Out-Of-State Trusts With North Carolina Beneficiaries, Apply For Tax Refund NOW

In the last article of this column, we discussed two big taxpayer wins delivered by the US Supreme Court.  One of those wins struck down North Carolina’s statute that imposed income tax on out-of-state trusts with in-state beneficiaries.

To quickly recap, under long-standing rules:

  • The trustee’s state of residency could tax all trust income from sources worldwide.
  • If the trust received income from another jurisdiction — such as rental income or business operations — that other state could tax that income and the trustee’s home jurisdiction would offer a tax credit to the trust to avoid double-taxation. 
  • If a beneficiary received distributions of income, a few things happen.  First, the beneficiary will pay tax to trustee’s state of residency (if that state has income tax).  Second, the beneficiary will pay tax to her / his home state and that home state would offer a tax credit to the beneficiary to avoid double-taxation.  Third, the trust would receive a deduction equal to the amount distributed to the beneficiary to avoid double-taxation.

How much income does a beneficiary recognize?  The amount actually distributed to the beneficiary AND the amount to which the beneficiary has a non-contingent right to receive (whether received or not).  

This “non-contingent right to receive” sounds odd.  But, it has an analogue that should seem familiar to many.  When does a shareholder recognize a dividend as income for tax purposes?  When it is declared as opposed to when it is received.  A dividend declaration is when the board of directors grants a non-contingent right to the shareholder of the dividend amount.  At some later point in time, the dividend is paid. Similarly, a beneficiary recognizes income for tax purposes when a trustee declares a non-contingent right to the beneficiary of the distribution amount.  At some later point in time, the distribution is paid.

So, under these long-standing rules, if 1) the trustee is not a resident of a state, 2) the trust has no assets in that state, and 3) the trust has no income from that state, then the only thing that state has the ability to tax is income distributed (if any) to an in-state beneficiary.

But, under these exact circumstances, in utter disregard of these long-standing rules and over 150 years of US Supreme Court cases affirming these rules, North Carolina sought to assess income tax on ALL trust income instead of the amount distributed to in-state beneficiaries.

One taxpayer wasn’t going to put up with it, fought it, and won.  As a result of its loss, the North Carolina Department of Revenue issued a notice (click here) that describes how similarly situated trusts / trustees who paid taxes to the state can apply for a refund.  Review the notice. If your trust fits the bill and is within the statute of limitations to claim a refund, you should immediately file a claim.

If your trust fits the bill but is past the statute of limitations, talk with an attorney.  It might be argued that North Carolina was acting under “color of law” when it violated your Constitutional rights and, as such, the statute of limitations is invalid.  Don’t know if this argument would stand the test in court but it might be your only / best theory.

Best of luck.

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