A recent United States Supreme Court decision, found here, has serious implications regarding state income tax on trust beneficiaries. In North Carolina Department of Revenue v. Kimberley Rice Keastner 1992 Family Trust, a New York resident executed a trust for the benefit of his daughter, who subsequently moved to North Carolina. The settlor and trustee of the trust lived in New York. The trustee managed the trust and had absolute discretion as to payments of income and principal, investment decisions, etc. The beneficiary daughter had no right to demand distributions of income or principal.
North Carolina State Trust Law
North Carolina’s income tax laws permitted the taxation of a trust based on the residence of a beneficiary. Therefore, even though the beneficiary received no distributions, and had no right to receive distributions, North Carolina taxed the trust based on her interest as a beneficiary in the amount of $1,300,000. The trust appealed the decision.
In June 2019 the US Supreme Court ruled in favour of the trust, holding that the state’s taxation based on the beneficiary’s residence violated the Due Process Clause of the 14th Amendment. Essentially, the Supreme Court held that the residence of a beneficiary with no rights to demand income and principal, and no control over the trust whatsoever, did not create the minimum connection necessary between the trust (a New York trust) and North Carolina such that North Carolina could tax the trust based on the beneficiary’s remote interests. The Supreme Court also noted that the beneficiary did not even have the assurance of getting trust assets in the future, since even though the trust was to terminate when the beneficiary reached the age of 40, New York law allowed the trustee to roll over the trust assets into a new trust instead of distributing it to her, which is what actually occurred in in this case.
California State Trust Law
Similar to North Carolina, California taxes even an out-of-state trust if a non-contingent beneficiary (someone with an unconditional interest in the trust income or principal) is a resident of California. The Court explicitly limited its holding to the facts at hand where the beneficiary was contingent and expressed no opinion regarding California taxation based on a non-contingent beneficiary. Therefore, the Supreme Court did not strike down California law, and there remains an open question as to its constitutionality.
Additionally, the Supreme Court explicitly expressed no opinion regarding California’s “throwback tax”. Throwback Tax is when the undistributed income accumulated in a trust is considered to be taxed to the beneficiary as ordinary income in the year earned at the beneficiary’s highest marginal rate for that year. When distributed to the beneficiary, these taxes will be subject to interest charges as well. The “throwback tax” under Cal. Rev. & Tax. Code Ann. §17745(b) provides that where no taxes have been paid in California on accumulated trust income because the resident beneficiary’s interest in the trust was contingent, once income is actually distributed to the beneficiary, there is a throwback tax on the accumulated income.
When setting up a trust, it is of vital importance to review the tax rules for each state in which there resides a grantor, beneficiary, trustee, or corporate trustee with multi-state offices. This Supreme Court decision highlights the potential chilling tax consequences when a grantor is not careful in choosing the trustees and beneficiaries. This is especially true for grantors, trustees and beneficiaries of cross-border trusts, where both Canadian and US tax regimes are involved. If you are a grantor, trustee, or beneficiary of a cross-border trust, it is important to consult with experienced cross-border attorneys to review the trust.