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U.S. Supreme Court hears North Carolina trust taxation case

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Matthew Melinson
Philadelphia
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Tom Coley
Charlotte
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Drew VandenBrul
Philadelphia
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Jamie C. Yesnowitz
Washington, DC
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Chuck Jones
Chicago
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Lori Stolly
Cincinnati
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Patrick Skeehan
Philadelphia
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On April 16, 2019, the U.S. Supreme Court considered oral arguments in North Carolina Department of Revenue v. The Kimberly Rice Kaestner 1992 Family Trust, a case concerning whether a state can tax a trust on its undistributed income when the only connection between the trust and the taxing state is the residency of its beneficiaries.1 Last year, the North Carolina Supreme Court held that the state’s imposition of income tax on a trust solely based on the North Carolina residence of the beneficiaries was unconstitutional because it violated the Due Process Clause.2 In affirming the North Carolina Court of Appeals, the North Carolina Supreme Court agreed that the trust did not have sufficient minimum contacts with the state to satisfy due process under the U.S. and North Carolina Constitutions. Matthew Melinson, Tom Coley, Drew VandenBrul and Jamie Yesnowitz from Grant Thornton LLP attended the hearing and they provided their observations in this alert.

Background In 1992, a New York resident (settlor) created a trust for the benefit of the settlor’s 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. On Dec. 30, 2002, the trust was divided into three separate trusts to benefit each of the settlor’s children, including Ms. Kaestner. The taxpayer that ultimately became the named party in this litigation was the separate trust 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 taxpayer consisted of various financial investments with custodians located in Massachusetts. Documents related to the taxpayer, such as the ownership documents, financial books and records, and legal records, all were kept in New York. The taxpayer’s tax returns were prepared in New York. During the tax years at issue, the trust did not make distributions to any of the beneficiaries in North Carolina. However, in 2009, Ms. Kaestner received a loan from the taxpayer, which she quickly repaid.

During the tax years at issue, North Carolina taxed the taxpayer on income accumulated each year, regardless of whether the taxpayer actually distributed income to any of the North Carolina beneficiaries. The taxpayer, through its trustee, sought a refund of these taxes from the North Carolina Department of Revenue totaling more than $1.3 million. After the Department denied its refund request, the taxpayer filed a complaint with a county superior court and argued that the taxes collected violated the Due Process Clause because the taxpayer did not have sufficient minimum contacts with the state. Because the case was designated as a mandatory complex business case, the North Carolina Business Court considered the case. The Business Court determined that the taxpayer did not purposefully avail itself of the benefits of the taxing state based solely on the beneficiaries’ residence in North Carolina. On this basis, the Business Court concluded that, as applied to the taxpayer, the statute allowing taxation of trust income “that is for the benefit of a resident of this State”3 violated due process under the U.S. and North Carolina Constitutions. The Court of Appeals affirmed the Business Court on appeal.4

In affirming the Court of Appeals, the North Carolina Supreme Court agreed that the taxation of the taxpayer solely based on the beneficiaries’ residence violated the Due Process Clause.5 When applied to taxation, “[t]he Due Process Clause ‘requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’”6 The fact that the taxpayer and its “North Carolina beneficiaries have legally separate, taxable existences is critical to the outcome here because 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 Because the taxpayer and its beneficiaries are separate legal entities, the Court concluded that due process was not satisfied solely from the beneficiaries’ contacts with the state. On Jan. 11, 2019, the U.S. Supreme Court agreed to consider the case.8

Preliminary observations of hearing On April 16, 2019, four representatives from Grant Thornton LLP attended the Kaestner Trust hearing at the U.S. Supreme Court. We provide our preliminary observations on a hearing which provided relatively light discussion on the due process aspect of this case (at least from the perspective of legal precedent), and instead focused heavily on the facts and the taxation of trust income in various hypothetical situations.

North Carolina treats beneficiaries as owners of trust The state began its argument by explaining that trust beneficiaries are the true owners of trust assets and income under trust law. According to the state, a “trust has no situs” and the focus is on where the benefits and protections of the trust’s beneficiaries are being extended. The state noted that Ms. Kaestner was eligible to receive distributions during the relevant tax years and the trustee had a fiduciary duty to meet her needs. The state disagreed with the North Carolina Supreme Court’s contention that “beneficiary contacts categorically don’t count” and “[b]eneficiaries are strangers to the trust income of which they are the true owners under trust law.” The state claimed that solely looking to the trustee or trustee-related contacts to determine the location of the trust would create a “recipe for tax avoidance.” The state concluded its argument by stating that this due process challenge could invalidate the law in 33 states if the U.S. Supreme Court held for North Carolina.

