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

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.

U.S. Supreme Court Grants Petition for Writ of Certiorari in Trust-Level State Income Tax Case

North Carolina Department of Revenue, Petitioner v. The Kimberley Rice Kaestner 1992 Family Trust, 814 S.E.2d 43 (N.C. 2018)

U.S. Supreme Court Grants Petition for Writ of Certiorari in Trust-Level State Income Tax Case

Author: Megan Neal of McDonald & Kanyuk PLLC

On October 9, 2018, the North Carolina Department of Revenue (“NC DOR”) filed a Petition for Writ of Certiorari to the U.S. Supreme Court, appealing the decision of the North Carolina Supreme Court in North Carolina Department of Revenue, Petitioner v. The Kimberley Rice Kaestner 1992 Family Trust, 814 S.E.2d 43 (N.C. 2018) (“Kaestner”).  The NC DOR asked whether the existence of a resident beneficiary of a non-grantor trust can trigger a trust-level state income tax within the state of the beneficiary’s residence.  On January 11, 2019, the U.S. Supreme Court granted the NC DOR’s Petition.

In Kaestner, the trust at issue was created by a New York resident grantor and was governed by New York law.  The trustee was a resident of Connecticut.  All books and records were kept, and all tax returns and accountings were prepared, in New York.  No beneficiary resided in North Carolina until years after the trust’s creation.  All of the trust’s assets consisted of financial investments that were kept in Boston.  The trust gave the trustee full discretion and no distributions had been made.  The North Carolina resident beneficiary received accountings and legal advice from the trustee and his firm and travelled to New York to discuss investment opportunities for the trust.  North Carolina taxed the trust on its accumulated income.  The trust paid the tax but sought a refund.  After the NC DOR denied its refund request, the trust filed a complaint alleging that the North Carolina tax violated the due process clause of the 14th Amendment and the Commerce Clause of the U.S. Constitution.  The Business Court held that taxation of the trust was unconstitutional and ordered that the trust be refunded with interest.  The NC DOR appealed the Business Court’s decision to the North Carolina Court of Appeals, which affirmed the Business Court’s decision, but the NC DOR appealed again.

The North Carolina Supreme Court ultimately determined that the trust at issue did not have sufficient minimum contacts with North Carolina to satisfy due process requirements.  Minimum contacts require “the taxed entity [to] ‘purposefully avail itself of the benefits of an economic market in the taxing state’…”.  Kaestner, 814 S.E.2d at 48. Simply put, a taxed entity’s minimum contacts cannot be established by a third party’s minimum contacts with the taxing state, and, here, mere contact with a North Carolina beneficiary does not constitute purposeful availment of North Carolina’s benefits and protections.

To date, the U.S. Supreme Court has been silent on whether a trust-level state income tax based solely on the residence of its beneficiaries comports with due process.  The Petition states, “[t]here is now a direct split spanning nine states. Four state courts have held that the due process clause allows states to tax trusts based on trust beneficiaries’ in-state residency.  Five state courts, including two state supreme courts …have concluded that due process forbids these taxes.”  The due process clause should not have different meanings in different states.

Practitioners should keep a keen eye out for the U.S. Supreme Court’s decision.  Any U.S. Supreme Court decision will assuredly have a substantial impact on planning to minimize trust-level state income tax.

February 26, 2019 Lunch re: Pro Bono Opportunities with Veterans Legal Services

The Trusts & Estates Consortium (“TEC”) is inviting trusts and estates attorneys to lunch to meet with attorney Lynn Girton from Veterans Legal Services (“VLS”) to hear about volunteer opportunities to provide pro bono estate planning services to veterans in need. Please contact Jennifer Civitella Hilario at jch@taxandtrustlaw.com if you can attend.

