Where does a trust “live” and, consequently, what set of tax rules will apply for the beneficiary? Fiduciary state income tax has always been a complicated tangle of rules. Every state has its own trust residency rules based on the location of the grantor, trustee, beneficiaries, where the trust is administered or a combination of these factors.
But a relatively recent case reminds us that understanding the state tax rules of a trust for which you are the beneficiary is critical to understanding how that trust will be taxed.
In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, North Carolina was taxing the income of the Kaestner family trust solely because its beneficiary was a resident of the state. In 2019, the U.S. Supreme Court held that North Carolina could not tax the trust since the residency of the beneficiary was the only connection to the state.
In this case, there are a couple of key facts that made a difference:
North Carolina argued they could tax any trust income that is “for the benefit” of a North Carolina resident — interpreting the phrase “for the benefit” widely to include any North Carolina beneficiaries regardless of whether they receive any income from the trust.
The Court disagreed, explaining that the resident must “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." The fact that the beneficiary lived in the state was not enough to tax trust income that had not been distributed to the beneficiary, or income in which they did not have the right to demand income or receive at some future date.
The right to demand income or receive future distributions was paramount to this case. Had the beneficiary received distributions or if the beneficiary had these distribution rights under the trust, North Carolina would have met a “minimum contact” standard, referenced by that Court, that would justify taxation.
Only a handful of states — North Carolina, Georgia and Tennessee — determine residency solely on where the beneficiaries reside. However, other states may look at a variety of factors when determining how to tax a trust for which you are responsible. The Kaestner case serves as a reminder that understanding the state tax rules based on the location of the trust’s grantor, trustee, administration and beneficiaries is crucial to determining trust residency and, ultimately, where the trust will be taxed. Aging beneficiaries moving to new states or replacing trustees with one from out of state can change the trust’s residency for income tax purposes. It’s important that trustees and tax preparers evaluate these types changes each year, and ideally before the changes are made.
Contact a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.