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U.S. Supreme Court provides guidance (although minimal) on the interstate income taxation of Trusts. North Carolina Department of Revenue vs. Kimberly Rice Kaestner 1992 Family Trust, 139 S. Ct. 2213, 588 U.S.  (June 21, 2019).  

 

When an individual owns several homes and travels between them, spending time in multiple jurisdictions, the tax “residence” of that individual can be somewhat nebulous. However, determining the appropriate jurisdiction for an income tax obligation of a trust is even more speculative and uncertain. Is the trust subject to taxation in the jurisdiction where the creator or testator resided? Should the trust be taxed where the trustee resides? Should the residence of the beneficiary or beneficiaries be the most important factor? Does it matter where the assets are located or where the income was earned?

In a recent unanimous decision of the United States Supreme Court, North Carolina Department of Revenue vs. Kimberly Rice Kaestner 1992 Family Trust, 139 S. Ct. 2213, 588 U.S. ___ (June 21, 2019), it was determined that the residence of the beneficiary could not be the sole reason for a state to impose its income tax on undistributed earnings of the trust. In related news, on June 28, 2019, the Supreme Court refused to hear a similar case from the Supreme Court of Minnesota named Fielding v. Minnesota Commissioner of Revenue, 916 N.W. 2d 323 (Minn. 2018). Fielding would be a more important case for New Jersey and Pennsylvania residents because our statutes, like Minnesota, impose tax on a trust based upon the residence of the creator/testator at the time of trust creation.

These concepts are complicated by the fact that we must not only understand a little about the types of trusts that can be created, but also the way those trusts are taxed for federal income tax purposes. More importantly, we need to understand how the States cast their net for taxation of trust earnings.

For federal tax calculations, while a grantor is living, a trust can either be established as a “grantor” trust, in which the grantor is subject to income tax on all trust earnings, or a “non-grantor” trust, in which income taxation is applied as a separate legal entity. With a grantor trust, the grantor will have to report and pay income tax on trust earnings as his/her alter ego if the grantor has reserved a power classified under the grantor trust rules of IRC § 671 et seq.  The objective of these grantor trust rules was to prevent a high bracket income taxpayer from “shifting” income to a lower bracket entity in the form of a trust. Historically, the grantor trust rules were a mechanism for attacking the concept of income shifting. Numerous IRS public announcements, culminating with Revenue Ruling 85 -13, found that a grantor trust is no more than the alter ego of the donor. Since 1985, it has been clear that the donor and the donor’s grantor trust are treated as one and the same taxpayer and the grantor is deemed to own the assets of the trust.

If a trust is not a grantor trust for income tax purposes, there are two possibilities. This happens either where the grantor has not reserved powers which would cause the income to be subject to income tax to the grantor under the grantor trust rules, or, more commonly, if the grantor has died.  There, a trust can either be a simple trust or a complex trust.  A simple trust is required to pay all income to the beneficiary. A complex trust is one in which the income can either be accumulated or distributed. An estate of a decedent has the same rates as a trust and would be treated like a complex trust, because there would be no obligation to pay income to beneficiaries. Under basic income tax principles for a non-grantor trust, whether simple or complex, income distributed to a beneficiary must be taxed to a beneficiary. A trust is a pass-through entity and is only subject to income on its earnings where the income is accumulated.

Since 1993, the income tax rates on trusts have been increased to where income shifting is no longer appropriate or desirable. Essentially, a trust reaches the highest marginal income tax bracket with only a modest amount of income (about $13,000). Worse yet, since the 2013 federal tax law added a tax on net investment income under the Affordable Care Act (“Obamacare”), an additional 3.8% tax is imposed on the highest marginal bracket. Once again, this occurs for a trust at a modest level of income of only around $13,000. Consequently, income shifting or accumulating income in a trust might not be appropriate unless the family is in the highest marginal bracket since virtually all of the trust income will be taxed at highest marginal rates.

What happens to a trust where state taxes are concerned? Statutorily in New Jersey, there is a gross income tax on the income or gains received by a trust not distributed or credited to the trust beneficiaries. N.J.S.A. § 54A:5-3. All such income and gains of a “resident” trust are taxable by New Jersey wherever the income is derived. A “nonresident” trust is subject to tax in New Jersey if the items of income or gain are derived from New Jersey sources.  NJ.S.A. § 54A:5 – 8. A “resident trust” is a trust, or a portion of a trust, consisting of property transferred by will of a decedent who at his death was domiciled in New Jersey, or consisting of property of a person domiciled in New Jersey at the time the property was transferred to the trust. N.J.S.A. § 54A:1-2(o)(2). A nonresident trust is a trust that is not a resident trust. N.J.S.A.  § 54A:1-2(p).

