On April 16, 2019, the US Supreme Court heard oral arguments for North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, which asks whether the Due Process Clause prohibits states from taxing trusts based on a discretionary beneficiary’s in-state residency.1 The Justices’ questioning addressed the Due Process Clause analysis, which examines the “fundamental fairness” of an action, largely focusing on whether North Carolina should be allowed to tax the trust based on connections with its beneficiaries and, if so, how to determine the amount of undistributed income that it could constitutionally tax. The analysis keyed off discussions of whether the beneficiary was a “part” of the trust such that the benefits the beneficiary received from the state were in essence benefits received by the trust.
The case is on appeal from the North Carolina Supreme Court, which held that North Carolina could not tax the undistributed income of a New York trust based solely on the fact that a discretionary beneficiary of the trust was domiciled in North Carolina.2
In 1992, Joseph Lee Rice III created the Joseph Lee Rice III Family 1992 Trust (the “Family Trust”) for the benefit of his children. The Family Trust was governed by New York law, administered in New York, and the trustee at all times was a resident of and domiciled in Connecticut. No beneficiary of the Family Trust resided in North Carolina until 1997 when Kimberley Rice Kaestner, a primary beneficiary of the Family Trust, moved to North Carolina.
In 2002, the Family Trust was divided into three separate trusts – one for each of Mr. Rice’s three children. The plaintiff in the case is the separate trust established for the benefit of Kimberley Rice Kaestner and her children (the “Trust”), all of whom lived and were domiciled in North Carolina during the tax years at issue. The assets in the Trust were financial investments including equities, mutual funds, and investments in partnerships managed by a custodian who was located in Massachusetts. Distributions from the Trust were within the trustee’s sole discretion. Indeed, the Trust made no distributions to North Carolina resident beneficiaries during the tax years at issue. The Trust filed North Carolina income tax returns for the 2005 through 2008 tax years, and North Carolina imposed income taxes on the Trust’s undistributed income. The Trust filed for a refund. The Department denied the refund claims.
The North Carolina Supreme Court, the North Carolina Court of Appeals, and the trial court all held that the Trust did not have sufficient nexus with North Carolina for income tax purposes. The North Carolina Supreme Court, echoing the lower courts’ reasoning, held that the tax imposed on a trust violates the Due Process Clause if the trust’s only connection with the state is the presence in the state of a beneficiary.3 The North Carolina Supreme Court relied heavily on Quill Corp. v. North Dakota, stating that the Due Process Clause requires “some minimum connection” between the state and the Trust in order for the state to tax the Trust.4 The minimum connection exists when “the taxed entity ‘purposefully avails itself of the benefits of an economic market’ in the taxing state ‘even if it has no physical presence in the State.’”5
The North Carolina Supreme Court emphasized that a trust is a separate and distinct entity from its beneficiaries, and a trust’s connections with the state – as distinguished from the beneficiaries’ connections -- are the connections integral to determining whether the tax on the Trust violates due process.6 The state argued that the beneficiary’s interest in the Trust’s income is an “equitable interest” protected by North Carolina and therefore subject to taxation in the state. The court found this unpersuasive, reasoning that the beneficiary’s residency in the state cannot be viewed as the Trust conducting purposeful activities in the state because the Trust and its beneficiaries are separate legal entities.7 Because the Trust did not purposefully avail itself of the protections and benefits of North Carolina law, the court held that the imposition of the North Carolina tax on the Trust’s accumulated income violates the Due Process Clause as applied to the Trust.8
The Department’s briefs argued, among other things, that holding for the Trust would be inconsistent with the Court’s decision in South Dakota v. Wayfair, Inc.9 The Department argued that the Due Process Clause minimum-connection analysis centers on “fundamental fairness” and that it is “fundamentally fair” for North Carolina to tax the Trust’s undistributed income because the state gave the Trust certain benefits and protections for which a state may tax. The Department reasoned that the Trust “purposely availed itself of North Carolina” because the beneficiaries received certain “benefits and protections from the state,” which helped the Trust conserve its income.
The Trust’s brief argued that for income tax purposes the only states that the Trust had nexus with are the states where the Trust is administered and where the trustee resides. The Trust reasoned that the beneficiary’s contacts with a state were therefore insufficient to establish nexus under the Due Process Clause. In its reply brief, the Department asserted that the beneficiary, and not the Trust, is the actual owner of the trust’s undistributed income. As such, the Department argued that the beneficiary’s nexus with North Carolina should be used to determine whether the Trust has nexus with the State.
Several amicus briefs were filed in Kaestner from law professors, trade organizations, state bar associations, and several states, many supporting the Trust. Several briefs explained that a discretionary beneficiary cannot create nexus for a trust for income tax purposes because the beneficiary has no ownership or control over the trust’s property. In addition, the benefits a beneficiary receives from a state are not passed through from the beneficiary to the trust. In the case of a discretionary beneficiary, the trustee is under no obligation to distribute any proceeds from the trust. As such, any benefits received by a beneficiary do not reduce the trust’s distribution obligation. Further, the settlor, trust, trustee, and beneficiaries are all separate legal entities with distinct legal obligations. The Department’s position disregards well-settled law that a trust and a beneficiary are separate and distinct, the briefs argue.
