On June 21, 2019, the Supreme Court unanimously agreed to limit States’ ability to tax trust income. Justice Sotomayor delivered the opinion for the case, entitled North Carolina Dept. of Revenue v. Kimberly Rice Kaestner 1992 Family Trust.
In the Kaestner Trust case, Joseph Lee Rice III had set up a trust in New York for his daughter. The daughter, Kimberly Rice Kaestner, was entitled to a discretionary interest in the trust. Having a discretionary interest in a trust means that Kimberly could only receive money out of the trust if the Trustee agrees. Kimberly moved to North Carolina and the State of North Carolina tried taxing the income on the trust based upon the fact that Kimberly was a state resident. It should be noted that the Trustee did not live in North Carolina and the Trust assets were located outside of North Carolina as well.
The Supreme Court rejected North Carolina’s argument that it should be able to tax the Kaestner Trust though. The Supreme Court upheld the principal that States must have a certain minimum connection with a Trust in order to be able to tax it. Before a State can tax a Trust based upon where a trust beneficiary lives, the Due Process Clause requires that such beneficiary must be entitled to receive trust assets or exercise a certain amount of control, possession, or enjoyment over the trust assets. Specifically, the Supreme Court ruled that “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”.
This ruling is important because it clarifies that a parent can establish a trust for child in a manner that minimizes state income taxes. For example, if Child lives in a state with a high income tax, and earns a nice living, Parent might not want to leave Child money outright upon death. Parent can establish a trust for the benefit of Child in a tax friendly jurisdiction so that Child can have money if needed, but otherwise it can grow free of a state income tax. Parent does not need to worry that the trust will be taxed based upon the residency of Child. The other benefit to this type of plan is that the trust can protect Child’s inheritance from creditors and divorce.