United States: State Tax On Trust Income Based Solely On In-State Residence Of Beneficiaries Found Unconstitutional

On June 21, 2019, the United States Supreme Court decided North Carolina Dept. of Revenue v. Kimberly Rice Kaestner 1992 Family Trust (hereinafter, "Kaestner").1 In a unanimous opinion delivered by Justice Sotomayor, the Court held that under the Fourteenth Amendment's Due Process Clause,2 a state may not tax trust income based solely on the in-state residency of the trust's beneficiaries where the beneficiaries have not received a distribution from the trust and have an interest in the income and assets of the trust that is entirely contingent on the exercise of the trustee's discretion. Because of the expansive nature of North Carolina's tax provisions at issue, and the greatly limited set of rights that the beneficiaries had to the trust assets pursuant to the terms of the trust agreements analyzed by the Court, the scope of Kaestner seems narrow and should have a limited impact on the state taxation of trusts.

The Kimberly Rice Kaestner 1992 Family Trust

The Kimberly Rice Kaestner 1992 Family Trust (referred to herein as the "Kaestner Trust" or the "Trust") was formed in New York nearly thirty years ago for the benefit of the grantor's children, none of whom lived in North Carolina at that time. The grantor was a New York resident, the Trust was governed by New York law and the trustee kept the Trust documents and records in New York. All of the Trust asset custodians were in Massachusetts. The Trust agreement gave the trustee, who was a Connecticut resident during the relevant tax years, "absolute discretion" over when, in what amounts and to which beneficiaries distributions, if any, would be made.

After Kimberly Rice Kaestner and her minor children (all of whom were beneficiaries of the Trust) moved to North Carolina, the State imposed tax in excess of $1.3 million on the Trust's income that had accumulated while they were North Carolina residents.3

The Due Process Clause

The Due Process Clause prohibits states from imposing taxes that do not "bea[r] fiscal relation to protection, opportunities and benefits given by the state."4 A two-step analysis from Quill Corp. v. North Dakota is used to determine whether a state tax is permissible under the Constitution:

  1. There must be a "minimum connection" or "definite link" between the 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."5

Prior to Kaestner, the Court has upheld a state tax based on a trustee's in-state residence, and has indicated that a state tax based on the site of the administration of a trust is permissible.6

Where a state tax is based on a connection to a beneficiary, the Court has focused on the extent of the in-state beneficiary's right to control, possess, enjoy or receive trust assets. The Court has upheld state taxes based on in-state residency of a beneficiary where the beneficiary had close ties to the taxed trust assets and where the tax was imposed on income that has been distributed to the beneficiary.7 However, the Court found a state tax based on the in-state residency of a beneficiary to be unconstitutional when the tax was imposed on the entirety of a trust's property and was not limited to the in-state beneficiary's share of the trust's property.8

Pre-Kaestner case law left a gap between a permissible state tax on trust income actually distributed to an in-state beneficiary and an impermissible state tax on all of a trust's assets, even those to which the in-state beneficiary was not entitled. The North Carolina law in Kaestner attempted to tax only the in-state beneficiaries' share of trust income, but without regard to the beneficiaries' control or possession of, or rights to, such income.9

The Lower Court Decisions

The trial court found the tax to be unconstitutional under the Due Process Clause because the beneficiaries' residence in North Carolina alone did not sufficiently connect the State and the Kaestner Trust. The North Carolina Supreme Court ultimately affirmed, reasoning that because the beneficiaries and the Trust have separate taxable existences, the beneficiaries' residence fails to establish a connection between the Trust and the State.

The Supreme Court: Taxation Based Solely on In-State Residency of a Beneficiary Does Not Satisfy Due Process

The Supreme Court found North Carolina's tax to be unconstitutional under the Due Process Clause because the tax failed to satisfy the first prong of Quill's two-step analysis. Whether a minimum connection exists under Quill requires an inquiry into whether the taxpayer has "certain minimum contacts" such that the tax does not offend traditional notions of fair play and substantial justice.10

The Court reasoned that when a state bases a tax on a trust beneficiary's in-state residence, the Due Process Clause requires "a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State's tax."11 Where the resident beneficiary does not have "some degree" of control, possession or enjoyment of the trust property, there is no minimum connection under Quill.

The Court went through a litany of rights and benefits that the beneficiaries did not have and did not receive in the tax years in question:

  • there was no actual distribution of income;
  • there was no right to demand Trust income, or otherwise control or possess the Trust assets;
  • the distribution of Trust assets was left to the trustee's "absolute discretion" (and, in fact, the Trust agreement specifically allowed the trustee to distribute income and assets to one beneficiary to "the exclusion of other[s]");12
  • there was no control over investment decisions regarding Trust assets;
  • there was no power to assign any right a beneficiary had in the Trust assets; and
  • there was no right to ever receive the Trust assets—the trustee had the power to roll Trust assets into a new trust rather than terminating it on the scheduled date (which was, in the original Trust agreement, set for 2009).