Taxpayer’s focus on beneficiary lacking control of trust income The taxpayer emphasized that the North Carolina beneficiary, which was the only connection in this case to North Carolina, did not possess or control the money during the tax years at issue. As explained by the taxpayer, the beneficiary “didn’t receive any of it, and she had no guarantee that she would ever receive a penny of it in North Carolina or anywhere else.” During the relevant tax years, the trustee, rather than the beneficiary, controlled the funds. The taxpayer opined that “this case presents a straightforward and textbook application of the settled rule that the unilateral activity of a third-party does not create jurisdiction.” Finally, the taxpayer argued that the U.S. Supreme Court previously had resolved this issue in Hanson v. Denckla9 and Safe Deposit & Trust Co. v. Virginia.10 As a result, there was no reason for the Court to reconsider these cases.

Justices Ginsburg, Sotomayor and Breyer question taxation of undistributed income Within the first minute of the oral argument, Justice Ginsburg cast doubt on the proposition that a state could tax a trust based on a beneficiary’s location if the beneficiary did not yet receive the money. Justice Ginsburg pressed the state on the contention that North Carolina wanted to use the beneficiary’s connection with the state to impose a tax on a trust without a connection to the state. Later in the hearing, she raised the interesting proposition that instead of an income tax on undistributed amounts in the trust, a property tax could be imposed by a state on the value of the trust assets.

During the hearing, Justice Sotomayor asked the state why it had the right to tax the entire trust income when there is no guarantee that the beneficiary would receive all of the income at any point. She seemed to have difficulty believing the state’s argument that the beneficiary automatically would receive the amounts in the trust. Also, she disagreed that the trust could be taxed solely on the basis that the state provides protective benefits to the trust, reflecting that the due process standard has not been met. In order for the state to win this case, Justice Sotomayor contended the Court would need to overrule its previous decision in Hanson.

Justice Breyer seemed particularly opposed to the state having the right to tax a trust solely based on the residency of a contingent beneficiary that may not ever receive the money from the trust, or may receive the money many years into the future. During the hearing, Justice Breyer used several wide-ranging hypotheticals to reflect this opposition.

Justice Gorsuch cautions on overruling precedent and scope of jurisdictional powers Justice Gorsuch seemed troubled that taking the state’s position would lead to overruling precedent, including Safe Deposit and Brooke v. City of Norfolk.11 He questioned the state whether these cases should be overruled in the name of fundamental fairness, and did not accept the state’s argument that such cases could be distinguished on different facts rather than overruled. In the final few minutes of the argument, Justice Gorsuch questioned whether the Court had ever held in Hanson, or elsewhere, that tax jurisdiction (a state’s right to tax a transaction) could be broader than adjudicative jurisdiction (a court’s right to hear a case). To that question, the state responded that while no case explicitly came to that conclusion, the way in which tax jurisdiction cases should be examined is different than in adjudicative jurisdiction matters -- the focus in tax jurisdiction matters is on the benefits and protections extended to the party being taxed.

Chief Justice Roberts concerned about allocating tax burden among states Chief Justice Roberts was interested in how to determine the location of a trust, and characterized the trust as “just a contract” when addressing the state, allowing the state to emphasize its argument that the trust was indivisible from its beneficiaries. Later on in the argument, Chief Justice Roberts appeared to support Justice Breyer’s concerns raised in his hypotheticals, by questioning whether there was an established way to allocate the tax burden between several states that may have a claim for taxing the trust based on the trust’s contacts. The Chief Justice then asked the taxpayer whether the trustee could treat beneficiaries differently on the sole basis that they lived in different states. The taxpayer replied that the trustee does not care where the beneficiaries reside and would not discriminate on this basis. As explained by the taxpayer, the fact that a beneficiary is located in North Carolina is not relevant to the trust’s operation, the trustee’s duties, or the way in which the trustee administers the trust.

