U.S. Supreme Court Rules North Carolina Tax on Trust Beneficiaries Is Unconstitutional

Thoughtware Alert Jul 22, 2019
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On June 21, 2019, the U.S. Supreme Court (Supreme Court) held that the North Carolina Department of Revenue (DOR) didn’t have the authority to impose an income tax on a trust that had no connection to North Carolina other than the beneficiary’s residence in North Carolina Department of Revenue, Petitioner v. The Kimberley Rice Kaestner 1992 Family Trust. The decision comes precisely one year after the Supreme Court’s sweeping decision in South Dakota v. Wayfair, Inc.

Nearly 30 years ago, Joseph Lee Rice III started a trust for the benefit of his children in his home state of New York and appointed a fellow New York resident as the trustee. The trust agreement granted the trustee “absolute discretion” to distribute the trust assets to its beneficiaries. The initial trust of Joseph Lee Rice III was later split into three separate trusts under the same agreement that controlled the original trust. A beneficiary of one of these subtrusts, the Kimberley Rice Kaestner 1992 Family Trust (Trust), resided in the state of North Carolina from 2005 through 2008.

The North Carolina DOR imposed an income tax of more than $1.3 million on the Trust under a North Carolina law (N.C. Gen. Stat. Ann. Section 105-160.2) authorizing the state to tax a trust that’s set up “for the benefit of” a state resident, even though the trust settlor and the trustee both resided in the state of New York and the beneficiary didn’t receive, or have the right to receive, any distributions during the time she was a North Carolina resident. The trust ultimately paid the tax and sued the North Carolina DOR, arguing the tax imposed violates the 14th Amendment’s due process clause. The North Carolina trial court held that the North Carolina’s taxation violated the due process clause, the North Carolina Court of Appeals affirmed, and the state Supreme Court upheld the trial court decision.

The Court referred to Quill Corp. v. North Dakota, to determine that for the trust to be taxable under the due process clause, it must have “some definite link, some minimum connection, between a state and the person, or transaction it seeks to tax.” The Supreme Court previously held that a tax on trust income distributed to an in-state resident can be imposed under the due process clause in Maguire v. Trefry, and that a tax based on a trustee’s in-state residence also can be imposed in Greenough v. Tax Assessors of Newport. The Trust, however, didn’t have the required minimum connection with the state of North Carolina because the beneficiary didn’t receive any income from the Trust during her years of residency and the language of the Trust agreement left the trustee with “absolute discretion” to distribute the assets and authorized the trustee, not the beneficiaries, to make investment decisions. The Supreme Court held that “the presence of in-state beneficiaries alone does not empower a state to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain ever to receive it.”

The decision also bore a resemblance to Hanson v. Denckla, in which the Supreme Court decided the Florida court lacked jurisdiction based on the minimum contacts test under the due process clause. There, the trust company had no substantial business with Florida and no offices in Florida. The only contact with Florida was the fact that a beneficiary moved there, which was ruled insufficient to support jurisdiction because the trust didn’t purposefully avail itself to Florida jurisdiction.

The North Carolina DOR directed the Supreme Court’s attention to 10 other state trust taxation statutes that also look to beneficiary residency; however, the Supreme Court didn’t indicate whether it found the state statutes to rely entirely on the beneficiary’s residence.

The majority carefully noted the implications of its holding and made clear its decision was limited to the specific facts before the Supreme Court and it wasn’t implying “approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.” The opinion and concurrence in the Kaestner ruling together make it overtly clear that the justices were cautious of the argument made by North Carolina that a decision in favor of the trust could “lead to opportunistic gaming of state tax systems.”

The majority stated, “our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.”

Overall, the holding doesn’t revamp the due process clause applied in Quill Corp. to tax matters or change the far-reaching nexus standards under the commerce clause created by Wayfair. Taxpayers raising due process arguments in defense of nexus assertions are essentially left in the same position today as they were before the Kaestner ruling, given the limited scope based on the facts in the case and the limited number of states with statutes similar to North Carolina. Time will tell if the Supreme Court will eventually articulate a clear standard for the due process clause in a majority opinion for taxpayers. Nevertheless, trustees in states with such statutes and similar facts to Kaestner should consider filing protective refund claims.

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