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The Impacts of Kaestner Beyond North Carolina

July 22, 2019
Tax Advisory

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The United States Supreme Court recently decided North Carolina Department of Revenue v. The Kimberly Rice Kaestner 1992 Family Trust, 2019 WL 2552488 (U.S. June 21, 2019), an income tax case involving a New York trust and a beneficiary residing in North Carolina. This ruling may have far-reaching impact with respect to taxation of trusts and beneficiaries located in other states, including Michigan.

The Kaestner Case

The Kimberly Rice Kaestner 1992 Family Trust (the "Trust") was an irrevocable trust created by a settlor located in New York who explicitly designated New York law to govern the trust agreement. The Trust's books and records were prepared and kept in New York, and the Trust was managed by a trustee located in Connecticut. Moreover, the Trust held only investments in financial assets. It did not own any real estate located in North Carolina or other investments in that State.

In short, the Trust had no contact with the State of North Carolina - except for the existence of a single beneficiary. The settlor created the Trust for the benefit of his children, and one such child resided in North Carolina.

But during the years 2005 through 2008, the Trust made no distributions to this North Carolina-resident beneficiary. The Trust did not have any obligation to distribute Trust income to this beneficiary and the beneficiary could not compel a distribution because the trustee had absolute discretion in that regard. However, under North Carolina law, the trustee was required to pay North Carolina income tax on this beneficiary's share of the undistributed Trust income – solely due to the fact that the beneficiary was a North Carolina resident.

North Carolina law required this result by imposing income tax on undistributed trust income that “is for the benefit of” a North Carolina resident. N. C. Gen. Stat. Ann. §105–160.2 (2017). Based on the facts in Kaestner, the Supreme Court unanimously rejected this application of the law and held that North Carolina cannot impose income tax on trust's income based solely on the existence of an in-state resident beneficiary. Under the facts in Kaestner, the Court determined that subjecting the trust to North Carolina income tax violated the Due Process clause of the Fourteenth Amendment because the trust's connection to North Carolina was too tenuous. The mere residence of a beneficiary was not sufficient connection.

Applying Kaestner to Michigan Trusts and Beneficiaries

Unlike North Carolina, Michigan law does not attempt to subject irrevocable, nonresident trusts to income tax on undistributed income simply because a beneficiary resides in-state. Instead, Michigan income tax apportions trust income based on its "source." In general, resident trusts are subject to Michigan income tax on all undistributed trust income (except for income attributable to another state). MCL 206.110. Nonresident trusts are subject to Michigan income tax only on income that is sourced to Michigan, like rents and royalties from real or tangible personal property located in Michigan. MCL 206.110-115.

In certain instances, Kaestner may decrease the amount of state income tax Michigan trusts pay on their undistributed income. For example, the trustees of a Michigan trust whose beneficiary resides in North Carolina (or other states with similar income taxation based on the residency of beneficiaries) will no longer be subject to tax on undistributed income in those states simply because of the resident beneficiary. If such a trust's income is not attributable to North Carolina under apportionment or similar provisions, then there may be a reduced state income tax liability for the trust. However, it is currently unclear both how states will interpret and apply Kaestner, and how taxing authorities and state legislatures in North Carolina and similarly situated states will react in response to the Supreme Court's ruling.

With respect to Michigan law, an interesting parallel to Kaestner exists in a Court of Appeals decision. Specifically, the Michigan Court of Appeals applied legal reasoning similar to the reasoning of the Kaestner Court to limit the State of Michigan's ability of classify certain trusts as a "Michigan resident trust" (as previously noted, a resident trust is generally subject to Michigan income tax on the trust's undistributed income). See Blue v. Michigan Department of Treasury. 185 Mich. App. 406, 462 N.W.2d 762 (1990).

In general, Michigan law classifies a trust as a resident trust if either: (a) the trust is created by the will of a decedent who was at his or her death domiciled in Michigan, or (b) the trust is created by, or consists of property of, a person domiciled in Michigan at the time the trust becomes irrevocable. MCL 206.18(1)(c). The Court of Appeals in Blue applied this statute to a trust whose settlor died while residing in Michigan. Pursuant to the statutory definition above, the trust in Blue should be a Michigan resident. However, the beneficiary was a resident of Florida, the trustee of the trust was a resident of Florida, all of the trust's assets and other indicia of ownership were located in Florida (with the exception of non-income producing real estate located in Michigan), and all brokerage accounts and bank accounts were held and administered in Florida.

The Michigan Court of Appeals determined that classifying the trust as a Michigan resident violated the Due Process clause of the Fourteenth Amendment because the trust's connection to Michigan was too tenuous. The mere residence of the settlor at the date of death was not a sufficient connection.

Conclusions

Kaestner provides an important and affirmative statement regarding the limits on a state's ability to impose its income tax on undistributed trust income. However, the decision does not provide clear answers to every trust income tax nexus question. North Carolina is not the only state that utilizes residency in its state income tax laws to determine nexus, residency, or taxable income, and it is currently unclear how Kaestner will affect state laws applicable in other states. It is also unclear how state legislatures will evolve their system of income taxation in response to Kaestner. Despite these remaining questions, the Supreme Court's holding in Kaestner does provide new metrics to be used in analyzing state income tax questions regarding states' abilities to tax trust income under the Due Process Clause.

Taxpayers with questions about state taxation of trusts and trust beneficiaries should contact their tax advisors to determine the state or multi-state implications of Kaestner, Blue, and other developments in the law to their specific situations. In addition, readers can contact any of the Varnum tax or estate planning attorneys with questions, or to obtain additional information.

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