Does Kaestner Have Any Relevance for the Taxation of Trusts in California?

• Publication year: 2019
• Author: By Paul N. Frimmer, Esq.*

DOES KAESTNER HAVE ANY RELEVANCE FOR THE TAXATION OF TRUSTS IN CALIFORNIA?

By Paul N. Frimmer, Esq.*

In a unanimous decision, the United States Supreme Court in North Carolina Dept. of Revenue v. Kimberly Rice Kaestner 1992 Family Trust¹ held that a state could not tax non-state source income of a trust if the trust's only contact with the state was the residence of a beneficiary who did not receive any distributions in the tax years in question. The facts in Kaestner are quite simple, and sharply focus the issue.

The Kaestner trust was created by a New York resident and was governed by New York law. The trust was not a "grantor" trust and thus was a separate taxpayer under federal tax law. The trustee was never a North Carolina resident (for the years in question, the trustee was a Connecticut resident working in New York), and the assets of the trust were located in Massachusetts. The trustee had complete discretion over whether, and in what amounts and proportions, to make distributions to the beneficiaries. All of the income of the trust was from non-North Carolina sources. When the trust was created, none of the beneficiaries lived in North Carolina. However, several years later the beneficiaries of the trust moved to North Carolina. During the years covered by the case, no distributions were made to any beneficiaries.

North Carolina law provides that the undistributed income of an out-of-state trust is taxed by North Carolina if a beneficiary of the trust resides in that state. The trust challenged the constitutionality of the application of this law on these facts. The North Carolina courts held for the taxpayer, finding that the North Carolina taxing statute was in violation of the due process clause of the United States Constitution. They held that if the only connection of the trust with North Carolina is the residence of a trust beneficiary, that connection was not a constitutionally sufficient nexus to impose North Carolina's income tax on the accumulated income of the trust.

The Supreme Court unanimously agreed with the result of the North Carolina decisions. The Supreme Court opinion is deliberately narrow and confined to the facts of the case; not only were there no distributions made to the North Carolina beneficiaries, but they had no assurance that there would be any distributions to them in the future given the terms of the trust.

Both the majority and concurring opinions in the Supreme Court decision expressly declined to give any indication how the result might differ if some of the critical facts were different. Based on this decision, trying to determine how the Court might apply the principles it distilled from older cases to different fact patterns, or to the tax law of different states, is speculative. The basic rule seems to be that the trust or its beneficiaries must have some connection to the state in a given year for the state to tax the trust's undistributed income that year. The hard...