Supreme Court Blocks North Carolina Tax on Out-of-State Trust

North Carolina was prohibited under the U.S. Constitution from taxing trust income based solely on the trust beneficiary’s residence, the U.S. Supreme Court ruled in a unanimous decision.

States tax trusts based on different factors. These factors can include the residency of the grantor, the residency of the trustee, the residency of the beneficiaries, where trust assets are administered, where trust assets are physically located, or some combination of thereof. However, regardless of the basis of taxation, a state must have sufficient contact or nexus with the trust for the tax to be constitutional.

At issue in North Carolina Dept. of Rev. v. Kaestner was North Carolina’s imposition of tax on a trust for which the settlor and trustee resided out of state and the trust administration took place in New York and Massachusetts. None of the trust’s funds had been distributed to the beneficiaries and the beneficiaries had no right to demand the income. A clause in the trust empowering the trustee to change beneficiaries made it uncertain as to whether the North Carolina beneficiaries would ever receive funds from the trust.

Limiting its holding to the specific facts presented, the U.S. Supreme Court found that North Carolina’s imposition of tax on the trust based solely on the fact that the beneficiaries resided in its jurisdiction violated the Due Process Clause of the U.S. Constitution.

In deciding the case, the Court looked to the extent of the in-state beneficiary’s right to control, possess, enjoy or receive trust assets. The less control a beneficiary has over the trust’s assets, the less likely it would be for a state to permissibly tax the trust solely based on the in-state residence of a trust beneficiary, the Court reasoned. Otherwise, the state’s “relationship to the object of its tax is too attenuated” to satisfy Due Process Clause requirements under the U.S. Constitution, the Court explained.

The Takeaway

Determining whether a state is allowed to tax a trust under the U.S. Constitution requires a complex and fact-specific analysis. The basic components of a trust (i.e., settlor, trustee or beneficiary) may each be located in a different state. The factors states consider in determining whether to impose tax on a trust vary greatly. While the Court’s focus on the level of control a beneficiary has over the trust’s assets is instructive, it remains unclear how the high court would apply this rationale in other scenarios, particularly because the Court specifically limited its holding to the facts and law in this case.