In two recent cases, taxpayers have successfully challenged state taxation of trust income on the basis that the taxing states had a minimal connection to the trust.
In The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Dept. of Revenue, 2015 WL 1880607 (April 23, 2015), the court ruled that both the North Carolina Constitution and the U.S. Constitution prohibited North Carolina from taxing the income of a trust when the trust’s only connection to North Carolina was the residence of some of its beneficiaries. The trust in question was created by a New York resident with another New York resident as initial trustee, and the trust was governed by New York law. When the trust was divided into separate shares for each of the grantor’s children, one of those children and her descendants lived in North Carolina. The trust for the North Carolinian beneficiaries was discretionary, and they in fact received no distributions from the trust during the taxable years at issue in the case. Further, the custodian of the trust’s investments was located in Boston, Massachusetts; all records were retained in New York; and no trustee was ever a North Carolina resident. The state of North Carolina still assessed taxes of over $1 million on accumulated trust income. A North Carolina statute provided for taxation on the “amount of taxable income of the estate or trust that is for the benefit of a resident” of the state. The Superior Court for Wake County granted summary judgment to the trustee, ruling that the North Carolina statute violated the commerce and due process clauses of both the North Carolina Constitution and the U.S. Constitution.
In a similar case, the New Jersey Superior Court upheld a state tax court decision disallowing taxes on trust income lacking sufficient contacts with New Jersey. In Residuary Trust Under the Will of Fred E. Kassner v. Division of Taxation, Dept. of Treasury, 2015 WL 2458024 (N.J. Super. Ct. App. Div. 2015), the New Jersey Superior Court sidestepped constitutional analyses and pointed instead to the “square corners” doctrine and the potential unfairness of taxing the income of a trust in contradiction of the New Jersey Division of Taxation’s published guidance. In 1999, the division had issued official guidance stating that it would not tax trust income if the trustees and trust assets are located outside New Jersey. The trust at issue was established under the will of a deceased New Jersey resident. The trust owned cash, bonds, and stock in the taxable year at issue. The trust held stock in four S corporations, and a portion of those S corporations’ income was allocated to New Jersey. The trust paid New Jersey income tax on that income. The trust did not, however, pay New Jersey taxes on earned interest income or income from the S corporations that was allocated outside New Jersey. The Division of Taxation issued a deficiency notice, claiming all such income was subject to New Jersey tax. Although the division changed its published guidance in 2011 to state that if a trust had any New Jersey income, all of its retained income would be subject to taxation in New Jersey, the taxable year in question was 2006. The Superior Court ruled in favor of the taxpayer, noting the unfairness of and potential confusion caused by retroactively applying the change in guidance.
If you have a question about state taxation of trust income, reach out to the private wealth professionals at BakerHostetler.