U.S. Supreme Court Decides Kaestner Case in Favor of Taxpayer in Narrow Holding

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North Carolina Department of Revenue v. Kimberley Rice Kaestner  1992 Family Trust, 588 U.S.  (June 21, 2019)

U.S. Supreme Court Decides Kaestner Case in Favor of Taxpayer in Narrow Holding

Authors: Joshua Caswell and Leigh Furtado of Howland Evangelista Kohlenberg LLP

A. Executive Summary.

In a unanimous opinion, the Supreme Court held that North Carolina’s efforts to tax the income of a trust based solely on the trust beneficiary’s residence in the state violated the Constitution’s due process clause.  After analyzing the beneficiary’s right to control, possesses, enjoy or receive trust assets, the Court concluded that North Carolina had not proven the necessary minimum connections between the state and the trust.  However, the ruling was a narrow one in light of the fact that the beneficiary had not received any distributions during the relevant time period and did not have the power to demand distributions.  Many questions remain as to whether a state could successfully base a tax on beneficiary residency where the beneficiary’s relationship to the trust assets differed from the facts of this case.

B. Case Summary.

In an opinion issued on June 21, 2019 and authored by Justice Sotomayor, the Supreme Court held that North Carolina’s efforts to tax the income of a trust based on the trust beneficiary’s residence in the state violated the Constitution’s due process clause.

In 1992, Joseph Lee Rice III (“Rice”) formed a trust for the benefit of his children (the “Trust”) in his home state of New York.  Rice named a fellow New York resident as the initial trustee.  In 1997, Rice’s daughter, Kimberley Rice Kaestner (“Kimberley”), moved to North Carolina.  In 2002, the Trust was divided into sub-trusts for Rice’s children.  The instant case relates to the sub-trust for Kimberley and her three children (“Kimberley’s Trust”), which was controlled by the same agreement that controlled the Trust.  Critically, this meant that Kimberley’s Trust was a so-called fully discretionary trust (the trustee had exclusive control over the allocation and timing of trust distributions).

This case arose when North Carolina attempted to tax the income earned by Kimberley’s Trust from 2005 to 2008.  Under N.C.G.S. § 105-160.2, the income tax of an estate or trust “is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of [the] State.”  Applying this statute, the North Carolina Department of Revenue assessed a tax of more than $1.3 million.

During the relevant period, the beneficiaries of Kimberley’s Trust were all residents of North Carolina.  However, the trust’s grantor was a resident of New York, the trust was governed by New York law, the trust’s documents and records were kept in New York and the custodians of the trust’s assets were all located in Boston, Massachusetts.  At no point during the relevant period was the trustee a North Carolina resident.  Moreover, the trust earned no income in North Carolina, made no distributions to Kimberley or her children and the trustee had only “infrequent” contact with Kimberley.  Finally, Kimberley’s Trust maintained no physical presence in North Carolina, made no direct investment the state and held no real property therein.

Kimberley’s Trust alleged that North Carolina’s imposition of its tax violated the due process clause because the trust lacked the necessary minimum contacts with the state.  North Carolina argued that the presence of in-state beneficiaries was sufficient to satisfy the minimum-contacts requirement under the court’s modern jurisprudence.

The Supreme Court rejected the state’s arguments, beginning its analysis by observing that tax due process cases are analyzed under a two-step framework that requires (1) “some minimum connection” between the taxpayer and the state, and (2) a rational relationship between the income the state seeks to tax and the state.  The opinion focuses on the first part of this test, which is determined under the same minimum-contacts framework used to analyze questions of personal jurisdiction under International Shoe Co. v. Washington, 326 U. S. 310 (1945), and subsequent, related cases.

In cases like this one, the hard question is not whether the beneficiary’s contacts are sufficient, but whether they matter for purposes of the minimum-contacts analysis.  The opinion holds that whether a beneficiary’s in-state contacts are relevant at the trust level depends on “the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets.”

