Nexus and Trusts

By William A. Raabe (Co-Editor, South-Western Federal Taxation Series).
Tax law cases before the U.S. Supreme Court are very rare. They only occur one to two times per year. However, the cases that the court does hear are often important sources of judicial tax laws. Wayfair (2018), regarding the sales/use tax nexus online transactions. Kaestner Family Trust (2019), is a narrow but interesting decision that deals with the nexus rules for trust and similar fiduciary entities.
Students should be familiarized with the structure of a trust as illustrated in Exhibit 20.2 and simplified below.
The Kaestner case dealt with the question of North Carolina’s ability to tax the annual taxable income from complex trusts. Each state has its own nexus rules. The Supreme Court ruling makes new laws with respect to this state and other states with similar nexus definitions.
Kaestner’s trust was an irrevocable, complex trust that was created in 1992 by a New York State grantor. The trust instrument contained language that stated that the entity would be administered under New York law and that the trust’s books and records would be kept in that state. However, the trustee was located in Connecticut. The trust held only financial assets. The trust did not hold any real estate or other tangible assets in North Carolina.
North Carolina was the only income beneficiary of the trust. The “family trust” was established “for the benefit” of the grantor’s children. This beneficiary was a child or grandchild of the grantor.
The trust language stated that beneficiaries could receive income only once a year or more often. The trustee had the sole discretion to determine the timing and amount of distributions and beneficiaries could not compel them. This is a common language for family arrangements, especially if the income beneficiaries are young or inexperienced.
No income distributions were made to North Carolina parties during the tax years that were involved in the decision. The trust did earn taxable income. According to Subchapter J rules, the entity was taxable on its undistributed income as its tax person; see text Exhibit 20,. Although the trustee filed an income tax return for North Carolina regarding the “beneficiary’s portion” of the entity taxable income, as required by state law, the return was filed “under protest” in anticipation of a judicial and administrative challenge.
North Carolina used the multistate tax language to claim nexus with trust due to the presence an in-state beneficiary. The US Supreme Court disagreed and stated that the Due Process clause in the 14th Amendment did not establish sufficient contact between the state entity and the fiduciary entity. These key facts were cited by the Court in its unanimous decision.
The North Carolina beneficiary did not receive any distributions
It was not certain that the North Carolina beneficiary would ever be able to receive an income distribution.
Distributions were made at sole discretion of trustee. Beneficiaries could not initiate or force distributions
Each state has its own definition of nexus with respect to fiduciary arrangements such as trusts. North Carolina is the only state that asserts nexus on the sole basis of the beneficiary’s residence. However, nexus can be created in some states by the presence or the living grantor of the trustee, tangible assets (and sometimes intangible), and receipt of income or remainder distributions.
Multiple trustees can cause problems, which is common in family trusts. A bank, an investment advisor and a family member are located in different states. Where is the entity’s nexus? Is there a bank or institutional trustee that has nexus with the bank? Chase is “present” throughout all 50 states.
What happens if the income beneficiary is able to demand a distribution but not in a particular tax years? Is there a nexus created when the beneficiary and the state are in regular meetings? Is there a nexus if the trustee and beneficiaries meet regularly? What happens if the meeting takes place via Skype? How many meetings are necessary to create a nexus? The state laws do not address the location or creation of nexus for digital assets like cryptocurrency or domain names.
After Kaestner, fiduciaries in North Carolina and other states with similar rules regarding nexus are eligible for immediate income tax refunds. All wealth managers should be aware of state nexus rules that affect fiduciary entities as well as beneficiaries to avoid double taxation. An optimization of the state income tax obligations of the parties might require asset/income relocation, relocation/replacement of trustees, or entity mergers/terminations.
Tax Policy
Should the Uniform Be Used?