Kaestner: Trust’s Beneficiary Residency Alone Insufficient Grounds for State Taxation

Overview

The United States Supreme Court issued a unanimous opinion on June 21, 2019 in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust ruling that a trust beneficiary’s residence alone is not sufficient grounds for a state to tax a trust’s undistributed income.¹ This decision disallowed the assessment of  more than $1.3 million in taxes by the North Carolina Department of Revenue that the trustee of the Kaestner Trust previously paid.

Background

The trust in question stems from a trust that Joseph Lee Rice III formed for the benefit of his children nearly 30 years ago. Rice decided the trust would be governed by the law of the state of New York and appointed a New York resident as the trustee. The trust agreement stated that the trustee would have absolute discretion to distribute the trust’s assets in any amount and proportions as he decides. At the time of the trust creation, none of the trust’s beneficiaries of the lived within North Carolina.

In 1997, Kimberly Rice Kaestner moved to North Carolina where she remained from 2005 through 2008, the time period in which the North Carolina Department of Revenue assessed more than $1.3 million in taxes. After Kaestner moved to North Carolina, the trustee of Rice’s initial trust divided the trust into three sub-trusts. One of the three sub-trusts, the Kimberley Rice Kaestner 1992 Family Trust (Kaestner Trust), was formed for the benefit of Kaestner and her three children. The same original agreement, allowing for complete control of trust assets and distributions be with the trustee, governed the Kaestner Trust. Additionally, the fact that the Kaestner Trust was governed by New York law also allowed for the trustee to roll over the assets of the trust into a new trust instead of distributing them when the Kaestner Trust would have terminated when Kaestner turned 40. The trustee did in fact roll the assets over into another trust, but this did not occur during the relevant tax years.

From 2005 through 2008, the trustee of the Kaestner Trust chose not to distribute any of the income generated by the Kaestner Trust to Kaestner or any of her children. Kaestner had infrequent contact with the trustee and all trust business, assets, documents, and custodians were maintained outside of North Carolina. The trust maintained no physical presence within North Carolina and owned no direct investments or real property within the state. Regardless, the North Carolina Department of Revenue decided to tax the trust income under N.C. Gen. Stat. Ann. §105-160.2 which the North Carolina Supreme Court interprets to authorize North Carolina to tax a trust on the sole basis that the trust beneficiaries reside within the State as the trust income “is for the benefit of” a North Carolina resident.²

Applying the statute and North Carolina Supreme Court interpretation, the North Carolina Department of Revenue assessed a tax on the full proceeds of the Kaestner Trust for tax years 2005 through 2008, amounting to more than $1.3 million, and required the trustee to pay it. The trustee paid the tax under protest and sued in state court stating that the tax applied to the Kaestner Trust violates the Due Process Clause of the Fourteenth Amendment. The trial court, the North Carolina Court of Appeals, and the North Carolina Supreme Court all held that the State’s taxation of the Kaestner Trust violated the Due Process Clause. The State Supreme Court stated that the Kaestner Trust and its beneficiaries “have legally separate, taxable existences” and the contacts between the Kaestner family and North Carolina cannot establish a connection between the Kaestner Trust and North Carolina.³ The U.S. Supreme Court granted certiorari to decide whether the Due Process Clause prohibits states from taxing trusts based only on the in state residency of trust beneficiaries.⁴

The Due Process Clause of the Fourteenth Amendment

The Due Process Clause of the Fourteenth Amendment provides that “[n]o State shall … deprive any person of life, liberty, or property, without due process of law” and is in place to ensure the fundamental fairness of governmental activity.⁵ Regarding State taxation, the Clause limits a State’s ability to impose taxes to those that “bear fiscal relation to protection, opportunities, and benefits given by the state.”⁶ This limit is dictated by “the simple but controlling question … whether the state has given anything for which it can ask return.”⁷ A two-step analysis is used to determine if a state tax abides by the Due Process Clause: (1) there must be some definite link, some minimum connection, between the state and the person, property, or transaction it seeks to tax;⁸ and (2) the income taxed must be rationally related to “values connected with the State.”⁹ The first factor is the one of most relevance in this case.

