Supreme Court Blocks North Carolina’s Taxation of Trust Income on the Basis of In-state Residency

On June 21, 2019, the U.S. Supreme Court (Court) issued their unanimous decision in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust (Kaestner) upholding a North Carolina Supreme Court ruling that declared a statute automatically subjecting a trust to income tax solely on the basis of the beneficiary’s in-state residency was invalid on the grounds that the statute violates the Due Process Clause of the Fourteenth Amendment under the U.S. Constitution. The Court noted their holding was limited to the specific facts presented in Kaestner and that they did not automatically imply approval or disapproval of state trust taxes premised on instate resident beneficiaries without understanding the beneficiaries’ relationship to the trust assets.

Background

A New York resident grantor had formed a trust under New York law for the benefit of his three children in which he had appointed another New York resident to act as trustee. The trust agreement granted the trustee “absolute discretion” to distribute the trust’s assets to the beneficiaries. In 1997, the grantor’s daughter, Kimberley Rice Kaestner (the Beneficiary), had moved to North Carolina. Thereafter, the trustee had divided the initial trust into three separate trusts. One of those trusts, Kimberley Rice Kaestner 1992 Family Trust (Kaestner Trust), was formed for the benefit of the Beneficiary and her three children. The Kaestner Trust documents were all maintained in New York while the trust asset custodians were located in Massachusetts. The trustee was later replaced by a Connecticut resident. The Kaestner Trust maintained no physical presence in North Carolina, made no direct investments in the state and held no property in the state.

During calendar years 2005 through 2008, the trustee chose not to distribute any of the trust’s income that it had accumulated to the Beneficiary or her children. For those years at issue, the trustee continued to maintain “absolute discretion” over trust assets and accumulated income with no control or future certainty of receipt by the Beneficiary or her children.

North Carolina Taxability of Kaestner Trust

The North Carolina Department of Revenue (Department) assessed tax on the Kaestner Trust for calendar years 2005 through 2008 in the amount of $1.3M on all accumulated taxable income solely on the basis of the Beneficiary’s North Carolina residency pursuant to N.C. Gen. Stat. § 105-160.2, which states:

“…tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State.”

The trustee paid the tax under protest and challenged the assessment in state court. The North Carolina Supreme Court had ruled that the Kaestner Trust did not maintain “sufficient contacts” with the state to “satisfy due process requirements of the Fourteenth Amendment to the United States Constitution and…the Constitution of North Carolina” to warrant an income tax obligation solely on the basis of the Beneficiary’s residency in the state. In light of the North Carolina Supreme Court’s decision in favor of the taxpayer, the Department appealed their decision to the U.S. Supreme Court by filing a petition for a writ of certiorari.

U.S. Supreme Court Decision & Analysis

The Due Process Clause states that “no state shall deprive any person of life, liberty or property without the process of law.” In order to test for state tax due process, there must be some “minimum connection” between the person or property to the state that wishes to tax as well as a rational relationship between the income the state wants to tax and the state in question.

In delivering the Court’s opinion, Justice Sonia Sotomayor provided that the Due Process Clause of the U.S. Constitution limits the states’ ability to impose only taxes that “bear fiscal relation to protection, opportunities, and benefit given by the state” [Wisconsin v. J. C. Penney Co., 311 U. S. 435, 444 (1940)]. In doing so, compliance with the Due Process Clause “requires some definite link, and some minimum connection, between a state and the person, property, or transaction that it seeks to tax,” and that “the income attributed to the State for tax purposes … be rationally related to “values connected with the taxing State” [Quill Corp. v. North Dakota, 504 U. S. 298, 306 (1992)].

In the context of the Due Process Clause being met in the case of state trust taxes premised on the in-state residency of beneficiaries, the Court cited two earlier decisions:

  • In Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U. S. 83 (1929), the Court provided the following guideline in establishing a “minimum connection” required under the Constitution to warrant the state’s attempt to tax the corpus of a trust located in another state.
    “When a tax is premised on the instate residence of a beneficiary, the Constitution requires that the resident 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.”
  • In Brooke v. Norfolk, 277 U. S. 27 (1928), a trust tax on an in-state resident beneficiary was invalidated in its entirety on the grounds that the trust property was not within the state, did not belong to the beneficiary and was not with their possession or control.
  • In contrast, the Court noted that the same elements of possession, control and enjoyment of trust property in the hands of the beneficiary led the Court to uphold state taxes on in-state residency of beneficiaries in their other prior rulings where the facts had shown the beneficiary having close ties to the taxed trust assets.

    Unlike trust beneficiaries, the Court also noted the focus on ownership and rights in the case of a trustee’s in-state residency can generally provide the basis for a state to tax trust assets given their established ownership and control of such assets.

    In applying these precedents to the facts in Kaestner, the Court determined that the required “minimum connection” was not established for the tax years in question under the Due Process Clause between the Beneficiary and the state of North Carolina on the following grounds:

    1. The Beneficiary did not receive any income from the Kaestner Trust during the years in question.
    2. They had no right to demand Kaestner Trust income or otherwise control, possess or enjoy the Trust assets in the tax years at issue.
    3. They could not rely on necessarily receiving any specific amount of income or other assets from the Kaestner Trust during the years in question.

    The Court did note that their decision in Kaestner was limited to the facts as presented in that case and that the determination of a Due Process Clause “minimum connection” for purposes of state taxation of in-state resident trust beneficiaries will depend on whether or not such beneficiaries have access, ownership or control of such trust property in the tax years at issue. An example of this in the Court’s decision cited California’s taxation of trusts on the basis of beneficiary residency but only in the case of non-contingent beneficiaries.