Trusts and Taxes Case is Good News for the People
If you have, or intend to have, any relationship with a trust in any capacity, then you need to know about the US Supreme Court’s opinion in Kaestner. https://www.supremecourt.gov/opinions/18pdf/18-457_2034.pdf
The issue is taxation. Some background is necessary to set the stage.
Trusts and Undistributed Income
Many trusts hold assets that generate income. If any of that income remains in the trust at the end of the year, then it is considered “undistributed income.”
Forty-three states and the District of Columbia impose an income tax on undistributed income for a non-grantor trust. A “non-grantor” trust is one where the donor of the trust’s assets gave up all control over the assets and is neither a beneficiary nor a trustee of the trust.
Naturally, those states want to tax as many trusts as they possibly can because more taxable trusts means more income to the state. We are not talking insignificant sums; California imposes a 12.30% tax on all undistributed income in a non-grantor trust.
A state can tax all of the undistributed income on trusts that it deems as “resident.” If it considers a trust to be “non-resident,” then it can tax only the income derived from sources within the state’s jurisdiction.
State Laws, Trusts and Taxes
States make their own rules about whether trusts are resident or non-resident. What we are left with is a crazy patchwork of laws. There is an excellent survey of state laws at Bloomberg BNA, https://src.bna.com/tBG
To try to avoid those onerous taxes, many people set up their trusts in one of the non-income tax states: Texas, Alaska, Florida, Nevada, South Dakota, Washington and Wyoming. That is a good first step, but it is not a complete shield because the income -tax states look beyond where the trust was established. They also consider trusts that were created through a testator’s will who lived in the state, trusts that are inter vivos (during someone’s lifetime) and were created or funded by a person who lived in the state, trusts being administered in the state, or trusts with trustees who live in the state.
Now we come to Kaestner. Kimberly Kaestner, a North Carolina resident, was the beneficiary under her dad’s trust. Although it had no connection to the trust other than Kimberly’s residence, North Carolina taxed Kimberly’s trust more than $1.3 million over a 3- year period. During that time, Kimberly had received no distributions from the trust, had no right to force the trust to distribute any money to her and did not enjoy any of the trusts’ assets. The trust did not have a physical presence, own real property, or make any direct investments in North Carolina.
North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, Who won?
Kimberly was not happy. She paid the taxes and then appealed. The Supreme Court, in a 9-0 decision, struck down North Carolina’s law as unconstitutional because the trust did not have enough of a minimum connection with North Carolina to justify it being taxed.
Kaestner should give some guidance to people who want to avoid another state’s income tax on their trust.
Virginia Hammerle is a litigation and estate planning attorney with Hammerle Finley Law Firm. Contact her at legaltalktexas@hammerle.com, and sign up for her newsletter.
