U.S. Supreme Court Blocks State from Taxing a Beneficiary for Non-Received Trust Income

The June 2019 Kaestner decision shows how a trust can provide a valuable layer of protection between the trust's earnings and the taxation of its beneficiaries.

In 1992, New York resident Joseph Lee Rice III established a trust for the benefit of his children. The trust provided that, after Mr. Rice's death, the successor trustee would have "absolute discretion" to distribute the assets to the beneficiaries. (At the time of the Supreme Court ruling, and as of this writing, Mr. Rice was still living.)

Significant to this case is that, when the trust was established, none of the beneficiaries happened to live in North Carolina. Subsequently, Mr. Rice's daughter, Kimberly Rice Kaestner, moved to North Carolina and lived there until 2008.

After Ms. Kaestner moved to North Carolina, the original trust was divided into three sub-trusts. One of the sub-trusts was for the benefit of Ms. Kaestner and her three children. The original trust's terms regarding distributions still applied.

While no assets of the sub-trust were distributed to Ms. Kaestner or her children while they lived in North Carolina, the North Carolina Department of Revenue took the position that, since she was a resident of the state and a beneficiary of the trust, Ms. Kaestner should pay taxes to the state on the trust's income during her time of residence, regardless of the fact that she had not actually received any trust income.

North Carolina sent Ms. Kaestner a $1.3 million tax bill for the trust's cumulative income from 2005 to 2008, pursuant to a state law (N.C. Gen. Stat. §105-160.2 [2017]) that provides for the taxation of any trust income that is for the benefit of a North Carolina resident.

Ms. Kaestner paid the tax bill under protest, challenging the assessment and requesting a tax refund on the grounds that it was a violation of the due process clause of the Fourteenth Amendment of the U.S. Constitution.

Taxpayer Victory

In unanimously deciding in Ms. Kaestner's favor in North Carolina Department of Revenue v. Kaestner Family Trust (June 2019), the U.S. Supreme Court ruled that North Carolina could not tax Ms. Kaestner on income earned by the trust, noting that no trust assets were distributed in North Carolina, the beneficiaries had no right to demand distributions, there was no guarantee of future distributions, and the beneficiaries' residence in the state did not create a connection between the trust and the state.

In short, Ms. Kaestner could not gain access to the trust's assets even if she so wished, and neither could, for tax purposes, the State of North Carolina.

The Value of a Trust

Because the Kaestner decision was based on facts that were specific to that case, some professionals are discounting its impact on estate planning and trust tax planning. We don't necessarily concur.

While Kaestner is by no means a landmark decision, we believe that it nonetheless generally affirms the value of a well-conceived trust strategy.

Even for families that do not consider themselves wealthy but nonetheless value control, privacy, and protection of heirs and beneficiaries, the appropriate use of a trust offers so many advantages over most other planning strategies that its omission from an estate plan should be the exception, not the rule.

Adapted from the Daily Plan-It newsletter