Imagine that you are a taxpayer living in Pennsylvania who has recently established a trust for the benefit of your Ohio-resident children. Further imagine that you have appointed your brother, a Maryland resident, to serve as the trustee, and your trust investments perform well and earn significant income during the year. This doesn’t sound complicated so far, but there’s a catch: when tax season arrives, which of these states have the power to tax your trust?
It goes without saying that each of these states will be quite willing to enthusiastically tax your trust. But their authority to do so is regulated by certain provisions of the United States Constitution which require the existence of “minimum contacts” between your trust and the state before taxation is permitted. Taxpayers and state tax authorities often don their boxing gloves to spar over the satisfaction of these minimum contacts, occasionally calling upon the courts to referee these disputes.
The limits of a state’s ability to tax a trust were recently examined by the United States Supreme Court. A taxpayer, who was a resident of New York, formed a trust for the benefit of his descendants. The trust was governed by New York law and was administered in the state by a Connecticut trustee. During the years in question, the beneficiaries resided in North Carolina. However, the trust earned no income in North Carolina, made no investments there and otherwise maintained no presence in the state. The beneficiaries also had no right to, and did not receive, any distributions from the trust.
The North Carolina taxing authorities sought to tax the trust on the grounds that the residence of the beneficiaries within the state was sufficient to create the minimum contacts necessary for taxation. However, on June 21, 2019, the Court unanimously ruled that North Carolina’s efforts to tax the trust violated the Due Process Clause of the Constitution. The Court reasoned 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 if the beneficiaries have no right to demand such income and their receipt of the income is uncertain.
Currently, there is no uniformity among states regarding the basis of taxation of trusts. A trust may be subject to a state’s taxation based upon the residence of the grantor, the location of the trust’s administration, the residence of the trustee or beneficiaries, or any combination of these factors. Because of this inconsistency between state laws, it is possible for more than one jurisdiction to conclude that it has the constitutional authority to tax your trust. We therefore strongly advise you to consult your tax advisor when establishing a trust to prevent any avoidable state tax consequences.
North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, U.S. Supreme Court, Dkt. 18-457, June 21, 2019.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.