By Alison E. Lothes, co-written by David A. Handler
Originally written for WealthManagement.com
• Recent taxpayer victories regarding the state law taxing of trust income
—Two recent cases have come out in favor of the taxpayer regarding the constitutionality and fairness of states taxing trust income when a trust may not have significant contacts with the taxing state. In our mobile society, where trustees, beneficiaries and assets move from state to state, these issues are becoming increasingly important. Planners and advisors need to keep their eyes open for potential new or additional state income taxes caused by a change in the residency of the trustees, beneficiaries and/or the location or situs of assets.
In The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue,1 a North Carolina state court declared that a statute that taxed the income of a trust of which the beneficiaries were state residents, but of which there were no other connections to the state, was unconstitutional under both the federal and state constitutions.
Joseph Lee Rice established an irrevocable trust in 1992. He and the initial trustee were residents of New York when the trust was established, and the trust was governed by New York law. In 2002, the trust ultimately divided into separate shares for each of Joseph’s children, including one trust for his daughter, Kimberley Kaestner. She lived in North Carolina at the time. In 2005, the initial trustee resigned, and a Connecticut resident was appointed to be the successor trustee.
Kimberley and her three children were North Carolina residents and the current beneficiaries of the trust. However, the trust was discretionary—neither she nor her children were entitled to any distributions of trust income and principal during 2005 to 2008, the years at issue. And, in fact, no distributions were made to them. However, North Carolina taxed the accumulated trust income for those years. The taxes exceeded $1 million.
The trust held investments, the custodian of which was located in Boston. The trust records were kept in New York. No trustee was ever a North Carolina resident. At no time did the trust hold any property in North Carolina.
The North Carolina statute imposes a tax on the “amount of taxable income of the estate or trust that is for the benefit of a resident” of North Carolina. The trustee sued, claiming that the statute violated the due process and commerce clauses of the federal and state constitutions. The court agreed.
The court upheld the trust’s motion for summary judgment, holding that the trust, as the taxpayer, didn’t have sufficient contacts with North Carolina to permit its taxation. It explained that the residency of the beneficiaries, alone, wasn’t sufficient to subject the trust to tax. It distinguished cases that established other states’ rights to tax trust beneficiaries on income distributed to them from cases in which there were more contacts with the taxing state (such as the residence of the settlor).
In an unpublished opinion (Residuary Trust Under the Will of Fred E. Kassner v. Division of Taxation, State of New Jersey),2 the Superior Court of New Jersey upheld a N.J. Tax Court’s decision for the taxpayer trust on a similar issue.
The trust was established under the will of Fred E. Kassner. He was a resident of New Jersey when he died, which made it a N.J. resident trust. However, the trustee was a N.Y. resident, and the trust was administered exclusively in New York. The trust owned no assets in New Jersey. In 2006, the year of the tax return in question, the trust owned cash, bonds and stock. The stock included stock in four S corporations. A portion of the S corporations’ income was allocated to New Jersey, and the trust paid N.J. income tax on that income. However, the trust had other income from the S corporations that was allocated outside New Jersey and earned interest income. It didn’t pay N.J. tax with respect to these latter categories of income.
The N.J. Division of Taxation (the Division) issued a notice of deficiency asserting tax on all of the trust’s undistributed income. The trustee sued in the N.J. Tax Court, and her motion for summary judgment was upheld. The court held that the trust only had sufficient contacts with the state if its trustee resided in New Jersey or it held assets in the state. The Division argued that the trust owned N.J. assets because it was a shareholder in an S corporation that owned N.J. assets. However, the N.J. Tax Court disagreed and found that the pass-through tax status of S corporations doesn’t cause the trust to own the S corporation’s assets.
The Division appealed. The Superior Court affirmed but for different reasons. It didn’t analyze the constitutional issues but instead decided the case on the basis of fairness. The Division had, in 1999, issued official published guidance stating that it wouldn’t assert tax on trust income (even for resident trusts) if the trustees and trust assets were outside New Jersey. In 2011, it changed its position and issued new guidance stating that if a trust had any N.J. income, all of its retained income would be subject to N.J. tax. The Superior Court held that regardless of whether this new position withstood constitutional challenges, it wasn’t fair to retroactively apply it to the trust in prior years. Without certainty of the tax law, a trustee would have a hard time knowing whether to distribute trust income or retain it.
• New proposed regulations issued relating to carry-over basis and Internal Revenue Code Section 1022
—The Treasury Department issued regulations (I.R.B. 2015-21, REG-107595-11 (May 26, 2015)) modifying and amending various sections of the IRC to incorporate cross references to, and address the applicability of, IRC Section 1022. Under Sec-
tion 1022, the executor of a decedent who died in 2010 may elect out of the estate tax and elect instead to have carry-over basis apply. Section 1022 also allows additional basis increases in some circumstances. The new regulations amend many provisions of the IRC to reflect the provisions of Section 1022.
1. The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 2015 WL 1880607 (April 23, 2015).
2. Residuary Trust Under the Will of Fred E. Kassner v. Division of Taxation, State of New Jersey, 2015 WL 2458024 (May 28, 2015).