On April 16, 2019, the U.S. Supreme Court heard arguments in Kaestner v. North Carolina Department of Revenue. The case will address the extent of the state’s authority to tax the income of certain trusts. The trustees of the Kaestner Trust argued that the North Carolina statute subjecting trusts to income tax based solely on the residency of a beneficiary within North Carolina violates the Due Process Clause of the U.S. Constitution.
In recent years, states have become increasingly assertive in attempting to apply state income tax to trusts that have certain ties to that jurisdiction. In addition, practitioners, trustees and beneficiaries have sought ways to reduce or eliminate income tax liability, particularly any state income tax that is levied on trust assets. Many advisors recommend moving a trust to a state without a state income tax, through decanting or other means, to reduce or eliminate that tax. But the lack of case law regarding state income taxation of trusts leaves uncertain whether a state can continue to tax a trust that moves from state to state.
Following decisions in various individual states over the past decade — including Fielding v. Commissioner of Revenue (Minnesota), Linn v. Department of Revenue (Illinois) and Residuary Trust A (Kassner) v. Director, Division of Taxation (New Jersey) — practitioners have been awaiting definitive guidance on the application of the Due Process Clause to the state income taxation of trusts on a more general basis. Kaestner could be that case. The Kaestner case might at least address whether states like North Carolina can constitutionally impose state income tax on a trust’s income based solely on a beneficiary’s residence within the state, or whether the trust must have additional ties to the state before income tax can be imposed. Practitioners are hopeful that the court’s opinion will have implications beyond North Carolina and help settle important fiduciary income tax issues across the country.
McGuireWoods has been following the Kaestner case through the North Carolina courts, providing updates and analysis of the orders of the North Carolina Superior Court, Court of Appeals and North Carolina Supreme Court.
In June 2018, the North Carolina Supreme Court ruled that North Carolina General Statute Section 105-160.2, which subjects a trust to North Carolina income tax if a trust beneficiary resides in North Carolina, was unconstitutional as applied to the trust in question. On appeal to the U.S. Supreme Court, the state of North Carolina seeks to overturn the lower court ruling.
The state of North Carolina opened oral argument with the theory that the beneficiaries of a trust are the true owners of the trust property. This led to immediate questions from Justices Breyer and Sotomayor, who asked whether this analysis depends on whether the trust beneficiaries are certain to receive the trust property, and whether trust distributions are made solely at the trustee’s discretion. Further, the justices inquired as to whether it was certain that the beneficiary would receive a distribution from the trust while a resident of North Carolina.
North Carolina also argued that a beneficiary’s residence provides a key connection between the trust and the state, supporting the state’s taxation of the trust. A number of the justices also questioned the state’s position in this regard. The justices noted that North Carolina is one of only four states that use the residency of a beneficiary to establish the nexus required to impose tax on a trust. Only Georgia, Tennessee and California, in addition to North Carolina, tax trusts on the same basis.
While not an issue for the Supreme Court’s determination, the justices challenged counsel for both parties about alternative methods of taxing a trust’s undistributed income. The justices noted that a “throwback” tax, already deemed constitutional, could address the issue by taxing the income when distributed in the future to the beneficiary. Justice Kavanaugh noted that if a state imposes a throwback tax, beneficiaries likely would move to a state without an income tax prior to the trust distribution.
Counsel for the trustee argued that the beneficiaries lack control over the trust assets, and this undercuts any argument of nexus between the trust and the state for purposes of tax based solely on the beneficiaries’ residence. Justice Kagan posed questions focused on fundamental fairness, regarding the trustee’s fiduciary duties to beneficiaries, the extent of the trustee’s legal control and the trustee’s ability to use trust property for the benefit of the trustee. Kagan and counsel for the trustee looked at all the states that had an interest in taxing the trust, including the state where the trustee resides, the state where the trust is administered, and the state where the beneficiary resides. Trustee’s counsel suggested that the appropriate jurisdiction for taxing the trust’s income is the state where the trustee resides or where the trust is administered. Justice Kagan questioned this approach, stating: “…[N]othing’s perfect. But as between…those three choices, I would think North Carolina has by far the greatest interest in taxation.”
The justices did raise underlying due process considerations, asking counsel for both parties to address prior precedent, including, specifically, Quill Corporation v. North Dakota (application of the Due Process Clause to state taxation) and Hanson v. Denckla (whether a state can gain personal jurisdiction over a trustee). Both cases support the taxpayer’s position and the justices seemed to focus on the potential lack of North Carolina’s personal jurisdiction over the trust, in that the trust is represented by the trustee and the trustee is not a resident of North Carolina. While personal jurisdiction is not an issue in the Kaestner case — as the trustee submitted to jurisdiction by filing tax returns for the trust, paying the tax, seeking a refund and bringing suit against the state — the personal jurisdiction issue is applicable in enforcing the state’s taxing authority on a trust/trustee and could be an issue that is relevant in other circumstances.
Many practitioners hope that the opinion in the Kaestner case would also shed light on whether a state can constitutionally impose income tax on a trust in which the settlor was a resident of that state, but in which the trust has since moved to another jurisdiction and maintains no other ties to that state. But in oral argument, the justices and the parties did not seem to focus on whether the settlor’s state of residence would be an appropriate nexus; instead, the discussion centered on the beneficiary’s or trustee’s relationship to the trust. But if the opinion focuses on whether the beneficiary’s or the trustee’s residence provides the appropriate nexus, the opinion might also provide guidance on whether the settlor’s residence could provide a similar nexus.
The Supreme Court’s decision is expected in June and taxpayers, as well as other states, will be awaiting the ruling and its analysis of the Due Process Clause and personal jurisdiction as applied to state taxing statutes.
