The Supreme Court of the United States (SCOTUS) has agreed to hear a case that questions the ability of a state to tax trust income when the trust is located in another state.

The case begins with a father who created a trust in New York to guide the transfer of his estate to his three children. In 2002, the trustee divided the trust into three separate trust accounts. One of the beneficiaries had her trust managed in Connecticut while she lived in North Carolina. Based solely on this beneficiary’s residence, North Carolina’s Department of Revenue taxed the trust.

The controversy: the state taxed undistributed income of the trust.

Trusts and tax obligations: A brief overview

The government generally considers a trust a standalone entity. This means it is often subject to federal and, in some cases, state income tax obligations. As such, state and federal laws generally require beneficiaries to report income earned on a trust on federal and state income tax returns — whether it is distributed or left within the trust.

It is generally acceptable for a state to tax distributions from the trust to beneficiaries. It is not as common, although not unheard of, to tax the undistributed income when the trust is in another state.

Eleven states throughout the country have similar rules. As noted in the case, a total of six states apply a tax on trusts based solely on a beneficiary’s in state residence. These states are North Carolina, California, Georgia, Montana, North Dakota and Tennessee. The other five use a beneficiary’s in-state residency as a factor, along with other contacts with the state, to apply a tax to the trust. These five states are Alabama, Connecticut, Missouri, Ohio and Rhode Island.  Of these states, nine have taken the issue to court. Four states have ruled in favor of the tax and five have found the tax a violation of the Due Process Clause.

Impact in Connecticut: The holding could change trust law in the state

Since Connecticut uses and has thus far supported a similar tax, a holding in favor of North Carolina would provide additional support for these laws. However, a ruling against North Carolina could result in challenges to the trust law in Connecticut.