FILE - U.S. Supreme Court

The United States Supreme Court Building in Washington, D.C.

The mere fact that beneficiaries of a trust live in a state is not enough cause to allow that state to tax their trust income, the U.S. Supreme Court has ruled. But the circumstances that led the court to rule against the State of North Carolina are extremely narrow and it is unclear how or if it could apply to other situations.

The Supreme Court ruled unanimously on North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust that beneficiaries of the trust who live in North Carolina do not have to pay state taxes on their income from the trust.

North Carolina’s law in question asserted the right to tax any income that is “for the benefit” of anyone who resides in the state. The opposing side, however, cited precedents that determined that in order for trust income to be taxed, the beneficiaries would need to have more of a connection to the trust, such as control over investments or guarantee of a stable income from it.

In the North Carolina case, the trust was created in New York and its documents were kept in New York. None of its assets were generated in North Carolina and they were “custodied” in Massachusetts. The beneficiaries are not the creator’s children, have no authority over the trust, may not assign their rights to the trust and are not guaranteed to receive future income from it.

The Court ruled that North Carolina’s relevant tax statutes violated due process by not establishing enough of a connection between the state and the people it wants to tax.

The Kaestner Trust sued to recover more than $1.3 million it paid to North Carolina in taxes on income earned from 2005 to 2008.

While the Supreme Court decision was unanimous, some in the legal community voiced concern that its sets up loopholes and tax shelters with which the very wealthy can transfer large sums of money without paying taxes by establishing trusts in low-tax states in order to benefit trustees who live in high-tax ones. North Carolina made that argument before the court, which responded that speculation about possible negative consequences was not enough of a factor to influence its decision.

Nationwide, trusts generate about $120 billion a year.

The narrowness of the scope, however, makes it unclear exactly how this decision can be applied to other state statues. Tennessee is currently the only other state that makes simple residence of beneficiary criteria for taxing trust income, but that state is phasing out its tax system.

Other states – including Arizona, California, Kentucky, New Mexico, Oregon, and Virginia – will tax if a trustee is a resident. And in Colorado, Indiana, Kansas, Mississippi, New Mexico, Oregon, South Carolina and Virginia, if a trust is administered in that state it is subject to state taxes. In at least 21 states, according to the National Law Review, if a trust was created in and funded in that state, it becomes liable to be taxed as soon as it becomes irrevocable.