Possibly the most interesting and ironic amicus brief filed in support of the Trust came from a group of states that included South Dakota, the plaintiff in Wayfair. The brief seeks to distinguish Kaestner from Wayfair by asserting that North Carolina did not contribute to the Trust’s creation of wealth. The filers argue that “Wayfair sustained South Dakota’s sales tax because South Dakota had created a market in which Wayfair could operate and profit; North Carolina’s laws and markets contribute nothing to the Kaestner Trust’s generation of income.”10
The briefs supporting North Carolina argued that substance over form was central to the Due Process Clause analysis and that holding for the Trust would disregard a trust’s significant in-state contacts through its beneficiaries. Likewise, prohibiting taxation infringes on a state’s sovereignty.
The Department argued that it is “fundamentally fair” for North Carolina to tax the Trust’s accumulated wealth because the beneficiary is the “true owner” of the Trust’s accumulated wealth and therefore the beneficiary should be taxed for the benefits it receives from the State. Some of the Justices appeared to struggle with the Department’s position in part because of the legal distinctions and separation between the Trust and the beneficiary. Justice Ginsberg asked the Department whether North Carolina “want[s] to use the beneficiary’s connection with North Carolina to impose a tax on the trust that doesn’t have a connection [to North Carolina]?” Justice Roberts also appeared to struggle with the Department’s position and asked on more than one occasion which states had the “primary claim on the taxation of this [accumulated] income?” The Department tried to focus the Court on the benefits the beneficiary received from North Carolina as a benefit received by the Trust.
Much of the questioning of the Department focused on whether the beneficiary was certain to get distributions, and some Justices were troubled that the Trust beneficiary did not receive any of the accumulated wealth during the years at issue and the amount the beneficiary would actually receive in future years was uncertain. Justice Breyer noted that the state had the power to tax an in-state beneficiary on actual distributions from a trust. Before the Trust’s income is distributed, there is no guarantee that the beneficiary will ever receive this income. Taxing in those circumstances, Justice Breyer stated, “Now there’s something wrong with that.” Justice Breyer questioned this point further, pointing out that even if the future distribution were assured it would still be difficult to determine what amount should be taxed because there is a timing issue—the beneficiary would not receive the income until a later year, therefore, the income in the present year should be discounted. The Department responded, arguing that it was “fundamentally fair” for the state to tax the in-state beneficiary’s current pro rata share because the beneficiary was part of the Trust and was therefore receiving benefits presently, even though the pro rata share could be more or less than what is eventually distributed to the beneficiary. The Department also tried to re-direct the Court to the question of whether the state has jurisdiction to tax at all and leave for another day the amount that the state could tax.
The Trust likewise focused its fundamental fairness argument on who owned the Trust property. The Trust argued that trust law makes clear that the trustee is the owner of the Trust. Further, the beneficiary does not have a vested interest in the Trust’s accumulated income because where the beneficiary is contingent and distributions are discretionary, there is no guarantee that the beneficiary will receive any of the Trust’s accumulated wealth. It would not be fundamentally fair to attribute the beneficiary’s presence to the Trust. Further, the Trust noted that the state received compensation for the benefits the beneficiary received through income tax imposed on the beneficiary. The Justices asked several questions regarding which states had the authority to tax the Trust’s accumulated income and why. The Trust explained that the authority to tax turned on legal protections afforded to the Trust or trustee. The Trust acknowledged that Connecticut could tax the Trust because the trustee resided in Connecticut and Connecticut provided protections to the trustee, the owner of the Trust. New York also has authority to tax the Trust’s accumulated wealth because the Trust was administered in New York and therefore New York afforded certain protections to the Trust.
Justice Kagan focused her questioning on whether the future distribution was really uncertain and indicated that because everything is done for the beneficiary’s benefit, the beneficiary’s state had “the greatest interest in taxation” as between the various states with connections to the Trust. Justice Kagan observed that North Carolina has a connection to the trust’s income because “[t]he person who is getting the benefit of this increase in the asset is only the beneficiary” and “the beneficiary, who's getting richer, is sitting in North Carolina.”
The Justices collectively asked questions about the practical and hypothetical application of state tax to trusts, but appeared to have different opinions regarding whether it is fundamentally fair for North Carolina to tax the Trust’s accumulated income, so there is a real possibility that this will be a split decision. We will continue to monitor this case.
1North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, _ _ _ U.S._ _ _ (2019) (No. 18-457).
2 Kimberley Rice Kaestner 1992 Family Trust v. N.C. Dep’t of Revenue, No. 307PA15-2 (N.C., June 8, 2018).
3 Id. and Kimberley Rice Kaestner 1992 Family Trust v. N.C. Dep’t of Revenue, No. COA15-896 (N.C. Ct. App., July 5, 2016).
4Id. at 10, quoting Quill Corp. v. North Dakota, 504 USUS 298, 307, 112 S. Ct. 1904, 1910 (1992). Although the physical presence rule of Quill was overturned by the US Supreme Court in South Dakota v. Wayfair, Inc., No. 17-494 (June 21, 2018), shortly after the North Carolina Supreme Court issued its decision in this case, we believe the decision is still sound. The court relied on Quill for the assertion that minimum contacts are required, not for its physical presence rule.
6Id. at 13.
8Id. at 18.
9 138 S. Ct. 2080, 2094 (2018).
10 Brief for South Dakota, Alaska, Nevada, and Texas as Amicus Curiae Supporting Respondent at 9, North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, _ _ _ U.S. _ _ _ (2019) (No. 18-457).