Justice Kavanaugh noted few states follow North Carolina’s approach to taxing trusts Justice Kavanaugh commented that very few states actually tax trusts in the manner that North Carolina does. The taxpayer responded that currently only three states – Georgia, North Carolina and Tennessee – use the presence of a contingent beneficiary as the sole factor on whether they will tax a trust’s accumulated income. Justice Kavanaugh mentioned that the contingent beneficiary issue that troubled other Justices appears to support the taxpayer’s position. Also, Justice Kavanaugh noted that in the instance that a state could not tax a trust based on beneficiary location until the beneficiary is receiving the distribution, the practical issue of a beneficiary moving to a state without an income tax would arise.

Justice Kagan views beneficiary location as relevant Justice Kagan challenged the taxpayer more than any other justice. She indicated that a trust could be subject to income tax in one of three jurisdictions: (i) the location of the trustee; (ii) the location of administration; or (iii) the location of the beneficiary. Recognizing that all three criteria for the authority to tax undistributed trust income are imperfect, Justice Kagan had difficulty accepting the taxpayer’s arguments that the trust should be taxed based on the location of the trustee or the state of administration. Instead, she seemed to support the proposition that the taxing authority should lie with the state where the party benefitting from the trust resides. In this case, Justice Kagan suggested that North Carolina had by far the greatest interest in taxation because that state is providing services to the only person who would benefit from the income growth of the trust. She did not think the contingent nature of the trust distributions to the beneficiaries was particularly important. Compared to someone who is not a trust beneficiary, the effect of a trust placed beneficiaries with the knowledge that they could receive substantial amounts of money in the future in far different circumstances and could influence the beneficiary’s life choices.

Justice Alito and Justice Thomas remain question marks Justice Alito expressed concerns to the taxpayer that he thought the case was simpler than the taxpayer’s argument was making it out to be. Justice Alito had thought the case was about a state imposing a tax on someone for an uncertain amount of money that the person may never receive. The taxpayer agreed with Justice Alito’s summary.

Justice Thomas followed his tendency to remain silent at hearings, and therefore left no hints as to how he plans to decide on this matter.

Commentary During the past 18 months, the U.S. Supreme Court has granted certiorari and heard several state tax matters. Last year, the Court decided South Dakota v. Wayfair, Inc., a landmark case concerning sales and use tax nexus standards.12 On Feb. 20, 2019, the Court decided Dawson v. Steager,13 in which it struck down a West Virginia law exempting the pension benefits of state and local law enforcement employees from state taxation.

Kaestner Trust may not be as groundbreaking as Wayfair, but it is significant because it concerns the Due Process Clause and the minimum contacts that are necessary before a state may impose a tax on a trust’s undistributed income based solely on the residence of the beneficiaries. In the oral arguments, it was somewhat surprising to see very little attention paid to Wayfair itself. The taxpayer raised Wayfair almost as an afterthought at the end of the argument, simply to emphasize the position that Wayfair was not relevant to this case. The taxpayer did note the differences between the economic activities performed by the taxpayer in Wayfair towards the taxing forum, versus the lack of activities performed by the trust that occurred in North Carolina.

The North Carolina Supreme Court determined that taxing the trust on undistributed income was unconstitutional because the trust is a legal entity separate from the identity of its beneficiaries. State courts currently disagree on whether the beneficiaries’ residence in a state is sufficient to impose income tax on a trust. State courts in Illinois,14 Minnesota,15 New Jersey,16 and Ohio17 support the North Carolina Supreme Court’s decision. Courts in California18 and Connecticut19 reached the opposite conclusion, but the North Carolina Supreme Court distinguished these cases.

Based on prior knowledge of the justices’ opinions and the lines of questioning pursed by the justices at the hearing, we believe that Justices Sotomayor, Breyer, Ginsburg, Gorsuch, Roberts, and Kavanaugh are relatively likely to support the taxpayer, while Justices Kagan, Alito and Thomas might be more inclined to support North Carolina. The prior U.S. Supreme Court decisions mentioned during the oral arguments are supportive of the position that the beneficiary’s residency in a state is not a sufficient contact for due process purposes. If the Court finds in favor of the state, some of the Justices indicated that in order to do so, the Court will need to overrule some of its prior decisions that were discussed during oral argument. Though that is precisely what was done in Wayfair, overruling precedent is not a step that the Court takes lightly (as evidenced by the discussion at oral argument), and the technological changes that supported such a move do not appear to exist in this matter.

