On June 21, 2019, the U.S. Supreme Court issued a unanimous decision in North Carolina Department of Revenue v. The Kimberly Rice Kaestner 1992 Family Trust, affirming the North Carolina Supreme Court in holding that the presence of in-state beneficiaries alone did not authorize a state to tax trust income that has not been distributed to the beneficiaries and where the beneficiaries had: 1) no right to the income, and 2) were uncertain to ever receive a distribution from the trust.
Recall that in 1992, Joseph Lee Rice, III, a New York resident, established a trust as the settlor (creator) under New York law for the benefit of his descendants. The trustee was also a New York resident at the time the trust was created, and a Connecticut resident during the tax periods at issue. The trust was subsequently divided into three separate share trusts, one of which was the Kimberley Rice Kaestner 1992 Family Trust (the Trust). The Trust’s beneficiary, Kimberley Rice Kaestner (daughter to the settlor), had no connection to North Carolina until she moved to the state in 1997.
Throughout the periods at issue, Ms. Kaestner received no distributions from the Trust and was not aware of its existence until after moving to the state. Additionally, no funds were distributed during the periods, and she had no right to withdraw assets because distributions were at the sole discretion of the trustee. All the Trust’s assets were located outside North Carolina, while the custodian of those assets resided in Boston, Massachusetts. All of the business of the Trust took place in New York, where the tax returns and accountings were prepared. The beneficiaries had no role in the management or investment decisions of the Trust. The only connection between the Trust and North Carolina was that Ms. Kaestner resided in the state for the periods in question
During tax years 2005 through 2008, North Carolina taxed all the worldwide income of the Trust on the basis that Ms. Kaestner, the sole beneficiary of the Trust, was a resident of the state. The Trust later challenged the North Carolina assessment, seeking a refund of prior-year taxes paid. The North Carolina Supreme Court found that a beneficiary living in the state did not create the necessary minimum contacts required under due process solely based on a beneficiary availing themselves of the benefits and protections of North Carolina law to subject the Trust to tax.
The petition for a writ of certiorari was granted by the U.S. Supreme Court on Jan. 11, 2019, and oral arguments were heard in mid-April.
For more information on the factual background of the case and the oral arguments in front of the U.S. Supreme Court, please read our alert, U.S. Supreme Court hears arguments in Kaestner trust tax nexus case.
Justice Sotomayor, writing for the Court, focused the issue on whether the Due Process Clause of the U.S. Constitution prohibited a state from taxing trusts based solely on the in-state residency of a trust beneficiary. Explaining that the Court uses a two-prong analysis in examining a tax law under the Due Process Clause, the Justice cited to the Due Process analysis in 1992’s Quill v. North Dakota decision that requires: 1) “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax,” and 2) “the income attributed to the state for tax purposes must be rationally related to values connected with the taxing state.”
After reviewing various trust taxation case law, the Court further explained that the Due Process Clause demanded attention to the relationship between the trust party and the trust assets that a state seeks to tax. In the case of an in-state beneficiary, the Court noted that the Constitution required the beneficiary to have “some degree of possession, control, or enjoyment of the trust property, or a right to receive that property” before a tax could be sustained.
In applying this analysis, the Court noted that the Trust made no distributions to the beneficiary located in North Carolina in the years at issue. The other parties to the Trust, including the trustee and settlor, resided outside of North Carolina. The Trust administration was conducted in New York and Massachusetts and the trustee had no direct investments in North Carolina. The only connection the Trust had with the state was the presence of an in-state beneficiary.
Accordingly, the Court found that North Carolina’s law (N.C. Gen. Stat. section 105-160.2) imposing a tax on a trust with only an in-state beneficiary as the sole connection to the state was unsustainable under the first prong of the Due Process Clause’s minimum connection requirement. First, the beneficiaries did not receive any income from the Trust in the years at issue. Second, the beneficiaries had no right to demand trust income or otherwise control, possess or enjoy the trust assets – the distribution of trust assets was entirely in control of the trustee. Finally, the Court noted that there was no guarantee that trust assets would ever be distributed to any beneficiary of the Trust.
The Court did not need to continue the due process analysis under the second prong because the minimum connection was not found.
Importantly, the Court specifically noted that the opinion was limited to the specific facts presented, and that the decision was not intended to “imply approval or disapproval” of trust taxes based on the residence of beneficiaries that may have different access or control of trust assets not present in the Kaestner fact pattern.
The Kaestner decision marks the one-year anniversary of another state tax nexus decision, South Dakota v. Wayfair, a landmark case that addressed state tax nexus under the Commerce Clause of the U.S. Constitution. Though Wayfair overruled the physical presence standard mandated by Quill v. North Dakota, it did not address whether non-resident taxpayers had sufficient contact with the state to satisfy the minimum contact requirements under the Due Process Clause of the U.S. Constitution.
Considering the far-reaching implications of the Court’s decision, Kaestner is one of the most important trust taxation cases considered by the Court in decades.
Another due process-related trust taxation challenge from Minnesota, Fielding v. Commissioner of Revenue, rejected a rule that taxed the trust based on the location of the grantor. Fielding is currently on petition to the Court and action on that petition is now anticipated with the Kaestner decision delivered.
Resident / nonresident trust taxation jurisdiction provisions are not limited to the definitions used by North Carolina and Minnesota, as a number of states impose taxes on a trust based upon one or more of these factors:
- The residency of the grantor of the trust at the time the trust became irrevocable (like the Minnesota law)
- The residency of the beneficiary or beneficiaries of the trust (like the North Carolina law)
- The residency of the trustee(s) of the trust
- The location where the trust is being administered
In the wake of this decision, trustees, trust administrators and trust planners should consider broad-scope trust residency reconciliations to determine whether past residency decisions are still applicable going forward and whether refund claims are available. Reconciliations may include reviewing the historic and current residence of the all the parties to a trust, including the beneficiary, grantor and trustee. Due to the notoriety and importance of the issue, we anticipate providing further guidance in the coming days.