By: William A. Raabe, Co-Editor of the South-Western Federal Taxation series
U.S. Supreme Court cases involving tax law are rare, numbering one every year or two. But the cases that the court does hear tend to become important sources of judicial tax law, whether they involve broad (e.g. Wayfair, 2018, regarding sales/use tax nexus for online transactions) or narrow issues. Kaestner Family Trust (2019) is an interesting if narrow decision that involves the nexus rules affecting trust and similar fiduciary entities.
Your students should be familiar with the structure of a typical trust, as illustrated in text Exhibit 20.2 and simplified here.
The Kaestner case addressed the issue of whether North Carolina could tax the annual taxable income of a complex trust. Every state’s nexus rules are different, and the Supreme Court holding makes new laws only with respect to that state and to others with identical nexus definitions.
The trust involved in Kaestner was an irrevocable complex trust, created by a New York State grantor in 1992. Language in the trust instrument stated that the entity was to be administered under New York law, and the books and records of the trust were kept in that state. The trustee, though, was located in Connecticut. The trust only held financial assets. No real estate or other tangible assets were held in North Carolina.
But one income beneficiary of the trust was located in North Carolina. The “family trust” was created “for the benefit of” the grantor’s children, and this beneficiary was a child of the grantor.
The trust language specified that annual (or more frequent) income distributions to beneficiaries were not required; the timing and amounts of the distributions were at the sole discretion of the trustee, and distributions could not be compelled by any beneficiary. This is somewhat typical language for family arrangements, especially when the income beneficiaries are young and/or inexperienced.
During the tax years involved in the decision, no income distributions were made to the North Carolina party. But the trust earned taxable income, and under the rules of Subchapter J, the entity was taxable on the undistributed income as its own tax person; see text Exhibit 20.4. The trustee filed a North Carolina income tax return with respect to the “beneficiary’s share” of the entity’s taxable income, as seemingly required under state law, but the return was filed “under protest,” in anticipation of an administrative and then judicial challenge.
Using the language of multistate tax law, North Carolina was asserting nexus with the trust solely due to the presence of an in-state beneficiary. But the US Supreme Court disagreed, asserting that the Due Process clause of the 14th Amendment found insufficient contact between the state and the fiduciary entity. The Court cited these key facts in making its unanimous decision:
- No distributions were made to the North Carolina beneficiary
- There was no guarantee that the North Carolina beneficiary would ever receive an income distribution
- Distributions were made at the sole discretion of the trustee and could not be initiated or compelled by any beneficiary
Every state’s nexus definitions are different with respect to fiduciary arrangements like a trust. Few states other than North Carolina assert nexus solely on the basis of a beneficiary’s residence. But nexus in some states is created by the presence of the trustee, the presence of the (living) grantor, the presence of tangible (and sometimes intangible) assets, and the receipt of (income or remainder) distributions when they are made.
Difficulties arise when, as is common for family trusts, there are multiple trustees (e.g. a bank, an investment advisor, and a family member) who are located in different states – where does the entity have nexus? Where does an institutional trustee like a bank have nexus? After all, Chase is “present” in all US states.
What if the income beneficiary can demand a distribution, but does not do so in a particular tax year? Is nexus thereby created with the beneficiary’s state? Is nexus created where the trustee and beneficiaries have periodic meetings? What if the meeting is conducted on Skype? How many meetings does it take to create nexus? And the presence of digital assets, like cryptocurrency or a domain name, currently are not directly addressed by state laws as to their location and creation of nexus.
Fiduciaries in North Carolina or other states with similar nexus rules are in line for immediate income tax refunds, after Kaestner. Certainly, all wealth managers should review state nexus rules as they affect fiduciary entities and beneficiaries, so that double taxation does not arise among the affected parties. An optimization of the state income tax obligations of the parties might require asset/income relocation, relocation/replacement of trustees, or entity mergers/terminations.
- Should the Uniform Principal and Income Act be expanded to include a set of common nexus definitions? Discuss.
- Should the Uniform Principal and Income Act be expanded to include a series of apportionment/allocation rules, to preempt the double taxation of entity income? Discuss.
- Summarize in two PowerPoint slides the nexus rules of your state concerning trusts and beneficiaries. Give full citations and links.
- Find two articles in Forbes or similar popular sources that discuss the implications of Kaestner. Summarize the articles in a one-page memo.
- Summarize the concurring opinion to Kaestner of Justices Alito and Gorsuch, in a memo to your instructor. What additional precedents and issues are raised in the concurrence?
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