On June 21, 2019, the U.S. Supreme Court issued a unanimous opinion, delivered by Justice Sotomayor, in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, holding that the North Carolina statute subjecting the trust to state income taxation, based solely on the trust beneficiary’s residence in the state, violates the Due Process Clause.
Clearly, the decision is a taxpayer victory. But the question remains whether the Court’s decision sheds further guidance on the broader issue: In what circumstances does the state taxation of trust accumulated income satisfy the Due Process Clause?
As McGuireWoods has reported over the course of this case through the North Carolina courts — see April 29 and Jan. 22 legal alerts for the most recent updates — the opinions of the state courts have been based solely on the facts and circumstances of this trust, the contacts of the trustee to North Carolina and the rights of the beneficiary, who was a resident in North Carolina. The state court opinions have been narrowly framed, and the U.S. Supreme Court’s opinion is similarly constructed. Justice Sotomayor reinforced that the Court’s holding is limited “to the specific facts presented” and that the decision does not “imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.” Specifically, footnote 8 stated that the Court does not “decide what degree of possession, control, or enjoyment would be sufficient to support taxation.”
In evaluating the relationship between the trust assets and the party to the trust the state seeks to tax, the Court focused on possession, control, and enjoyment as critical in supporting state taxation under the Due Process Clause. In the context of the trust, the Court specifically noted the beneficiaries’ inability to compel distribution, which was solely in the trustee’s discretion. In addition, during the years at issue, the beneficiaries never received a distribution from the trust and had no right to “otherwise control, possess, or enjoy the trust assets.”
Many were hoping the opinion would be broader so as to provide guidance in the context of other state statutes subjecting trusts to income taxation. But a few highlights may have broader implications to the state taxation of trusts. In its opinion, the Court evaluated prior decisions on the issue, noting that the relationship between the relevant trust constituents (settlor, trustee, or beneficiary) and the trust assets is critical in the due process analysis. The Court wrote: “Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the state seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee.”
In its analysis, the Court reviewed its precedent of the sufficiency of possession and control of the trust property as to the settlor to justify taxation under the Due Process Clause. Twenty-seven states and the District of Columbia define a resident trust, for state income tax purposes, as a trust whose grantor was resident of the state. The state of Minnesota filed writ with the U.S. Supreme Court, seeking review of the Minnesota Supreme Court’s decision holding that its statute on income taxation, which is based on the settlor’s residence, is unconstitutional. In the Kaestner opinion, the Court analyzed precedent in the context of statutes based on the in-state residence of settlors, and again focused on the possession and control of the trust assets as related to the settlor. Citing to both Curry v. McCanless and Graves v. Elliott, which upheld the state income taxation of trusts based on the residence of the settlor, the Court pointed to the fact that settlors of the trusts at issue in these cases retained the right to dispose of the trust property (Curry) and the power to revoke the trust (Graves).
While the Kaestner opinion does not provide guidance on what circumstances would support state taxation of trusts based on the residence of a trust beneficiary, in reading between the lines, possession, control, and enjoyment are the critical factors. Where the trust beneficiary has no right to compel distributions, has no expectation regarding distributions, nor the power to appoint or control the trust property, taxation is not supported.