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The U.S. Supreme Court recently heard oral arguments in a case, North Carolina Department of Revenue v. Kaestner 1992 Family Trust, Docket No. 18-457 (argued on April 16), in which a trust challenged a North Carolina law that taxes resident-beneficiaries on the income earned and retained by a nonresident trust. The trust prevailed at the trial level, appellate level and in the North Carolina Supreme Court, but the U.S. Supreme Court granted the North Carolina Department of Revenue's petition for a writ of certiorari on the question of whether the due process clause of the Fourteenth Amendment prohibits states from taxing trusts based on trust beneficiaries' in-state residency. The petitioner asserted that there was a split among the nine states that had considered taxation of trust income based on a beneficiary's residence and that the split could only be resolved by the Supreme Court. While we await the court's decision, this case presents an interesting mix of arguments regarding the proper analysis of the minimum contacts inquiry and a public policy appeal by the petitioner to “modernize” trust taxation along the lines of a recent court decision that eliminated the physical-presence requirement in the sales tax context.

General Trust Taxation Rubric

Taxation of income from trusts involves looking at federal law, state law, the language of the applicable trust, and the identity and location of the grantor, trustee, beneficiaries and assets held by the trust. In short, the analysis can be complex. Some states, looking to bring in additional revenue, have passed laws expanding the reach of their power to tax trust beneficiaries. One distinguishing feature of the North Carolina law is that it taxes beneficiaries who have not actually received taxable income from a trust.

There are a few preliminary trust tax issues to understand. Income from a trust is sometimes taxed at the trust level, while at other times it is taxed to beneficiaries. Trusts known as revocable (or living) trusts permit the grantor of a trust to revoke the trust. These trusts are generally ignored for both federal and Pennsylvania trust tax purposes and income is taxed just as if the individual grantor had received it. There are also other types of irrevocable grantor trusts which are taxed to the grantor for federal tax purposes and, in a minority view, to the trust itself for Pennsylvania purposes. These grantor trusts can be utilized by estate planning attorneys to leverage estate and gift tax savings. This leaves the traditional nongrantor irrevocable trust, which is the type of trust at issue before the court.

For these nongrantor trusts, most forms of taxable income actually distributed to a beneficiary or that are required to be distributed to a beneficiary are taxed to that beneficiary. Essentially, the trust takes a deduction for the distributed income, with possible limitations for some forms of income such as capital gains, and distributes a K-1 to the beneficiary. States that impose an income tax would generally require that the individual beneficiaries then report the income on their individual tax return just as they would report any other income received. A trust that retains income and is not required to distribute it, on the other hand, will pay tax at the trust level. For federal income tax purposes, this can have negative consequences since the tax brackets are compressed and trusts reach the highest rate of taxation at just $12,750 in annual income. For a trust with a Pennsylvania grantor, Pennsylvania trustee and Pennsylvania beneficiaries, the state tax consequences are what one would expect: the taxable income, whether paid by the trust or the beneficiary is taxed at Pennsylvania's flat tax rate of 3.07%.