The International Shoe Co. v. Washington, 326 U.S. 310 (1945) analysis is used to determine if the requisite minimum connection with the object of its tax exists, requiring that a State has certain minimum contacts such that the tax does not offend traditional notions of fair play and substantial justice. The same case says that only those who derive benefits and protection from associating with a State should be obligated to the State in question. These minimum contacts are flexible and are typically based off the reasonableness of government action.¹⁰

A plethora of past cases has established contacts with trusts or constituents that a State might treat, alone or in conjunction, as providing a “minimum connection” that justifies a tax on trust assets. Taxes on income distributed to an in-state resident,¹¹ a tax based on a trustee’s in-state residence,¹² and a tax based on the site of trust administration¹³ each pass muster under the Due Process Clause of the Fourteenth Amendment. The Kaestner Trust presents a new permutation of facts before the United States Supreme Court.

Holding: North Carolina Tax Based Solely on the Residence of the In-State Beneficiary Alone is Unconstitutional

The Kaestner Trust made no distributions to any North Carolina residents during the relevant tax years. The trustee and the administration of the Trust resided out of State. No direct investments within North Carolina were made by the Trust, and no real property within the State was owned. The only connection North Carolina possessed to rest its tax upon is the in-state residence of the beneficiaries. The United States Supreme Court held that the presence of in-state beneficiaries alone is not enough to empower a state to tax trust income where (1) the beneficiaries have no right to demand that income and (2) are uncertain to ever receive it. The complete discretion of the Kaestner Trust trustee in distributions and the ability to elect to roll the trust into a subsequent trust satisfied both of these requirements.

As such, the United States Supreme Court applied past precedents of Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83 (1929) and Brooke v. Norfolk, 277 U.S. 27 (1928) that invalidated state taxes premised on the in-state residence of beneficiaries. In Safe Deposit, the Court rejected Virginia’s attempt to tax a trustee on the entire corpus of the trust estate, explaining that nobody within Virginia had present right to control, possession, or to receive income from the trust. In Brooke, the Court rejected a tax on the entirety of a trust fund because the trust property was not within the State nor did it belong to the beneficiary and was not within her control.

In this case, the Supreme Court makes a ruling that in order to tax a trust based off the residency of the beneficiaries, some elements of possession, control, and enjoyment of trust property must be present. The Court will follow Safe Deposit and will make a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax when determining the constitutionality of a State’s tax based upon the in-state residence of a trust beneficiary.

Qualification by the Court

The U.S. Supreme Court addresses the argument proposed by the North Carolina Department of Revenue that ruling in favor of the Kaestner Trust will undermine state taxation regimes. The Court states that this ruling will have no such sweeping effect and believes that the ruling will not lead to opportunistic gaming of the state tax system. However, the Court leaves the door open to possible trust construction that would allow a beneficiary to wait until moving to a low tax state before receiving distributions in order to avoid the payment of tax. The Court states that settlors who create trusts in the future will have to weigh the potential tax benefits against the costs to trust beneficiaries control over trust assets within such arrangement that does not allow a beneficiary to receive trust income, has no right to that income, and is uncertain of receiving a specific share of that income.

The Concurrence: [Stick to the Facts at Hand]

Justice Alito filed a concurring opinion, in which Chief Justice Roberts and Justice Gorsuch joined, that made clear statements that the Court is only applying existing precedent to the current case. The opinion states that this decision is not to answer questions not presented by the facts of the case and does not open any points resolved by prior decisions for reconsideration. “The Court’s discussion of the peculiarities of this trust does not change the governing standard, nor does it alter the reasoning applied to our earlier cases.”

Closing

Regardless, practitioners and planners can take refuge that certain trust constructions that stick to the peculiarities of the Kaestner Trust can stay out the reaches of states that purport to impose a tax over in-state resident beneficiaries based on residency alone. 

This article is in large part based on the significant efforts of Michael Williams, law clerk at Edmondson Sage Dixon, PLLC. Michael graduated law school at the University of Mississippi in May and will begin his Tax LL.M. studies at NYU in August.

Joshua W. Sage, J.D., LL.M.

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1. North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 586 U.S. ­­­___ (2019) https://www.supremecourt.gov/opinions/18pdf/18-457_2034.pdf.
2. 371 N.C., at 143-144, 814 S. E. 2d, at 51.
3. 371 N. C., at 140-142, 814 S. E. 2d, at 49.
4. North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 586 U.S. ­­­___ (2019).
5. Amdt. 14, §1
6. Wisconsin v. J.C. Penney Co., 311 U.S. 435, 44 (1940).
7. Wisconsin, 311 U.S. 435 (1940).
8. Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
9. Id.
10. Id.
11. Maguire v. Trefry, 253 U.S. 12, 16-17 (1920).
12. Greenough v. Tax Assessors of Newport, 331 U.S. 486 (1947).
13. Hanson v. Denckla, 357 U.S. 235 (1958), Curry v. McCanless, 307 U.S. 357 (1939).