In North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust, a beneficiary received a tax bill from the state for over $1 million.

The problem? She had not received the income the state was attempting to tax. The state was attempting to apply a tax to the woman’s trust distribution, a distribution she did not receive that year. The state claims it still had a legal right to tax the amount she could have received. The resulting dispute made its way to the Supreme Court of the United States (SCOTUS).  

Important to know: The case uses the term “trust triad” in its decision. This term refers to the three key players in the life a trust: the creator, known as the settler, the person or entity that manages the trust, known as the trustee, and the person who benefits from the trust, known as the beneficiary.

Issue of the case: The case questions the application of state income taxes. If the beneficiary takes that payment, the state tax law of the beneficiary’s residence would likely apply. But how do state income taxes apply when there is no distribution?

A search for an answer: Ultimately, in this case, the SCOTUS held state taxing agencies were not able to tax a trust for an in-state beneficiary unless the beneficiary receives a distribution. The court was adamant to clarify the holding only applied to situations when the beneficiary did not receive trust income, did not have the ability to demand that income and was unlikely to receive a share of the trust income.

Broader application: At this time, states have rules to apply income tax on trusts to those within the trust triad. Massachusetts, for example, considers a trust a resident of the state for tax purposes if the settlor and trustee are Massachusetts residents. Connecticut generally only considers the state of the settlor and New York will generally tax a trust if the creator or beneficiary is a resident of the state.

In addition to state taxation issues, trusts also fall subject to federal taxes. Federal issues abound and are guided by the language of the trust. As a result, those who are looking to set up a trust are wise to seek the counsel of an attorney experienced in both trust and tax law.