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On June 21, 2019, the U.S. Supreme Court unanimously concluded in North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust
that the state of North Carolina did not have the power to tax a trust’s undistributed income based solely on the fact that the trust’s beneficiaries were North Carolina residents.1
As such, the Court ruled that the state lacked the minimum connections necessary to tax the trust under the Due Process Clause of the U.S. Constitution. The decision, authored by Justice Sonia Sotomayor, upheld a North Carolina Supreme Court decision to the same effect.2
In 1992, Joseph Lee Rice III (the settlor) created a trust for the benefit of his children. The settlor chose a Connecticut resident trustee to manage the trust. In 1997, Kimberly Rice Kaestner, the settlor’s daughter and a primary beneficiary of the trust, moved to North Carolina. In December 2002, the trustee divided the trust into three subtrusts to benefit each of the settlor’s children. One of these subtrusts was formed for the benefit of Ms. Kaestner and her three children, all of whom resided in North Carolina from 2005 to 2008, the tax years at issue. The assets held by the trust consisted of various financial investments with custodians located in Massachusetts. Documents related to the trust, such as the ownership documents, financial books and records, and legal records, were all stored in New York. The trust’s tax returns were prepared in New York. Under the trust agreement, the trustee had exclusive control over the allocation and timing of trust distributions. During the tax years at issue, the trust did not make distributions to any of the beneficiaries located in North Carolina.
North Carolina law provides for the taxation of trust income “that is for the benefit of a resident of this State.”3
During the tax years at issue, North Carolina taxed the trust on the full proceeds accumulated during each year, on the sole basis that the trust beneficiaries resided in the state. The taxpayer, through its trustee, sought a refund of the more than $1.3 million in tax paid to the North Carolina Department of Revenue. After the Department denied the refund request, the taxpayer sued in state court, arguing that the tax as applied to the trust violated the Due Process Clause of the U.S. Constitution.4
The state trial court agreed, deciding that the Kaestners’ North Carolina residence was too tenuous a link between the state and the trust income to support imposition of the tax. The North Carolina Court of Appeals affirmed the trial court on appeal.5
Affirming the Court of Appeals, the North Carolina Supreme Court agreed that the taxation of the trust solely based on the beneficiaries’ residence violated the Due Process Clause.6
The court found critical the fact that the trust and its North Carolina beneficiaries had “legally separate, taxable existences.” Reasoning that “a taxed entity’s minimum contacts with the taxing state cannot be established by a third party’s minimum contacts with the taxing state,”7
the court concluded that due process was not satisfied solely from the beneficiaries’ contacts with the state. The U.S. Supreme Court granted certiorari
on Jan. 11, 2019,8
with oral arguments taking place on April 16, 2019.
State tax violates Due Process Clause
The Court unanimously affirmed the decision of the North Carolina Supreme Court, holding that the presence of a trust’s in-state beneficiaries alone does not allow the state to tax undistributed trust income “where the beneficiaries have no right to demand that income and are uncertain ever to receive it.” The Court expressly limited its holding to the facts of the case, noting that its decision does not apply to trust taxes premised on the residence of beneficiaries with a different relationship to trust assets.
Due process analysis applied in trust beneficiary context
When applied to state taxation, the Court explained that the Due Process Clause requires “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”9
Against this backdrop, the Court examined North Carolina’s tax by focusing on the relationship between the trust’s beneficiaries and the trust assets that the state sought to tax, focusing on the extent of the in-state beneficiary’s “right to control, possess, enjoy, or receive trust assets.” The Court reviewed its decisions in Safe Deposit & Trust Co. of Baltimore v. Virginia10
and Brooke v. Norfolk11
, two cases that considered state trust taxes based on the in-state residency of the beneficiaries. Although the cases were distinguishable in that they dealt with taxes imposed on the trust’s property instead of the trust assets, the Court nonetheless invalidated the taxes in these cases because it found that the in-state resident beneficiaries had insufficient control or possession of the trust property.
In contrast, the Court noted that it has upheld state taxes based on the residency of beneficiaries where the trust income is actually distributed to an in-state beneficiary, because it has determined that the beneficiary “own[s] and enjoy[s]” an interest in the trust property.12
Similarly, the Court has upheld trust taxes where the settlor was a resident of the state, because the settlor had the power to dispose of the trust property, amounting to “a potential source of wealth which was property in her hands.”13
The same held true for state taxes based on the residence of the in-state trustee, which satisfied the necessary relationship between the trust assets and the trustee based on the trustee’s legal interest in the trust assets.14
In summary, the Court concluded that in order for a state tax to survive Due Process Clause scrutiny based on the state residence of a beneficiary, the resident must have “some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset.”
North Carolina lacks minimum connections with in-state beneficiaries
Applying the above principles, the Court concluded that the residence of the trust beneficiaries in North Carolina alone did not supply the minimum connection necessary to uphold the state’s tax. The Court arrived at this conclusion based on three principal reasons. First, the in-state beneficiaries did not receive any trust income during the tax years in question. If they had, the income would have been taxable based on the power of a state to tax all income earned by an in-state resident. Second, the beneficiaries had no right to demand the trust income or otherwise control, possess or enjoy the trust assets. Rather, the trustee had “absolute discretion” over when, whether and how the trust assets were to be distributed. The trustee had the power to make investment decisions regarding trust property under the terms of the trust agreement. With sole discretion reserved to the trustee, Kaestner and her children could not demand distributions during the tax years in question. Third, the beneficiaries could not depend on receiving any specific amount of trust income in the future. For these reasons, the Court concluded that the beneficiaries had no right to control or possess the trust assets or to receive income from the trust.
