State Income Taxation of Trusts: Some Lessons of Kaestner
Originally appeared in Estate Planning, a Thomson Reuters publication. Copyright 2019 Thomson Reuters/Tax & Accounting.
On 6/21/2019, the Supreme Court of the United States published its decision in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust 1 (Kaestner). It holds that, by reason of the due process clause2 of the Fourteenth Amendment of the U.S. Constitution, a state may not impose its income tax on undistributed income of a trust merely because a beneficiary, who was eligible to receive but did not receive any distribution from the trust in the years in question, was a resident of the state. In essence, the decision was unanimous, although Justice Alito filed a concurring opinion, to which Chief Justice Roberts and Justice Gorsuch joined. That concurring opinion will be further discussed below because it may temper certain statements made in the court’s opinion.
The decision is limited to the facts of the case which in Kaestner is narrow and seems to mean that a state, such as North Carolina, may not impose its income tax on undistributed trust income merely because a beneficiary who resides in the state is eligible to receive trust distributions. The decision does not provide the parameters of when a state may impose its tax on undistributed trust income. But it appears to be filled with significant discussion of the issue. That discussion may inform states on how to restructure their state income tax laws so they can impose their state income tax on undistributed income of a trust. It also should inform practitioners on how to try to structure, and trustees how to administer, trusts to avoid a state tax. Although the court’s opinion is narrow, the implications to draftspersons and trustees seem to be broad.
It is worth noting that the Kaestner decision was based solely on due process. Another ground that taxpayers have used to try to avoid having a state impose its income tax on undistributed trust income is the commerce clause contained in Article I, Section 8, Clause 3 of the Constitution. But that was not addressed by the Court, even though the trial court in North Carolina did address it, and found that the Commerce Clause also foreclosed income taxation of the trust’s undistributed income.
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