When:  February 26th 2019 from 12pm-1pm

Where: John Hancock, 197 Clarendon Street, Boston MA

83 Fed. Reg. 59343 – IRS Releases Proposed “Anti-Clawback” Regulations

83 Fed. Reg. 59343

IRS Releases Proposed “Anti-Clawback” Regulations

Author: Paul Cathcart of Hemenway & Barnes LLP

Public Law 115-97, commonly known as the Tax Cuts and Jobs Act (“TCJA”), temporarily doubles the basic exclusion amount for gifts made and decedents dying between 2018 and 2025, inclusive.  See I.R.C. § 2010(c)(3)(C).  What TCJA did not address was whether gifts made during that period that are above the single-exclusion amount but below the double-exclusion amount and, therefore, gift-tax free might nevertheless generate estate tax if the individual dies after 2025,.  See I.R.C. § 2001(b).  Practitioners have called this the possibility of “clawback.”

In the TCJA, Congress appeared to direct that “clawback” be avoided by the promulgation of “such regulations as may be necessary or appropriate to carry out [I.R.C. § 2001]” with respect to any difference between the basic exclusion amount for the year of any gift and the basic exclusion amount for the year of death.  I.R.C. § 2001(g)(2).  Such an anti-“clawback” regulation has now been proposed.  83 Fed. Reg. 59343 (Nov. 23, 2018).  The proposed new subsection of Treas. Reg. § 20.2010-1 would effectively provide that if the sum of the basic exclusion amounts allowed against the decedent’s prior taxable gifts exceeds the statutory basic exclusion amount for the year of the decedent’s death, the decedent’s basic estate tax exclusion amount is the larger of the two.  The effect would be to increase the decedent’s basic estate tax exclusion amount to the extent necessary to shelter any gifts that did not generate tax when they were made but would otherwise have generated tax in the decedent’s estate.

The proposed new subsection involves only “basic exclusion amounts” and does not involve or affect the computation of any deceased spousal unused exclusion amount (“DSUE”).  Under the proposal, exclusion would not be allowed against lifetime gifts “off the top,” so the additional exclusion amount allowable between 2018 and 2025 would remain “use it or lose it.”

The preamble to the proposal also expresses the agency’s view that no regulation is needed to address so-called “reverse clawback” because, under the existing statutes, the additional exclusion allowable between 2018 and 2025 is not offset by prior gifts that generated tax.

Comments on the proposal are due by February 21, 2019.  Outlines of topics for discussion may also be submitted by the same due date, in which case a public hearing will be held on March 13, 2019.

PLR 201825003 – IRS Determines Conditional Transfer of a Remainder Interest a Completed Gift

PLR 201825003

IRS Determines Conditional Transfer of a Remainder Interest a Completed Gift

Author: John H. Ramsey of Goulston & Storrs

In PLR 201825003, released June 22, 2018, the IRS considered whether the transfer of a remainder interest in a collection of artwork to two foreign museums was a completed gift for gift tax purposes. In this case, a favorable ruling would have been that the transfer did not constitute a completed gift.

Upon the death of the taxpayer’s spouse, the taxpayer transferred (i) legal title, (ii) naked ownership and a (iii) remainder interest in an art collection to the museums. The taxpayer retained a life interest in the artwork, but retained no right to transfer title to the collection.  The transfer was dependent on receiving a favorable ruling from the IRS and several conditions subsequent, each of which was not within the taxpayer’s control.

Nevertheless, the IRS concluded that the transfer of the remainder interest was a completed gift (see Section 2501 of the Internal Revenue Code, Regs Section 25.2511-2(b) – requiring no dominion and control of property nor any retained interest by the taxpayer; taxpayer has no power to change the disposition).  In this case, the IRS concluded that a completed gift would be made because the taxpayer did not retain sufficient rights to change the disposition of the property.

Importantly, though this topic was not discussed in the letter ruling, the transfer described would not qualify for a charitable income tax deduction, as contributions to foreign charities generally do not qualify for the income tax deduction and a gift of a future interest in tangible personal property is considered made only when all intervening interests have expired under Section 170(a)(3) of the Code. In addition, the gift would not qualify for the gift tax charitable deduction, as the taxpayer retained an interest in the transferred property and the gift was not structured as a qualifying charitable remainder trust or guaranteed annuity, as described in Section 2522(c)(2) of the Code.  Therefore, despite making a completed gift for gift tax purposes, the taxpayer would be left with no offsetting deduction.

