Trust prevails in challenge to North Carolina income tax

Blog Post

The U.S. Supreme Court handed down a decision on June 21 that ruled a North Carolina tax levied on a trust violates the Fourteenth Amendment’s Due Process Clause.  The decision in Kaestner 1992 Family Trust v. North Carolina is a narrow one holding that states may not tax trust income when its only connection with the taxing state is a resident who is a discretionary beneficiary.  While the power to tax a trust requires case-by-case analysis, any one or more of the following could still establish a sufficient connection to create an income tax obligation following the Kaestner Trust case: the in-state residency of trustees, the in-state administration of the trust, or the in-state residency of the settlor of an inter vivos trust.

 

 

The facts of the Kaestner Trust case are relatively straightforward and we have outlined them in our prior articles following the case.  The Kaestner Trust’s only connection with North Carolina during the 2005 through 2008 tax years at issue was a resident beneficiary, Kimberly Rice Kaestner.  The settlor was located in New York, the trustee was a Connecticut resident, and the trust held financial instruments located in Massachusetts.

 

During the tax years at issue, the beneficiary had no right to, and did not receive, any distributions from the Trust.  The trust agreement granted the trustee the “absolute discretion” to distribute the trust’s assets to the beneficiaries.  

 

The North Carolina Department of Revenue imposed the $1.3 million tax for these tax years under the authority of a state law that levies the income tax on trust income earned “for the benefit of a resident of this State.”  The court case ensued after the Kaestner Trust paid the tax for tax years 2005 through 2008 and later filed a refund claim on the basis that the state statute is unconstitutional for violating Due Process. In other words, the trust argued that its resident beneficiary did not create a sufficient connection with North Carolina for the state to impose the income tax.  The North Carolina Supreme Court ruled in favor of the Trust and the State of North Carolina was granted certiorari to bring an appeal in the U.S. Supreme Court.  

 

 

The Supreme Court summarized its holding as follows: 

 

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.

 

In setting forth this pronouncement of law, the Supreme Court focused its attention on a benefits-burdens analysis.  That is, states may only impose taxes that “bear fiscal relation to protection, opportunities and benefits given by the state.”  There must be a sufficiently “minimum connection” between the person, property, or activity that is taxed and the income attributed to the taxing state for tax purposes. 

 

The inquiry into the minimum connection required to impose a trust income tax based upon the presence of an in-state beneficiary turns upon beneficiary’s right to control, possess, enjoy, or receive trust assets.   The legal analysis must inquire into these powers of the beneficiary (or lack thereof) and their relation to the tax that the state seeks to impose.  Though not presented under the facts of the Kaestner Trust case, courts should take a similar approach in situations where states seek to impose a trust income tax on the basis of an in-state trustee or settlor. 

 

The Supreme Court found that North Carolina could not impose its tax on the Kaestner Trust for the years at issue for three reasons.  First, the in-state beneficiary did not receive any income from the trust during the tax years at issue.  Second, the in-state beneficiary had no right to demand income from the trust or otherwise control, possess, or enjoy trust assets during the tax years at issue.  Finally, the beneficiary could not rely upon receiving any specific income from the trust in the future.   

 

With such reasoning in mind, the Supreme Court’s ruling is a narrow one.  If the Trust had additional contacts with North Carolina, say an in-state trustee or settlor, it may have created a sufficient connection to impose the tax.  Even a beneficiary with a future right to receive Trust funds under the trust agreement could have potentially created this minimum connection to tax.

 

 

On a related note, following the Kaestner Trust decision, the U.S. Supreme Court on June 28 denied the State of Minnesota’s petition to hear a similar trust income case that we have been following, namely Fielding v. Commissioner of Revenue.   We will continue to monitor legal developments in this area and report on them as they occur.