In Kaestner decided by the U.S. Supreme Court, a New York resident created a trust in 1992 to benefit his three children. One of the three children, Kimberly Rice Kaestner, relocated to the State of North Carolina in 1997 with her children. In 2002, the trust was divided into three separate trusts, one for each child. The trust continued to be administered outside North Carolina and the books and records for the trust were maintained outside of North Carolina.

Kimberly, a North Carolina resident, was the principal trust beneficiary of her separate trust, and received no income from the trust. . Under North Carolina General Statute §105-160.2, a tax is imposed upon taxable income of the trust “that is for the benefit of a resident of the state….”  The trustee of the trust therefore paid tax to North Carolina on the income of the trust, but then sued North Carolina for a refund claiming the payment of the tax violated both the due process and commerce clauses of the United States Constitution. The trustee was a resident of Connecticut, the assets (financial investments) were held in Boston, and Kimberly met with the trustee in New York to talk about trust investments.

The North Carolina Supreme Court had found that the North Carolina approach was unconstitutional. First, the trust and beneficiaries were different taxpayers. Second, even if the beneficiaries had an equitable interest in the trust assets, there was not a sufficient connection between the North Carolina beneficiaries of the trust to allow North Carolina to subject the trust income to taxation. The North Carolina court based its opinion on the “Due Process”  clause of both the North Carolina Constitution and the United States Constitution. It found there was not a link, some minimum connection, between the trust and the property it sought to tax.

The United States Supreme Court, in affirming the North Carolina ruling, also relied on the lack of a minimum connection to the object of the tax sought. Once again, the U.S. Supreme Court found a violation of the Due Process Clause of the Fourteenth Amendment because of the unfairness of the situation.

The decision is a narrow ruling and will not provide much guidance in other states’ situations.  There had been some academic thought that the trends over the last decade to allow greater constitutional “nexus” between states and individuals that have some, but not substantial, contact, would impact trust taxation. For example, in the recent U.S. Supreme Court decision in South Dakota v. Wayfair, 138 S. Ct. 2080, 585 U.S. ___ (2018), the Court expanded a state’s ability to require merchants to collect tax (usually sales tax) from afar.

Generally, states impose income tax on the undistributed income of non-grantor trusts based on five various criteria. First, some are based on the residence of a testator (e.g., a “testamentary” trust) or second, residence of the grantor when the trust is made irrevocable. This is the rule in New Jersey and Pennsylvania.  Third, some states tax income if the trust is administered in the state. Fourth, some states impose tax if the trustee is a resident, and finally, but no longer based on the holding of Kaestner, if the beneficiary resides in the state.

In New Jersey, two landmark cases, Pennoyer v. Director, 5 N.J. Tax 386 (Tax  1983), and Potter v. Director,  5 N.J. Tax 399 (Tax 1983), the New Jersey Tax Court set limits on the ability of the New Jersey Division of Taxation to tax trust income. They also held that that due process rules of the United States Constitution  prevented  New Jersey from taxing trust income if the trustee,  assets and beneficiaries were all located outside of New Jersey.  In Pennoyer and Potter, the Court dealt with a testamentary trust and an inter vivos trust and concluded that state income tax could not be imposed.

More recently, whether New Jersey had jurisdiction over a trust was questioned in a significant decision, Kassner Residuary Trust A v. Director, 27 N.J. Tax 68 (Tax 2013).  There, a trust created under the Will of a New Jersey resident owned stock in a New Jersey S corporation. The family relocated to New York and the trust had no continuing contacts with New Jersey, except for owning stock in a corporation that had elected Subchapter S status. The New Jersey Division of Taxation sought to tax the other outside investment income of the trust even though the Trust paid New Jersey tax on New Jersey source income from the “S” stock.

The New Jersey Appeals Court did not reach the constitutional arguments of earlier and longstanding precedents of Potter and Pennoyer,  and instead stopped short because of the “square corners” doctrine. 28 N.J. Tax 541 (App. Div. 201 5). This doctrine requires that the government “turn square corners” in  announcing policies. On appeal the Division conceded that the trust owned no assets in New Jersey merely because of its stock holding. The Appellate Court found that the Division had changed its policy regarding determining the residency of a trust without notice to taxpayers. Even though the tax year in question was 2006, the State litigation policy was newly established during the tenure of this 2011 litigation. Since then, New Jersey has reiterated its position it will not tax a trust that has i) no tangible assets in New Jersey, ii) no income from a New Jersey “source” and iii) no New Jersey trustees. New Jersey Tax Topic Bulletin GIT-12.

 

In conclusion, the Kaestner case will not have that much impact on New Jersey trusts because our statutory structure is different from the structure of North Carolina.  However, if a resident trust can structure its affairs to limit its New Jersey contacts, it may escape New Jersey taxation on accumulated income.