Supreme Court Determines Trust Is Not Subject To North Carolina Income Tax

June 25, 2019

By Richard Bloom and Melissa Gonzalez

In a much anticipated decision, the US Supreme Court ruled in N.C. Department of Revenue v The Kimberley Rice Kaestner 1992 Trust, US, No. 18-457, 6/21/19 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 to receive it.

Mr. Joseph Lee Rice III (the “grantor”), formed 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’s administration was split between New York and Massachusetts. The trust agreement granted the trustee “absolute discretion” to distribute the trust’s assets to the beneficiaries “in such amounts and proportions” as the trustee might “from time to time” determine. In 1997, the grantor’s daughter, Kimberly Rice Kaestner (“Kaestner”), moved to North Carolina. The trustee later divided the initial trust into three separate sub- trusts. One of the sub-trusts was the Kimberley Rice Kaestner 1992 Family Trust (“Kaestner Trust”) which was formed for the benefit of Kaestner and her three children.  The agreement that governed the original trust also governed the Kaestner Trust. North Carolina sought to tax the Kaestner Trust under N. C. Gen. Stat. Ann. §105–160.2 – a law authorizing the state to tax any trust income that “is for the benefit of” a state resident.

North Carolina assessed a tax of more than $1.3 million for tax years 2005 through 2008 during which Kaestner had not received any income from the Kaestner Trust, had no right to demand trust income or otherwise control, possess, or enjoy the Kaestner Trust’s assets and could not count on receiving any specific amount of income from the Kaestner Trust in the future. Nor did the Kaestner Trust have a physical presence, make any direct investments, or hold any real property in North Carolina. The trustee paid the tax under protest and then sued the taxing authority in state court, arguing that the tax as applied to the Kaestner Trust violates the Fourteenth Amendment’s Due Process Clause.

The North Carolina trial court held that Kaestner’s in-state residence was too tenuous a link between the state and the Kaestner Trust to support a tax, and that the state’s taxation of the Kaestner Trust violated the Due Process Clause. The North Carolina Court of Appeals and the North Carolina Supreme Court agreed.

When the matter came before the US Supreme Court, it applied a two-step analysis to decide if the tax abided by the Due Process Clause.

  1. There must be “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax,” (Quill Corp. v. North Dakota, 504 U. S. 306 (1992). That “minimum connection” inquiry is “flexible” and focuses on the reasonableness of the government’s action.
  2. “The income attributed to the State for tax purposes must be rationally related to ‘values connected with the taxing State.’’” Id.

The Supreme Court also highlighted that the Due Process Clause limits States to imposing only taxes that “bea[r] fiscal relation to protection, opportunities and benefits given by the state.” (Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444).

In the trust beneficiary context, the Court’s due process analysis focuses on the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets. It further stated that when a state seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses, and how that interest relates to the object of the state’s tax.

In a unanimous opinion, the US Supreme Court concluded that the residence of the Kaestner Trust beneficiaries in North Carolina alone does not supply the minimum connection necessary to sustain the state tax.

Because the North Carolina tax on the Kaestner Trust did not meet the first step of the Due Process Clause analysis, the Court did not address the second step.  In addition, the Court noted that the state’s counterarguments were “unconvincing.”

Mazars Insight

The decision of the US Supreme Court is strictly limited to the facts of this case.  The Court stated, in a footnote, that it does “not decide what degree of possession, control, or enjoyment would be sufficient to support taxation.”  The Court also did “not address whether a beneficiary’s ability to assign a potential interest in income from a trust would afford that beneficiary sufficient control or possession over, or enjoyment of, the property to justify taxation based solely on his or her in-state residence.” The Court also had no reason to address “whether a different result would follow if the beneficiaries were certain to receive funds (from the Kaestner Trust) in the future.”

In dismissing one of North Carolina’s arguments, the Court stated that “today’s decision does not address state laws that consider the in-state residency of a beneficiary as one of a combination of factors, that turn on the residency of a settlor, or that rely only on the residency of noncontingent beneficiaries.” This leads one to question whether other states’ taxing schemes will eventually be challenged.

Please contact your Mazars USA LLP professional for additional information.

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