On June 21, 2019, the United States Supreme Court handed down its decision in North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust (no. 18-457)(https://www.supremecourt.gov/opinions/18pdf/18-457_2034.pdf). The issue in the case was whether the state of North Carolina could tax the income of the trust based solely on the North Carolina residence of the beneficiaries where the trust was created by a New York resident with a New York trustee (during the years in question, the trustee was in Connecticut and assets were in the hands of custodians in Massachusetts).
The Court found that mere residency is insufficient to justify taxation where, during the tax years in question, the beneficiaries had received no distributions, had no right to compel distributions and none were scheduled to be made in the tax years in question, notwithstanding the fact that the trust was scheduled to terminate in the year following the last of the tax years in question (see “Key Fact” discussion below). More particularly, the Trustee was given absolute discretion to make distributions, without any sort of ascertainable standard such as health, education and maintenance and support.
The decision was unanimous in favor of the taxpayer. Justice Sotomayor delivered the opinion for a unanimous Court. Justice Alito filed a concurring opinion in which Chief Justice Roberts and Justice Gorsuch joined.
Quick background: Joseph Rice III formed a trust for his children while he living in New York and appointed a New York resident trustee. In 1997, his daughter, Kimberly Rice Kaestner, moved to North Carolina with her children. The trustee was replaced with a Connecticut trustee and the custodians of the assets were in Massachusetts. The trustee later divided Rice’s initial trust into separate trusts, one of which was for Kimberly, and North Carolina sought to tax that trust’s income under a law authorizing the state to tax any trust income that is for the benefit of a state resident. During the years in question, 2005 through 2008, Kimberly had no right to, and did not receive, any distributions. The trust did not have a physical presence in North Carolina or make any direct investments in the state, or hold any real property in North Carolina. The trustee paid the tax under protest and then sued in state court, winning at the trial court, appellate court and state Supreme Court. The state of North Carolina applied for writ of certiorari to the United States Supreme Court, which was granted.
The decision was based upon the Due Process Clause of the Fourteenth Amendment. The Court cited numerous of its own prior case decisions. It started by saying that, “In the context of state taxation, 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 (1940).” It continued by saying the legitimacy of the taxing power requires drawing a line between taxation and mere unjustified confiscation, citing Miller Brothers Co. v. Maryland, 347 U.S. 340, 342 (1954). Quoting the Wisconsin case, it said the boundary turns on the “simple but controlling question whether the state has given anything for which it can ask return. 311 U.S., at 444.”
Based on that, the Court applied a two-step analysis to decide if the state tax abides by the Due Process Clause. The first thing the Court said was there must be some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax, citing the case of Quill Corp. v. North Dakota, 504 U.S. 298 (1992) overruled on other grounds, South Dakota v. Wayfair, Inc., 585 U.S. ____(2018). The second part of the test was that the income the state seeks to tax must be rationally related to values connected with the taxing State.
The court looked to the case of International Shoe Co. v. Washington, 326 U.S. 310 (1945), saying that a state has the power to impose a tax only when the taxed entity has certain minimum contacts with the state such that the tax does not offend traditional notions of fair play and substantial justice. Id. at 316. The Court went on to cite numerous cases where taxes had been upheld, such as where trust income distributed to an in-state resident was taxable, where tax on the trust income was upheld where the trustee resided in the state seeking to tax the income, and a case suggesting that a tax based on the site of trust administration was constitutional.
However, in this case, the trustee made no distributions to anyone in North Carolina. The trustee resided out of state, and trust administration was split between Connecticut and Massachusetts. No direct investments were made in North Carolina and the settlor did not reside there. “Of all the potential kinds of connections between the trust and the State, the State seeks to rest its tax on just one: the in-state residence of the beneficiaries.” Id., at 7. The Court held that to be insufficient.
It is important to note that the Court said, “In limiting our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.”
The state of North Carolina had argued that a trust and its constituents (settlor, trustee and beneficiary) are “inextricably intertwined” and because case law supports state taxation where the trustee resides in estate, so too must it support taxation when the beneficiary’s residence is in estate. The State cited the decision of Stone v. White, 301 U.S. 532 (1937) in which the Court refused to “shut its eyes to the fact” that a suit to recover taxes from a trust was in reality a suit regarding “the beneficiary’s money.” Id. at 535. Citing the case of Greenough v. Tax Assessors of Newport, 331 U.S. 486 (1947), the State argued “that its tax is at least as fair as the tax in Greenough because the Trust benefits from North Carolina law by way of the beneficiaries, who enjoy secure banks to facilitate asset transfers and also partake of services (such as subsidized public education) that obviate the need to make distributions (for example, to fund beneficiaries’ educations).”
