Take-Away: Last week the U.S. Supreme Court issued its long awaited decision in North Carolina Department of Revenue v. The Kimberly Rice Kaestner 1991 Family Trust, 588 U.S. ___ (Issued June 21, 2019). The Court unanimously affirmed the decision of the North Carolina Supreme Court, which held unconstitutional North Carolina’s income tax statute that had imposed an income tax on the Kaestner Trust’s accumulated income solely on the basis that North Carolina was the residence of one trust beneficiary.

Background: The facts behind this decision were pretty simple. The trust was formed in 1992 in New York by its New York settlor. The trustee was from New York. The assets were held in New York or Connecticut. The trust was established for the settlor’s daughter and her descendants (her three children.) In 1997, that daughter moved to North Carolina. At all times the trustee and the trust assets were not located in North Carolina. However, North Carolina sought to tax the irrevocable trust relying upon its statute that provided that the State could tax any trust income that is for the benefit of a state resident. The tax was assessed from 2005 through 2008, taxing $1.3 million. At no time during those years did Ms. Kaestner have any right to, nor did she receive any distributions from the trust. The trustee paid the tax and sought a refund; it claimed that the imposition of the tax based solely upon Ms. Kaestner’s residency in North Carolina violated the Fourteenth Amendment’s Due Process Clause.

Court’s Decision: The presence of an in-state beneficiary 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 they are uncertain if they will ever receive that accumulated income.

  • With regard to the taxation of trust beneficiaries, a due process analysis State trust taxes focuses on the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets. As such, a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax is required.
  • In this case, Ms. Kaestner did not have the minimum connection with North Carolina that was necessary to sustain the State’s income tax. She neither had the right to receive income, nor could she demand a distribution of trust income or principal. Nor was she ever assured that at some later date she would receive any of the accumulated income held in the trust.

Due Process Analysis: When confronted with a claim of violation of Due Process, normally a two-step analysis is followed by courts: (i) the party to be taxed must have minimum contacts with the taxing State- it requires some definite link, some minimum connection between a state and the person, property or transaction that it seeks to tax and (ii) the income attributed to the State for tax purposes must be rationally related to the values connected with the taxing State. This Due Process ‘test’ should not be confused with the ‘test’ used to regard to violations of the Constitution’s Commerce Clause, which was recently altered by the Supreme Court in its South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018) decision, which dropped the ‘physical presence’ requirement for a State to impose a tax on commercial activity within the taxing State.

Conclusion: Only a handful of states have statutes that authorize the imposition of State income taxes on an irrevocable trust based solely on the residence of a trust beneficiary. As such, the impact of the Kaestner decision will be pretty narrow.

In addition, there was no reference in the Court’s decision to another State income tax of an irrevocable trust that has gained a lot of attention, Fielding v. Commissioner of Revenue, 916 N.W. 2d 323 (2018). Fielding held that the residence of the trust’s settlor, standing alone, was an insufficient basis, under due process principles, to permit a State to impose its income tax on an irrevocable trust.

Both Kaestner and Fielding suggest that when dealing with a due process controversy with respect to the income taxation of a trust, it is resolved with reference to the trust, i.e. the trustee, and that the residence of the beneficiary, settlor, or testator is not relevant to that analysis.

The Kaestner decision is important for dynasty-type trusts that are established to continue for generations, to avoid estate and GST taxation, and which can be located in jurisdictions that do not impose any income tax, e.g. South Dakota.