion” to distribute the trust’s assets to the beneficiaries in such amounts and proportions as the trustee might from time to time decide; that the Trustee’s exclusive control over the allocation and timing of trust distributions was “critical”; that the Trust agreement explicitly authorized the trustee to distribute funds to one beneficiary to the exclusion of others, with the effect of cutting one or more beneficiaries out of the Trust; and that the decision of when, whether, and to whom the Trustee would distribute the Trust’s assets was left to the Trustee’s “absolute discretion.”  The Court stressed that the Trust Agreement authorized the Trustee, not the beneficiaries, to make investment decisions regarding Trust property, which made the beneficiaries’ interest less like a potential source of wealth that was property in their hands.

7.     Trust Not Subject to Governing Law.  

The Court noted that the Trust was formed under New York law, and not under North Carolina law, and that the Trust was subject to New York law. 

8. Physical Location of Trust Records.  

The Court indicated that the Trustee kept the Trust documents and records in New York, and not in North Carolina.

9. Physical Location of Asset Custodians.  

The Court indicated that the Trust asset custodians were located in Massachusetts, and not in North Carolina. 

10. No Direct Investments in Taxing State.

The Court noted that the Trust maintained no physical presence in North Carolina, made no direct investments in the State, and held no real property there.  

11. Number of Meetings Between Trustee and Beneficiary.

The Court noted that the Trustee’s contacts with Kaestner were “infrequent”; therefore, the number of meetings between the trustee and the beneficiary may be relevant. 

12. Geographic Location of Meetings Between Trustee and Beneficiary.

The Court noted that there were only two meetings between Kaestner and the Trustee, both of which took place in New York; therefore, the geographic location of trustee/beneficiary meetings may be important.

13. Termination of Trust at Specified Age.

The Court noted that the Trust agreement provided that the Kaestner Trust would terminate when Kaestner turned 40; but that, after consulting with Kaestner, and in accordance with her wishes, and after the relevant tax years, the Trustee rolled over the assets into a new trust instead of distributing them to her.  Thus, it would seem that drafting a trust as long-term trust, or even as perpetual trust, would be a safer option.  

CONCLUSION

Although the decision in Kaestner generally was a favorable decision for taxpayers, it was, by its terms, a very narrow holding.  The Court concluded that the residence of the Trust beneficiaries in North Carolina alone did not supply the minimum connection necessary to sustain the State’s tax; and could not, consistent with due process, serve as the sole basis for North Carolina’s tax on trust income.  For these reasons, the Court affirmed the judgment of the Supreme Court of North Carolina. As noted by the concurring opinion of Justice Alito, for intangible assets held in trust, the Court’s precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry.