In this blog we go back to the topic of family trusts. On June 21st of this year the Supreme Court issued their opinion on a trust case dealing with the State’s ability to tax a trust. NORTH CAROLINA DEPARTMENT OF REVENUE v. KIMBERLEY RICE KAESTNER 1992 FAMILY TRUST. In this case, an irrevocable family trust was created in New York for the benefit of children. It provided for a New York trustee and was to be governed by New York law. From 2005-2008 one of these children lived in North Carolina. During these years the trustee made no distributions to the North Carolina beneficiary. This was the trust’s only connection to North Carolina.
The catch is that North Carolina decided to tax the beneficiary to the tune of $1.3 million. The trustee paid “under protest” and then sued for repayment. His argument was that the taxation violated the Constitution, specifically the Due Process Clause of the Fourteenth Amendment. The Supreme Court agreed. The connection for North Carolina taxation was far too tenuous.
How does KAESTNER 1992 FAMILY TRUST apply to me?
It is likely that much of the ruling doesn’t apply in California. This is important to understand, too. Why not? The beneficiary in North Carolina only had “contingent benefits”. In New York, there was a trustee who maintained sole discretion for distribution of assets. The North Carolina beneficiary could not access the money. California only taxes state residents with non-contingent benefits in out of state trusts. This seems to be more of a rope of connection instead of the thread in Kaestner.
One future line of inquiry is into the wording of the North Carolina trust. To avoid taxation, in California, an out of state trust must contain specific language regarding trustee discretion to avoid taxation. It is possible that California’s language requirement is too narrow. The beneficiary in Kaestner did not have access to the money and could not draw on it. The New York trustee had complete distribution discretion.
Why did the SCOTUS rule the way they did?
First, the Supreme Court said that North Carolina did not have the necessary connection to tax the trust, digging back to the “minimum connections” test of International Shoe that the tax “does not offend ‘traditional notions of fair play and substantial justice.’ ” International Shoe Co., 326 U. S., at 316; see Quill, 504 U. S., at 308. The mere residence of the trust beneficiary did not meet this test. Second, they noted that the trustee had absolute discretion to distribute assets, which the trustee did not do during the years in question. Third, the North Carolina beneficiary could not rely upon any distribution at all, ever.
In conclusion, Kaestner gives guidance about the states ability to tax a trust. There is likely minimal fallout for California. In the mean time it seems smart to draft trusts with Kaestner in mind to avoid any current tax at trust level. Seek professional guidance now.