Take-Away: In a widely anticipated court decision, the North Carolina Supreme Court decided last week that North Carolina could not tax an irrevocable Trust when the sole basis for imposing the income tax  was the North Carolina residence of one trust beneficiary. The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, No. 307PA15-2 (June 2, 2018.)

Brief Facts: The Trust was established in New York. After the Trust’s creation, but before separate shares were created, Kimberly moved to North Carolina where she continues to reside. Thus, Kimberly was a resident of North Carolina when her separate share (trust) was created under the Trust. The Trustee was a resident of Connecticut. All of the Trust’s records were maintained in New York, along with the entire trust corpus. Consequently, the sole basis for North Carolina’s effort to impose an income tax on the trust was Kimberly’s residence in North Carolina.

Decision: The Court found that there was not a sufficient nexus under the Due Process Clause of the U.S. and North Carolina Constitutions to permit North Carolina to impose a tax on the income accumulated in the trust share established for Kimberly. (Obviously, distributions from the trust share to Kimberly would carry out distributable net income (DNI) and she would report that distributed income on her North Carolina state income tax return.)

Conclusion: As the competition among states for trust business ramps up, the imposition of state income taxes on accumulated trust income is becoming a hot issue in the decision where to situs a trust among several states that are competing for business. At the same time, state income tax laws are being challenged around the country when there is very little, if any,  connection between the state and the trust to justify the state’s ability to impose an income tax on the trust’s income. As just one example, one of the positive features of Delaware’s trust law is that Delaware will not impose a state income tax on a Delaware trust if there are no Delaware trust beneficiaries. Kaestner is just one more example of where trustees and trust beneficiaries are pushing back against states that impose income taxes on accumulated trust income where there is little basis for imposing the tax to begin with.