The Court rejected those arguments. It acknowledged that the beneficiary is central to the trust relationship and beneficiaries are commonly understood to hold beneficial interests or equitable title, but the rights and remedies of beneficiaries vary widely from trust to trust. A beneficiary may have only a future interest subject to conditions, or the relationship between the beneficiaries in the trust assets may be “so close as to be beyond separation.” Id. at 14.
The State also argued that ruling in favor of the Trust would undermine numerous state taxation regimes, but the Court disagreed, finding that North Carolina is one of a small handful of states that rely on beneficiary residence as a basis for trust taxation, and “one of an even smaller number that will rely on the residency of beneficiaries regardless of whether the beneficiary is certain to receive trust assets.” Id. at 15.
Justice Alito’s concurring opinion was very short. He said that states have broad discretion to structure their tax system but the Federal Constitution imposes limits, one of which is the Due Process Clause. Because of the Due Process Clause, the Court had to look at the connections between the assets held in trust and North Carolina. He said it was easy to identify a state’s connection with tangible assets but intangible assets present a more difficult question. Justice Alito said that prior cases asked whether a resident of the state had control, possession, or the enjoyment of an asset. Because a trustee is the legal owner of the trust assets and possesses the powers that accompany that status, the trustee’s state of residence can tax the trust’s intangible assets. Turning to the beneficiary’s powers, he pointed out that this case presented the question of whether the connection between a beneficiary and a trust is sufficient to allow the beneficiary’s state of residence to tax the trust assets and the income they earn while the assets and income remain in the trust in another state.
Justice Alito’s primary thrust from that point onward was that the decision in this case was not new law. It was built on prior cases. He cited Brooke v. Norfolk, 277 U.S. 27 (1928) and Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83 (1929). He analyzed those two cases, both of which involved attempts by the Commonwealth of Virginia to tax trust income. He demonstrated that those prior case decisions answered the question in this case. He said, “Here, as in Brooke and Safe Deposit, the resident beneficiary has neither control nor possession of the intangible assets in the trust. She does not enjoy the use of the trust assets. The trustee administers the trust and holds the trust assets outside the State of North Carolina. Under Safe Deposit and Brooke, that is sufficient to establish that North Carolina cannot tax the trust or the trustee on the intangible assets held by the trust.”
Key Things to Remember. If you have a trust with a beneficiary in another state, that state may be able to levy a tax on the trust income if there is more to support the tax than mere residency of the beneficiary. For example, are distributions being made to the beneficiary? If so, those distributions may be taxable. Can the beneficiary compel distributions, as they may be able to do in a trust which allows distributions under an ascertainable standard. Again, that may allow taxation. Does the trust maintain any activity in the state, such as a place were the trust is administered or there are income producing assets?
Key Fact. The trust, by its own terms, was to terminate when Kimberly attained the age of 40, which would occur in 2009, the year after the span of years at issue in this case. The Court said, “After consulting with Kaestner and in accordance with her wishes, however, the trustee rolled over the assets into a new trust instead of distributing them to her. This transfer took place after the relevant tax years. See N.Y Est., Powers & Trusts Law Ann. §10-6.6(b) (West 2002)(authorizing this action).”
That statement seems to fly in the face of other assertions by the Court that Kimberly could not count on necessarily receiving any specific amount of income from the trust in the future. In fact, the statement above is correct. Under that statute, the trustee was empowered, as a trustee with pure discretion, such as in this case, to transfer the assets to a new trust without the advice or consent of the beneficiaries. The statute also empowers the trustee to create the new trust with a term that is longer than the trust from which the assets came. If that is correct, then the trustee’s consultation with Kimberly was most likely done in order to avoid a dispute with her about the decanting.
California Throwback Tax. There is an interesting footnote in the Court’s opinion which quickly and simply refers to “throwback” taxes, such as those imposed by the state of California, on income earned during the time a beneficiary is a California resident but distributed to the beneficiary after the beneficiary has moved out of California.