Court decision key for estate planners

Ruling could help them construct trusts that avoid state tax collection efforts

Sep 20, 2019 @ 1:38 pm

By Thomas McGraw, Christina Reda and Jordan Sprechman

Rarely does a case involving the taxation of trusts, or their beneficiaries, make its way to the U.S. Supreme Court.

So, when the court chose to hear what is now known as the Kaestner case, the estate planning community paid rapt attention to the decision, which was issued June 21.

In Kaestner, Justice Sonia Sotomayor, writing for a unanimous court, upheld the judgment of the North Carolina Supreme Court that it is unconstitutional, as a violation of the 14th Amendment's Due Process Clause, for North Carolina to tax trust income when the trust has almost no connection with the state.

Although the trust beneficiaries lived in North Carolina during the tax years in question, there were no other sufficient facts to establish a "minimum connection" between the trust and North Carolina. Specifically,

(a) The grantor was not a resident;

(b) No beneficiary was a resident when the trust was created;

(c) Documents and records were not located there;

(d) Assets were not custodied there;

(e) The trust was not governed by its laws;

(f) The trustee has never been and is not a resident;

(g) The trust owns no real property there;

(h) Decisions to make distributions are made in the absolute discretion of the trustee, such that the beneficiaries were permitted to receive, but not under the trust's terms, to demand, distributions;

(i) The trustee in fact did not make any distributions to any of the beneficiaries (who by then were North Carolina residents) in any of the tax years in question.

Taxes unjustified

The court's decision was narrowly written. For example, after noting that the beneficiaries had received no trust income, had no right to demand it, and had no assurance that they would ever receive a specific share of it, Ms. Sotomayor wrote that a contingent beneficiaries' residence cannot serve as the "sole" basis for taxation at the state level.

Because the decision is limited to its specific facts, many observers believe that the case has little precedential value. That is true. However, it is equally true that Kaestner reinforces to some degree a roadmap that guides sophisticated planners in developing facts that help trusts, or beneficiaries, minimize or even avoid state tax on trust income.

For instance, in creating or avoiding state connections that can create state taxation of a trust's income, planners should be cognizant of not only a trust's governing law and situs, but also the residence of its books and records, as well as the location of the assets' custodians.

They should consciously decide whether a trust should grant power to beneficiaries to demand trust assets, whether up to a certain amount or percentage (e.g., 5% of the principal or $5,000, whichever is greater) or within an "ascertainable standard" (e.g., health, education, maintenance, support) — a standard that creates a right for beneficiaries to demand trust assets.

[Don't miss our Women Adviser Summit — coming to San Francisco.]

They should monitor existing individual trustees' residences (situs may move when a trustee moves), and know where corporate trustees "reside." Many corporate trustees operate multiple trust companies, which have different residences.

They should consider under what circumstances to create "pot" trusts (trusts for the benefit of multiple beneficiaries, with distributions to be made in the trustee's discretion) versus multiple separate trusts, each for a separate beneficiary. Similarly, they should consider whether to mandate income distributions to a beneficiary, or leave all discretion over distributions to the trustee (perhaps informed by a nonbinding "letter of wishes").


Finally, they should consider empowering someone — e.g., the grantor, trustee, or a protector — to modify trusts so that, for instance, the trust can be reformed; its situs and governing law changed; assets split apart (or combined); or its assets decanted into a similar trust with different administrative provisions.

Of course, these are things grantors and trustees should be thinking about anyway. Kaestner makes clear that a state's ability to tax trust income is limited. Sophisticated planners should consider the factors mentioned in Kaestner in putting, where feasible, trust assets beyond the reach of state taxing authorities.

[Recommended video:Genius Series: David Grau Sr. on the adviser's duty to plan succession]

Constitutionality uncertain

The narrow nature of the holding leaves uncertainty around the constitutionality of other states' trust taxation regimes. A footnote in the case identifies other state statutes that use beneficiary residency as a factor in determining state taxation, including California. This uncertainty could prompt the filing of refund claims and result in litigation regarding other fact patterns, particularly in those states.


What do you think?

View comments

Recommended next

Upcoming event

Nov 13


Top Advisory Firm Summit

Formerly known as the Best Practices Workshop, this new one-day conference will also include content from the Best Places to Work event!The Top Advisory Firm Summit will provide CEOs, COOs, CTOs, CMOs, and Managing Partners from the... Learn more


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting It'll help us continue to serve you.

Yes, show me how to whitelist

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print