By: Laura Ames
Levitan v. Rosen
Massachusetts Appeals Court, May 6, 2019
A recent Massachusetts Appeals Court case has revisited the question of whether a spouse’s beneficial interest in a discretionary trust should be included in the marital estate and thus subject to equitable division upon a divorce. In Massachusetts, upon a divorce, the court (guided by state statute) will determine which of the couple’s assets are ‘marital’ assets comprising the marital estate. The court then divides the marital estate ‘equitably’ (meaning fairly, but not necessarily equally) between the husband and wife.
In Levitan v. Rosen (“Levitan”), the wife was a beneficiary of an irrevocable trust (the “Trust”), created by her father. The wife served as co-Trustee along with an independent, unrelated Trustee. The terms of the Trust gave the independent Trustee discretion to distribute as much of the income and principal to the wife as he deemed advisable (this type of trust is often referred to as a discretionary trust). Additionally, the wife had the ability to withdraw up to 5% of the principal annually.
In 2013, after 16 years of marriage, the wife filed a complaint for divorce. The Probate and Family Court issued a judgment of divorce nisi, ruling that the 5% of the Trust the wife was able to withdraw annually constituted a marital asset subject to equitable division, but excluding the remainder of the wife’s Trust interest from the marital estate because it was subject to the Trust’s spendthrift provisions (discussed below). The wife appealed the ruling.
Appeals Court Findings
The Appeals Court disagreed with portions of the Probate Court’s judgment. The Appeals Court concluded that the wife’s entire interest (including the 5% withdrawal right) was governed by the Trust’s spendthrift clause. A spendthrift clause is a provision included in a trust that is meant to prevent creditors, including divorcing spouses, from attaching the beneficiary’s interest. However, the Court also found that the wife’s entire interest in the Trust was part of the marital estate. The effect of this decision is that while the spendthrift clause prevented the Trust assets from being paid over to the husband in the divorce, the Trust assets were considered part of the greater marital estate for calculation purposes, and in determining what an equitable division of the marital assets would be, the Trust assets were ‘allocated’ to the wife’s share.
The Appeals Court in Levitan interpreted the 2016 Pfannenstiehl Supreme Judicial Court Case, which established guidelines for determining what type of trust interest would be included in the marital estate in a divorce. The court in Pfannenstiehl held that for a trust interest to be included in the marital estate, the interest should be a “fixed and enforceable” property right, not so “remote or speculative” that the interest is better characterized as a “mere expectancy.” The Appeals Court’s interpretation of the Pfannenstiehl ruling led them to conclude that because
(1) the wife was the sole beneficiary of her share, (2) no additional beneficiaries (such as children) could ever be added to her share, and (3) the primary intent of the Trust was to provide for the wife (as opposed to further generations), the Trust interest was a fixed and enforceable property right, not a mere expectancy, and thus considered a marital asset.
The Appeals Court’s finding that the entire Trust interest was subject to the spendthrift clause is consistent with the purpose of the clause; indeed, it’s why practitioners include spendthrift provisions. However, the finding that the Trust assets were includable in the marital estate is concerning for many estate planners. Using fully discretionary trusts with independent Trustees is a long-standing planning technique, and this decision prompts questions from practitioners about protecting certain discretionary trust assets in the event of a divorce and also how best to structure trusts for children and future generations in order to protect the assets from a divorcing spouse.
The Appeals Court focused on the fact that the wife was the sole beneficiary of the Trust and the primary intent of the Trust was to benefit the wife, which led the Court to conclude that her interest was sufficiently distinguishable from a “mere expectancy.” Depending on the given circumstances, it may be appropriate to include trust language that clarifies the Donor’s intention to benefit multiple generations, and/or to establish a trust for a group of beneficiaries as opposed to establishing separate trusts or trust shares for each beneficiary.
North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust
United States Supreme Court, June 21, 2019
In June of 2019, the U.S. Supreme Court issued its decision in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust (“Kaestner”), regarding the limits of a state’s power to tax a trust. In Kaestner, the North Carolina Department of Revenue interpreted its state statute so as to impose a tax on any trust income that is earned by a trust established for the benefit of a North Carolina resident, regardless of whether or not the beneficiary actually received any trust income in the tax year, had any demand rights to the income, or could count on receiving income from the trust. The U.S. Supreme Court ruled against North Carolina, finding that a trust beneficiary’s residence alone was not enough to tax the trust’s undistributed income.
By way of background, the Trust in Kaestner (the “Trust”) was originally created in 1992 by a New York resident for the benefit of his three daughters. The Trust was governed by the laws of New York, and the Trustee for the tax years in question was a resident of Connecticut. The financial records, accountings and tax returns were prepared and kept in New York, and the Trust assets were held by custodians in Boston. No party to the Trust resided in North Carolina until Kimberly Kaestner, one of the three daughters and a beneficiary of the Trust, moved to North Carolina in 1997. In 2002, the Trust was segregated into three separate trusts, one for each child. Ms. Kaestner and her three daughters were the beneficiaries of her separate Trust, and the Trustee had the “absolute discretion” to make distributions to the beneficiaries “in such amounts and in such proportions” as the Trustee might “from time to time” decide. No distributions were made to the beneficiaries during the tax years in question.
Between 2005 and 2008, North Carolina found the Trust owed the Department of Revenue more than $1.3 million in income taxes, despite the fact that the beneficiaries had not received any distributions from the Trust during those years. In order to avoid interest and penalties, the Trustee of the Trust paid the tax, and then filed a claim for a refund on the basis that the North Carolina tax provision was unconstitutional.
The case made its way through the lower levels of the North Carolina court system before being heard in the North Carolina Supreme Court, which ruled in favor of Ms. Kaestner and the Trust. The North Carolina Department of Revenue then asked the United States Supreme Court to hear the case.
U.S. Supreme Court Ruling
The U.S. Supreme Court upheld the lower court’s finding that North Carolina’s taxation of undistributed income from a trust based solely on the beneficiaries’ residence in North Carolina was unconstitutional because it violated the Due Process Clause of the Constitution. The Court held that the statute violated the Due Process Clause because the state lacked the minimum connection with the object of its tax that the Constitution required. Case law cited by the Court noted that there must be some “definite link, some minimum connection, between a state and a person, property or transaction it seeks to tax,” and the Court found none in Kaestner.
However, the Court in Kaestner was careful to emphasize that its ruling was based on the specific facts of this case, and did not address other states’ trust taxation regimes. While the Court concluded that the Kaestner Trust beneficiaries did not have the requisite relationship with the trust property to justify North Carolina’s tax, the opinion makes it clear that the Court was not deciding “what degree of possession, control, or enjoyment would be sufficient to support taxation” of the Trust.
A number of recent state court cases have come out on the issue of state income taxation of trusts, and Kaestner is the first time the U.S. Supreme Court has addressed the issue in many decades. For that reason, the case is significant and helpful for practitioners and advisors. The Court’s ruling certainly gives some guidance to practitioners when analyzing the state taxation of trust income. However, the Court’s narrow holding does not necessarily offer guidelines for what specific connections between a state and a trust would allow the state to tax the trust. Careful consideration must be given when out-of-state parties are involved in a trust: for example, whether the appointment of an out-of-state Trustee could cause the trust to be subject to tax in the Trustee’s state of residence as well as the state in which the Trust assets are located.