A decision in this case is expected by the end of the Court’s term in late June. The decision may alter the course of existing litigation on this subject, invalidate applicable laws in many states, and have retroactive effects that could lead to refund opportunities for similarly situated trusts.
 

1 U.S. Supreme Court, No. 18-457.
2 814 S.E.2d 43 (N.C. 2018), cert. granted, 139 S. Ct. 915 (2019).
3 N.C. GEN. STAT. § 105-160.2.
4 789 S.E.2d 645 (N.C. Ct. App. 2016).
5 814 S.E.2d 43 (N.C. 2018), cert. granted, 139 S. Ct. 915 (2019). Note that a dissenting opinion was filed in this case.
6 Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992), quoting Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-45 (1954).
7 Citing Walden v. Fiore, 571 U.S. 277 (2014).
8 139 S. Ct. 915 (2019).
9 357 U.S. 235 (1958). In Hanson, the Court held that the unilateral activity of those who claim a relationship with the nonresident does not constitute a contact with the foreign state.
10 280 U.S. 83 (1929). In Safe Deposit, the Court held that stocks and bonds that were in the hands of the legal titleholder with a definite taxable situs at its residence could not be taxed by the other state where the beneficial owner resided. The stocks and bonds had acquired a separate situs from the beneficial owner.
11 277 U.S. 27 (1928). In Brooke, the imposition of Virginia income tax on a Maryland trust with a Virginia beneficiary violated the Fourteenth Amendment. As explained by the Court, “the property is not within the State, does not belong to the petitioner and is not within her possession or control.”
12 138 S. Ct. 2080 (2018). For a discussion of this case, see GT SALT Alert: Wayfair Ruling Overturns Quill Physical Presence Requirement.
13 139 S. Ct. 698 (2019). For further information, see GT SALT Alert: U.S. Supreme Court Rules West Virginia State Employee Pension Benefit Tax Break Discriminates Against Federal Retirees.
14 Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. App. Ct. 2013). In this case, the Illinois Court of Appeals held that there was insufficient contact between Illinois and the taxed trust to satisfy due process because the trust did not have property in Illinois and conducted all of its business in Texas.
15 Fielding v. Commissioner of Revenue, 916 N.W.2d 323 (Minn. 2018). The Minnesota Supreme Court found unconstitutional the application of a Minnesota income tax statute defining a “resident trust” to four related, inter vivos trusts whose primary link to the statue was the grantor’s Minnesota domicile. For a discussion of this case, see GT SALT Alert: Minnesota Supreme Court Denies Application of Resident Trust Tax Law on Due Process Grounds. The Minnesota Department of Revenue filed a petition for writ of certiorari with the U.S. Supreme Court in November 2018, and as of this date, the Court has not yet decided whether it will hear the case.
16 Residuary Trust A v. Director, Division of Taxation, 27 N.J. Tax 68 (2013), aff’d per curiam, 28 N.J. Tax 541 (2015). The New Jersey Tax Court held that neither the deceased testator’s New Jersey domicile nor the business interests in the state of several corporations in which the trust held stock allowed New Jersey to tax undistributed income from sources outside the state under the due process minimum contact standards.
17 T. Ryan Legg Irrevocable Trust v. Testa, 75 N.E.3d 184 (Ohio 2016). The Ohio Supreme Court held that the state could tax a Delaware trust without violating due process because the Ohio resident created the trust to dispose of his interest in a business that conducted business in Ohio and the settlor’s contacts in Ohio were material.
18 McCulloch v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964). In Kaestner Trust, the state cited to this case for the proposition that a “beneficiary’s state of residence may properly tax the trust on income which is payable in the future to the beneficiary, although it is actually retained by the trust, since that state renders to the beneficiary that protection incident to his eventual enjoyment of such accumulated income.” However, the North Carolina Supreme Court distinguished McCulloch because it was decided before Quill, on a set of facts different than Kaestner Trust.
19 Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Conn. 1999). The Connecticut Supreme Court held that taxation of an inter vivos trust did not violate due process because the beneficiary resided in Connecticut, but the Court did not consider whether a trust has a legal existence separate from the beneficiary.



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