North Carolina Loses in Trust Tax Case, Supreme Court Rules

The Supreme Court ruled in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust that a state does not have the authority to tax a trust’s undistributed income solely because the beneficiary resides in that state. This case potentially had far reaching implications if the unanimous decision was ruled in favor of North Carolina. States often seek new avenues of revenue through taxation but The Kimberley Rice Kaestner 1992 Family Trust did not meet Due Process “minimum contacts” with state clause for state authority to tax a trust.

New York Resident, Joseph Lee Rice, created a trust for the benefit of his children decades ago. New York law governed the trust and a New York resident was appointed as trustee. In 1997, Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina and the trust was later divided into three separate sub-trusts for the benefit of Kimberley and her children. This caused North Carolina to tax the trust under a law authorizing the State to tax any trust income that “is for the benefit of” a state resident. North Carolina courts interpreted the law found at N.C. Gen Stat. Ann. §105–160.2 to mean that a trust owes income tax to North Carolina anytime the trust’s beneficiaries resides in the state, even if the beneficiaries received no distributions during the taxed year and have no right to demand distributions from the trust. Administration of the The Kimberley Rice Kaestner 1992 Family Trust and the trustee and trust assets remained in New York and never within the State of North Carolina. No distributions were made to the beneficiaries.

After the trustee paid $1.3 million dollars to the North Carolina Department of Revenue for the tax assessed on the trust for years 2005 through 2008, the trustee appealed on the basis that the assessment by the Department violated the U.S. Constitution’s Due Process Clause. North Carolina state courts agreed, finding that residency of the beneficiaries alone was too tenuous a link to support the tax on the trust’s undistributed income. Following this decision, the Department petitioned the U.S. Supreme Court for a Writ of Certiorari, which was granted.

North Carolina imposed a tax based on only one contact which was the beneficiary’s residence. The trust documents and records were kept in New York. There was no physical presence of the trust in North Carolina and the trust made no direct investments in the State. The trustee maintained exclusive control over distributions from the sub-trusts and made no distributions to the beneficiaries who lived in North Carolina. The Supreme Court affirmed North Carolina lacked sufficient connections to the trust and did not have authority to tax the trust.

The Court noted that, under the Due Process Clause, “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,” and that “only those who derive benefits and protection from associating with a State should have obligations to the State.” Therefore, a state may tax a trust’s income if it is actually distributed to an in-state resident, or if the trustee is an in-state resident, or if the trust is administered within the state. But “when a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property.” Because Kimberley had none of those rights during the relevant tax years, her residence in North Carolina did not provide the minimum contacts needed for the State to tax the trust’s income.

Although the Supreme Court’s unanimously ruled against the right of North Carolina to tax this particular trust, this is unlikely to be end of the matter. States will continue to look for ways to tax trusts even before money is distributed to a beneficiary.  And there may be situations where a state will be able to establish enough contacts with it to meet constitutional requirements.  In the near term, some lawyers may seek refunds of state taxes on behalf of clients who paid taxes under laws that were similar to the North Carolina struck down here. Most importantly, lawyers and their clients will use the results of this decision to design out of state trusts that avoid state taxation of trusts.  The exact impact of Kaestner remains to be seen, but it is already clear that it will change how trusts are drafted and interpreted for years to come.

Ashley, Marketing Manager