Because the beneficiaries possessed such greatly limited rights to the Trust assets, the Court determined there was no minimum connection between the Kaestner Trust and North Carolina, and thus North Carolina could not impose a tax on the Kaestner Trust.

Consequences

The Court in Kaestner in many ways bent over backwards to minimize the reach of its holding. Every particular limitation created by the Trust documents was emphasized by the Court, and the Court did not specify if any of the identified limits on the beneficiaries' rights could be altered while retaining the same result under the Due Process Clause. Indeed, the Court in multiple parts of the opinion emphasized that it was not deciding what would happen if the facts were even slightly more expansive, such as (1) if the "relationship to trust assets differ[ed] from that of the beneficiaries" in Kaestner,13 (2) if "the degree of possession, control, or enjoyment" of the trust assets were greater in any way than that possessed by the beneficiaries in Kaestner,14 (3) if the beneficiaries had the "ability to assign a potential interest in income from a trust"15 and (4) if "the beneficiaries were certain to receive funds in the future."16 The Court also emphasized how North Carolina's taxing regime was more expansive than most other state regimes, specifically contrasting it to the tax provisions of (among others) Alabama, Connecticut, Georgia and California.

It is possible that the narrowness of the Court's holding is what inspired Justice Alito (joined by Chief Justice Roberts and Justice Gorsuch) to write a concurring opinion. The concurring opinion suggests that these Justices find the questions presented by the facts of Kaestner to be an even more straightforward application of prior precedent than the rest of the Court. The concurring opinion, in fact, could be read to endorse the conclusion that a state could never tax a trust's accumulated income based solely on the in-state residence of a beneficiary even if the beneficiary were non-contingent. If the Court were to end up adopting such a view, then certain jurisdictions (such as California) could no longer tax the accumulated income of out-of-state trusts based solely on the presence of non-contingent beneficiaries according to its current practice.

The only sure conclusion that can be drawn from Kaestner is that nothing much has changed in the taxation of trusts. It is unlikely that courts will expand Kaestner beyond its particular facts, that states will alter their approach to trust taxation or that advice to taxpayers will be different following Kaestner. That said, taxpayers should continue to be aware of the facts-and-circumstances approach that seems to be taken to determine whether a trust's assets may be subject to certain state taxes, and as always, that the establishment and maintenance of a trust requires careful planning and good advice. Please contact any of the authors listed above, or your usual Proskauer attorney, to discuss this further.

The authors would like to thank Michael LaMonte, law clerk at Proskauer Rose LLP, for his invaluable assistance with writing this blog post.

Footnotes

1 North Carolina Dept. of Revenue v. Kimberly Rice Kaestner 1992 Family Trust, No. 18–457, slip op. (U.S. June 21, 2019).

2 The Due Process Clause of the Fourteenth Amendment states: "No state shall . . . deprive any person of life, liberty, or property, without due process of law . . . ." U.S. Const. amend. XIV, § 1.

3 Note that the original trust was divided into three subtrusts by the trustee. One of the subtrusts was formed for the benefit of Kaestner (one of the original beneficiaries) and her three children, and was governed by the same agreement that governed the original trust. For purposes of this blog post, all references to the "Kaestner Trust" or the "Trust" refer to both the original trust and the subtrust at issue.

4 Wisconsin v. J.C. Penny Co., 311 U.S. 435, 444 (1940).

5 504 U.S. 298, 306 (1992).

6 See Greenough v. Tax Assessors of Newport, 331 U.S. 486, 494 (1947) (tax based on trustee's residence); Hanson v. Denckla, 357 I.S. 235, 251 (1958) (tax based on site of trust administration); Curry v. McCanless, 307 U.S. 357, 370 (1939) (tax based on site of trust administration).

7 See Guaranty Trust Co. v. Virginia, 305 U.S. 19 (1938); Maguire v. Trefry, 253 U.S. 12 (1920).

8 See Safe Deposit & Trust Co. of Baltimore v. Virginia (Safe Deposit), 280 U.S. 83 (1929); Brooke v. Norfolk, 277 U.S. 27 (1928).

9 See N.C. Gen. Stat. Ann. § 105-160.2 (providing for a tax on any trust income that "is for the benefit of" a North Carolina resident).

10 International Shoe Co. v. Washington, 326 U.S. 310, 316 (1945).

11 Kaestner, at 9 (citing Safe Deposit, 280 U.S. at 91).

12 Id. at 11.

13 Id. at 7.

14 Id. at 10 n.8.

15 Id. at 11 n.9.

16 Id. at 12 n.10.

State Tax On Trust Income Based Solely On In-State Residence Of Beneficiaries Found Unconstitutional

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