The full PLR can be found at: https://www.irs.gov/pub/irs-wd/201825003.pdf.


Coming in as a Successor Trustee – Releases and Best Practices

Program Date: Friday, November 2, 2018

Speakers: Gerald Baker of Boston Private and Stacy K. Mullaney of Fiduciary Trust Company

Program ChairsDanielle Greene of Boston Private and Susan A. Robb of First Republic

Materials: Click here for the speakers’ handouts.

Program Topic:  This program provided discussion of liability and exposure considerations for fiduciaries in connection with the acceptance of appointments as successor trustee. The speakers assessed risks and identified options for individual and corporate fiduciaries coming in as successor trustees.

PLR 201834011 – Consequences (or Lack Thereof) of Divisions and Gift of QTIP Income Interest

PLR 201834011

Consequences (or Lack Thereof) of Divisions and Gift of QTIP Income Interest

Author: Kevin Ellis of Hemenway & Barnes LLP

In PLR 201834011, released August 24, 2018, the Internal Revenue Service ruled that a surviving spouse’s division of a Qualified Terminable Interest Property (“QTIP”) Trust, and her subsequent non-qualified disclaimer of the interests of one of the resulting trusts to a charitable remainder beneficiary, has no adverse income, estate or gift tax consequences.

The decedent’s spouse (the “Spouse”) was the beneficiary of a traditional Marital Trust (on which a QTIP election was made) (the “QTIP Trust”). The Spouse proposed, by court-approved agreement, to split the single QTIP Trust into two trusts on a non-pro rata basis, and thereafter to disclaim her interest in one of the two resulting trusts. The underlying trust provided that if the Spouse disclaimed an interest in the QTIP Trust, the disclaimed interest would pass to a charitable trust.

At issue in the PLR were the following:

  1. Would the division of the QTIP Trust trigger any gain recognition or loss?
  2. Would the resulting trusts, after the division, still qualify as QTIP trusts?
  3. Would the deemed gifts from the Spouse’s disclaimer of her interests in one resulting trust qualify for the gift tax charitable deduction?
  4. Would such a gift of the assets of one of the resulting trusts remove those assets from the Spouse’s gross estate?
  5. Would the disclaimer as to one of the resulting trusts also cause a deemed gift of the other, non-disclaimed trust (of which the Spouse continued to be the sole income beneficiary)?
  6. Would the disclaimer cause the Spouse’s retained interest in the non-disclaimed trust to be valued at zero under IRC § 2702 (and presumably cause a deemed gift as a result)?

The IRS’s ruling was favorable to the taxpayer on all accounts. The ruling bifurcated the proposed transaction – first, the division of the QTIP Trust into two resulting trusts, and next, the subsequent gift of interests in one of those trusts. The IRS ruled that:

  1. The non-pro rata division of the QTIP Trust into two resulting trusts (one of which the Spouse would disclaim) would not cause a recognition of any gain or loss under IRC §61 or §1001 because the same beneficiary – the Spouse – held the same interests in the QTIP Trust before and after division.
  2. The division of the QTIP Trust would not disqualify the two resulting trusts from continued treatment as QTIP trusts. The terms of the resulting trusts mirrored those of the QTIP Trust, and the Spouse continued to be the sole income beneficiary, with a qualifying lifetime income interest in both resulting trusts.
  3. The Spouse will be treated as having made a gift of her income and remainder interests in the disclaimed resulting trust, and such a gift qualifies for the gift tax charitable deduction (because the disclaimed assets pass to a charitable trust). It is important to note that IRC §§ 2511 and 2519, together, provide that when a spouse makes a gift (or makes a non-qualified disclaimer, which is treated like a gift) of her income interest in a QTIP trust, she is deemed to have made a gift of the entire property of such QTIP trust – even though she only had an income interest in the property. In this case, that gift of the entire interest was not an issue because the gift tax charitable deduction allowed for deductibility of the entire gift.
  4. The assets of the disclaimed trust are deemed to have been transferred under IRC §2519, and as a result will not be included in the Spouse’s gross estate under IRC §2044(a).
  5. Following on the IRS’s treatment of the transaction as two separate steps, the deemed gift of the assets of one resulting trust would not cause a deemed gift of the assets of the retained resulting trust under IRC §2519 because the two trusts were to be treated as distinct, separate trusts.
  6. Building on the findings in (4) and (5), the IRS concluded that the Spouse’s disclaimer of the assets in one resulting trust will not cause her interest in the retained trust to be valued at zero under IRC §2702, again because the two trusts were distinct and separate from each other.

