United States

U.S. Supreme Court to hear Kaestner trust tax nexus case

INSIGHT ARTICLE  | 

The U.S. Supreme Court will revisit state tax nexus for the second year in a row after granting North Carolina’s petition for certiorari in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust (Docket No. 18-457). Recall that last summer, the Court issued its opinion in South Dakota v. Wayfair, which eliminated the physical presence nexus requirement set forth in Quill v. North Dakota. In Wayfair, the Court found that a more than de minimis economic presence, based on volume or value of sales to in-state customers, was enough to satisfy the “substantial nexus” requirement of the four-part Commerce Clause test established under Complete Auto Transit, Inc. v. Brady.

While Wayfair provided some clarity on state tax nexus under the Commerce Clause of the U.S. Constitution, it did not address or eliminate the purposeful availment requirement of the Due Process Clause. In 1992, Quill found that due process concerns of fairness are satisfied when the out-of-state taxpayer “purposely avails itself” of the benefits of the forum state. On appeal to the U.S. Supreme Court, Kaestner asks whether due process prohibits states from taxing trusts based on the in-state residency of a nonresident trust beneficiary.

Background

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.

The challenge

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. Under North Carolina law, the tax imposed on a trust is computed on the amount of taxable income of the trust that is for the benefit of a resident of North Carolina (see N.C. Gen. Stat. section 105-160.2), regardless of whether any of that income is actually distributed to North Carolina beneficiaries. The Trust subsequently sought a $1.3 million refund from the North Carolina Department of Revenue. The department denied the refund request, and the Trust filed a complaint in the Wake County Superior Court, alleging that the tax was unconstitutional. The Trust prevailed in that court, and again on appeal to an appellate court, both of which found that the tax as applied to the Trust was unconstitutional under the Due Process Clause.

On appeal to the North Carolina Supreme Court, the state argued that the Trust had the requisite minimum contacts with North Carolina through the residency of the beneficiary, Ms. Kaestner, sufficient to satisfy the Due Process Clause of the U.S. and State Constitutions. The Court, in explaining due process as applied to taxation, noted that there must be some definite link, some minimum connection, between a state and the person, property or transaction (the Trust in this case) it seeks to tax. Accordingly, the 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.

It should be noted that section 105-160.2 was not ruled unconstitutional on its face, and that the decision was limited to its application to the facts of the case. Although the lowermost court also found the provision violated the Commerce Clause, neither the appellate court nor the state Supreme Court addressed those claims.

On Jan. 11, 2019, the U.S. Supreme Court granted the state’s petition for certiorari. Argument is scheduled for April 16, 2019.

Added complexity

The Minnesota Department of Revenue recently petitioned the U.S. Supreme Court to hear another due process-related trust taxation issue in Fielding v. Commissioner of Revenue. In Fielding, the Minnesota Supreme Court held that Minnesota’s grantor-domicile rule, as applied to trusts that had only “extremely tenuous” contacts with Minnesota, was unconstitutional under the Due Process Clause. That Court found that the relevant Minnesota connections were to the trustee, not to the Minnesota grantor who established the trust at an earlier time. The U.S. Supreme Court may decide to combine Fielding with Kaestner to address the due process issues simultaneously.

Takeaways

Kaestner and Fielding could have significant implications on the state taxation of trusts. Nonresident trust taxation jurisdiction provisions are not limited to 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 or trustees of the trust
  • The location where the trust is being administered

It is possible, particularly in light of the U.S. Supreme Court’s recent state tax decisions, that one or more of these provisions could be found to be unconstitutional and/or the Court could set out a unified jurisdictional standard. In the near term, trustees should review their trust residency decisions, and should prepare for the Kaestner decision, as well as the possibility of a U.S. Supreme Court decision in Fielding. A decision in Kaestner is expected by the end of June.

Finally, all multistate taxpayers should prepare for the potential wider-ranging impacts of a U.S. Supreme Court decision regarding how the Due Process Clause applies to state taxes. Particularly given the Court’s repudiation of the Quill Commerce Clause analysis and nonstate tax oriented Due Process Clause decisions over the last eight years, it is possible that there could be some broader clarification of the Quill due process minimum contacts approach.

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