Supreme Court Shuts Down a State Scheme to Tax Out-of-State Trusts

States have been aggressively trying to expand their tax bases, and their efforts aren’t always successful.

The U.S. Supreme Court recently shut down an attempt by North Carolina, which other states have fully or partially replicated, to impose income taxes on what are essentially out-of-state trusts.

In the case, the trustee resided in Connecticut, the records were kept in New York and the custodian of the trust assets resided in Massachusetts. The creator, or settlor, of the trust didn’t reside in North Carolina, and the trust had no assets in North Carolina. Several beneficiaries of the trust resided in North Carolina, but they hadn’t received any income distributions from the trust.

Even so, North Carolina law said the trust owed state income taxes on all the undistributed income of the trust because an actual or potential income beneficiary of the trust resided in North Carolina.

The Supreme Court said the law was unconstitutional.

For a state to be able to impose in-come taxes, there must be a minimum connection between the state and the item it seeks to tax. The tax might be allowed if income is distributed to an in-state beneficiary, the trustee is resident in the state and the trust is administered in the state (though the last point isn’t essential).

None of these connections existed in this case, so the North Carolina tax was unconstitutional. (North Carolina Department of Revenue v. The Kimberly Rice Kaestner 1992 Family Trust, United States Supreme Court, Case No. 18-457.)

The Supreme Court also decided not to review a Minnesota case that disallowed the state’s aggressive effort to tax a trust. In the Minnesota case, the only connection between the trust and the state was that the settlor was a Minnesota resident at the time the trust be-came irrevocable. (Bauerly v. Fielding, United States Supreme Court, Case No. A17-1177.)

These cases likely mean that people in high-tax states who set up trusts for family members should consider having the trusts managed and located in the low-tax states that are courting the trust business. Your family could save significant tax dollars each year, depending on the income of the trust. Talk with your estate planner about the best state in which to locate your trusts and how much it would cost to have an out-of-state trust.