The Court concluded by addressing North Carolina’s counterarguments in support of the tax, explaining why they were unpersuasive. First, the Court disagreed with the state’s assertion that beneficiaries are essential to a trust and therefore have an equitable interest in its assets. In doing so, the Court was reluctant to adopt a categorical rule based on the wide variation in beneficiary interests in trust assets. Second, the state argued that the invalidation of its law would undermine various state taxation regimes. In response, the Court pointed out that only a handful of states currently rely on beneficiary residency as the sole basis for trust taxation, let alone the residency of beneficiaries without regard to whether the beneficiary is certain to receive trust assets. Finally, North Carolina warned that siding with the trust would lead to “opportunistic gaming of state tax systems,” but the Court noted that this consideration is by no means a certainty given the costs and benefits of structuring trusts in this way. The Court noted that “mere speculation about negative consequences” does not compensate for the missing minimum connection between the state and the trust income.
Concurring opinion protects court precedent
Justice Alito filed a concurring opinion joined by Chief Justice Roberts and Justice Gorsuch. Joining in the opinion reached by the majority, the concurring justices pointed out that the Court’s opinion was restricted given the “unusually tenuous” connection between North Carolina and the trust income. Justice Alito wrote separately to clarify that the Court merely applies existing precedent in cases such as Safe Deposit and Brooke, and that its decision not to extend its ruling beyond the facts of the case does not alter the reasoning applied in the Court’s earlier decisions on the subject.
The Court’s decision in Kaestner Trust
marks the fourth significant state tax case decided by the Court in the past year. On June 21, 2018, exactly one year before the Kaestner Trust
decision, the Court decided South Dakota v. Wayfair, Inc.
, the landmark case overruling the physical presence standard for sales and use taxes previously enunciated in Quill Corp. v. North Dakota
On Feb. 20, 2019, the Court decided Dawson v. Steager
in which it struck down a West Virginia law exempting the pension benefits of state and local law enforcement employees from state taxation. Most recently on May 13, 2019, the Court decided Franchise Tax Board of California v. Hyatt
, ruling that an individual taxpayer was not permitted to bring a private lawsuit against California in Nevada state court under sovereign immunity principles implicit in the U.S. Constitution.17
Such an occurrence is uncommon for the Court, which has taken a greater interest in hearing state tax cases in recent years. It has not been since the early 1990s that the Court has decided as many significant state tax cases.18
While we expected the Court to decide Kaestner Trust
in favor of the taxpayer following oral arguments,19
the Court’s invalidation of North Carolina’s law in unanimous fashion is somewhat surprising for a number of reasons. First, the Court has delivered split 5-4 decisions in recent state tax cases such as Wayfair
, signifying that the justices do not uniformly measure the limits of states’ power to tax as allowed under the U.S. Constitution in the same manner. Second, certain justices challenged the trust’s position during oral arguments, appearing to be more sympathetic to the state’s argument for taxation. For example, Justice Kagan suggested that North Carolina had the greatest interest in taxing the trust income because it was providing services to the beneficiaries, the only people who would benefit from the income growth of the trust. Despite these concerns, all justices agreed that the connection between the state and the trust was too tenuous to support the North Carolina tax based on the facts presented.
may be remembered as being relatively anti-climactic precisely because of the Court’s insistence that the decision not be applied beyond the very narrow facts surrounding the trust and its relationship to the trust’s beneficiaries. While it was anticipated that the decision could have potentially significant implications regarding the scope of the Due Process Clause in state tax nexus matters, the reach of Kaestner Trust
may be limited, especially outside North Carolina.20
The Court took pains to note that its decision is not intended to express any opinion on the validity of state taxes that rely on the residency of beneficiaries having different relationships to the trust assets.21
However, the ruling might call into question the trust tax regimes of other states that enact taxes with comparable rules, leading to potential refund opportunities for similarly situated trusts.
Missing from the Court’s decision was any substantive discussion of Wayfair
, the groundbreaking nexus case that overturned decades of Court precedent in National Bellas Hess v. Illinois Department of Revenue22
. That being the case, Kaestner Trust
involved a state tax as applied to undistributed trust income, a very different fact pattern from South Dakota’s sales and use tax law at issue in Wayfair
. Ironically, although the Court overruled Quill
’s physical presence standard in Wayfair
under a Commerce Clause analysis, Kaestner Trust
followed the analysis outlined in Quill
for purposes of whether a state tax meets the Due Process Clause.
Also missing from the Court’s analysis was a discussion of the taxation of trust income for federal purposes. Generally, only a trust’s undistributed income (distributable net income) is subject to tax at the trust level,23
while actual distributions from the trust to the beneficiaries are deducted at the trust level and subject to tax at the individual level.24
It is interesting that the Court declined to discuss the important distinctions between the federal and state tax treatment of trusts, and whether the federal treatment informs the state analysis in any way.
In striking down the North Carolina law, the Court was careful not to overturn existing precedent in the area of state trust taxation, which represented another departure from the Court’s Wayfair
decisions. Overturning precedent is not a decision that the Court takes lightly, and the Court saw no need to do so here. In fact, the concurrence emphasized that the Court directly applied existing precedent, and that its reluctance to apply the decision beyond the facts of the case does not bring into question the reasoning of the Court’s prior decisions.
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