Applying this test to Kimberley’s Trust, the court concluded that the in-state beneficiaries lacked the requisite control or possession for their contacts with North Carolina alone to establish jurisdiction.  They neither received money from the trust during the relevant period nor had any right to demand trust distributions.  Furthermore, because the Trust gave the trustee sole discretion over distributions, there was no guarantee that a particular beneficiary would ever receive a distribution.  As such, North Carolina’s statute violated the Constitution’s due process clause of the Constitution.

C. Remaining Questions and Considerations.

Not unexpectedly, the Court’s holding was quite narrow and limited by the facts of the case at hand where Kimberley had not received any distributions during the relevant time period.  The justices took great care to emphasize that the Court was not ruling on the appropriateness of state taxation of trust income under many other factual scenarios where the relationship of the beneficiary to the trust assets differed from the case at hand.  In the concurrence, Justice Alito stated that the connection of North Carolina to the trust income was “unusually tenuous” in this matter and that therefore the Court’s opinion is circumscribed.

As a result, the Court provided little guidance on the following scenarios:

  1. In the opinion and at oral argument, the Justices emphasized that Kimberley and her children could not count on receiving any specific amount of income from the Trust in the future. Would the outcome be different if a trust distributes to a beneficiary at a particular age?  It should be noted that the terms of the Kaestner Trust directed that Kimberley’s share be distributed to Kimberley when she reached aged forty, but the Trustee rolled over the trust estate to a new trust as permitted under New York law.
  2. North Carolina argued that a ruling in Kimberley’s favor would result in forum shopping and invalidate state taxation statutes around the country. The Court found this argument unconvincing and noted that only a small handful of states consider beneficiary residency as the sole basis for trust taxation, and even fewer rely on the residency of the beneficiary where it is uncertain if the beneficiary will receive distributions.
  3. The Court noted that “critically” the Kaestner trustee had exclusive control over the allocation and timing of distributions. Would the result have been different if the trust contained an ascertainable standard but did not require distributions?
  4. The Due Process clause requires that when a tax is based on the residency of a beneficiary, he or she must have some degree of possession, control or enjoyment of the trust property. But, the Court also refused to address what degree of possession, control or enjoyment sufficiently supports taxation.
  5. Similarly, the Court did not consider whether a beneficiary’s ability to assign an income interest would constitute sufficient possession, control or enjoyment to support taxation.
  6. Since the lack of distributions and/or the ability to demand distributions resolved the question in the Kaestner case, the Court did not consider the Trust’s broader argument that the trustee’s contacts alone determine a state’s power over a trust. This line of argument resulted from disputed interpretations of Hanson v. Denckla, 357 U.S. 235 (1958).  The Court did not explicitly rule out a circumstance where beneficiary residence provides sufficient minimum contacts for taxation.  The question remains as to what relationship between the beneficiary and the trust assets would be sufficient to satisfy the Due Process Clause.
  7. This decision does not address state laws that consider beneficiary residency as one of a number of factors. The question remains as to the appropriate weight to assign to this factor going forward when balancing the considerations outlined in those statutes.
  8. The Trust did not raise a challenge to the practice known as throw-back taxation where a state taxes accumulated income at the time it is distributed. By bringing this issue up on its own accord is the Court indicating a potential opening for future arguments?
  9. In drafting trusts, settlors will need to weigh the potential tax benefits of a completely discretionary trust where the beneficiary cannot demand distributions against the cost to the beneficiaries of less control over the trust assets.

D. Conclusion.

As the Supreme Court stated, North Carolina’s argument failed to grapple with the wide variation in the interests of beneficiaries to trust assets and the impact of different discretionary standards on beneficiary possession, control and enjoyment.  The sufficiency of minimum contacts in the trust taxation context will inevitably result in a fact-specific inquiry.  Although it is now clear that a state cannot base a tax on undistributed income to a beneficiary who has not received distributions and cannot demand such distributions, there are still many unanswered questions for practitioners involved in both the drafting and the administration of trusts.  As the State of North Carolina asserted in its brief, trust income nationally exceeded $120 billion in 2014, and states, beneficiaries and trustees are all motivated to protect their perceived slice of the pie.