SCOTUS Rules that North Carolina Tax on Certain Trusts Violates the Due Process Clause of the Fourteenth Amendment

On June 21, 2019, the Supreme Court of the United States issued a unanimous opinion finding that North Carolina’s imposition of an income tax on trusts based solely on the residence of a trust’s beneficiaries is unconstitutional.  North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457.
 

Background

The Kimberly Rice Kaestner 1992 Family Trust’s (Kaestner Trust’s) only connection to the state of North Carolina was the residence of the trust’s beneficiaries. The Kaestner Trust was established as an inter vivos trust by a New York settlor and was administered by a New York trustee pursuant to the laws of New York, who maintained the Kaestner Trust’s books and records in New York. The Kaestner Trust’s assets were custodied in Massachusetts, and the Kaestner Trust maintained no real property in North Carolina nor made any direct investments in the state.  When the Kaestner Trust was created, the beneficiary was a resident of New York.  Subsequently, she and her family moved to North Carolina. 
 
The trustee had “absolute discretion” to distribute the trust’s assets to beneficiaries “in such amounts and proportions” as the trustee determined “from time to time.” During the years in question, the trustee did not make any distribution of income to the Kaestner Trust’s beneficiaries.  A beneficiary of the Kaestner Trust could not assign any right they may have to trust property.
 
The North Carolina Department of Revenue sought to tax the income of the Kaestner Trust under its tax law, which imposes an income tax on trust income that “is for the benefit of” a North Carolina resident. North Carolina courts had traditionally interpreted this law to permit taxation when a trust’s beneficiaries lived in the state, even if the beneficiaries received no income distribution from the trust and had no right to demand any income from the trust.
 
The trustee of the Kaestner Trust paid the tax assessed and then sued in state court for a refund. The trial court ruled in favor of the Kaestner Trust holding that a beneficiary’s residence, by itself, does not establish the minimum connection necessary for the state to impose a tax. Both the North Carolina Court of Appeals and the North Carolina Supreme Court affirmed. The Supreme Court of the United States granted certiorari.

 

SCOTUS Holding

The 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.” In its rationale, the court looked to its previous rulings, which found that the due process clause of the U.S. Constitution requires a taxpayer to have a minimum connection to the state seeking to impose a tax and that such contacts limit a state tax from being imposed on those who derive no “benefits and protections” from associating with a state. 
 
In Kaestner 1992 Family Trust, the trustee held absolute discretion on the amount and timing of distributions to the beneficiaries and, in the years in question, made no distributions to the beneficiaries. Further, the beneficiaries had no right to demand trust income, to make investment decisions, or to assign their interests in the trust to another person.
 
Subsequent to the years under review by the North Carolina Department of Revenue, the trustee rolled Kimberley Kaestner’s interest in the Kaestner Trust to a new trust. This was done under the laws of New York and in accordance with Ms. Kaestner’s wishes. Had the trust assets not been rolled over, the Kaestner Trust would have terminated when Ms. Kaestner turned 40 years old and required the distribution of the Kaestner Trust’s assets to Ms. Kaestner. The court held that this action was not demonstrative of Ms. Kaestner being able to demand distributions in the tax years under review or count on receiving any income in future years.
 
The court distinguished the North Carolina tax under review from other state trust tax cases previously decided in favor of the state’s tax by the court under the due process clause, which include: (1) a tax on trust income distributed to a state resident, (2) a tax based on the trustee’s residence, and (3) a tax imposed based on the site of the trust administration.
 
The court concluded that when a state income tax on a trust is premised on the residency of a beneficiary, settlor, or trustee, the due process clause requires a relationship between that resident and the trust assets the state seeks to tax.  When a state asserts tax jurisdiction over a trust based on the residence of a beneficiary, the due process clause requires the resident to have some degree of possession, control, or enjoyment of the trust property or a right to receive that property.
 

BDO Insight 

• While Kaestner 1992 Family Trust presents an obvious win for taxpayers, its application beyond the state of North Carolina could be limited. The court stressed that its opinion was limited to the situation where a state seeks to tax a trust based solely on the residency of a beneficiary when the beneficiary received no trust income, had no right to demand income, and is uncertain to ever receive income.
• Trusts that have previously paid North Carolina income tax due to a beneficiary’s residence, should consider whether a claim for refund is warranted.  In addition, trusts that filed returns in states applying residency of the beneficiary as the criteria for the trust’s residency, should consider the facts and circumstances surrounding that filing.  Claims for refund may also be warranted in those cases.

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