The full PLR can be found at: https://www.irs.gov/pub/irs-wd/201834011.pdf


IRS Notice: 2018-61 – Effect of IRC Section 67(g) Costs Paid or Incurred in the Administration of an Estate or Trust

IRS Notice: 2018-61 – Effect of IRC Section 67(g)

Costs Paid or Incurred in the Administration of an Estate or Trust

Author: Kerry Reilly of K. Reilly Law LLC

Section 67(g) was enacted as part of the Tax Cuts and Jobs Act, December 22, 2017. That section disallows the itemized miscellaneous deductions exceeding the 2% floor for tax years beginning after December 31, 2017 and ending January 1, 2026.

Generally, the Adjusted Gross Income (AGI) of a trust or estate is calculated the same way for those entities as it is for an individual (Section 67(e)), which would support the disallowance of the above deductions. However, exceptions are provided under Section 67(e)(1) for costs paid or incurred for transactions that would not have been otherwise incurred if the property was not held in a trust or estate (see Regulations Section 1.67-4). Additionally, deductions allowed under Sections 642(b), 651 and 661 shall continue to be allowed for trusts and estates in determining AGI (Section 67(e)(2)).

The Notice highlights that it is the “type of service” that is determinative for whether it is an allowed deduction solely as a result of the trust or estate framework or would continue to be incurred regardless of the entity (includible – IRS Form 1041, 706, decedent’s final 1040 versus Form 706, property maintenance costs – not includable (see Regs. Section 1.67-4(b) and (c))).

The Notice goes on to say that “nothing in Section 67(g) affects the ability of the estate or trust to take a deduction listed under Section 67(b),” and that the Treasury and IRS will be issuing regulations to that effect.

Lastly the Notice asks for comments on Section 67(g) as it relates to a beneficiary’s ability to deduct Section 67(e) expenses upon the termination of a trust or estate pursuant to Section 642(h).

The full text of the Notice can be found at: https://www.irs.gov/pub/irs-drop/n-18-61.pdf


Estate and Income Tax Planning for “Small” Estates (Now Under $11 Million!)

Program Date: Thursday, April 26, 2018

Speakers: Paul M. Cathcart, Jr. and Charles R. Platt of Hemenway & Barnes LLP

Program ChairsHeidi A. Seely of Rackemann, Sawyer & Brewster and David L. Silvian of Day Pitney LLP

Materials: Click here for the speakers’ handout.

Program Topic:  This program discussed estate tax and basis step-up planning choices for Massachusetts residents who expect to be subject to state, but not federal estate tax—those with assets between about $1 million and $11.2 million per person.  The program provided an overview of the current law and focused on opportunities for income-tax basis planning and Massachusetts estate tax planning.

The Philanthropic Enterprise Act of 2017 (a/k/a “Newman’s Own Exception”)

By: Nikki Marie Oliveira, Esq., Bass, Doherty & Finks, P.C.

On February 9, 2018, the Philanthropic Enterprise Act of 2017 (the “Act”) was signed into law as part of the Bipartisan Budget Act of 2018. The Act addresses excess business holdings and allows private foundations to own for-profit businesses in certain circumstances.  Under the prior law, such ownership was forbidden, which was in place for public policy reasons to prevent families from establishing private foundations to serve as tax shelters for their business interests.

The Act, which became effective as of 2018, now makes up I.R.C. §4943(g). In general, Section 4943 imposes the “excess business holdings” rule on private foundations, which is triggered when a private foundation and its disqualified persons (e.g., substantial contributors, directors, officers and their family members and businesses) own more than 20% in the aggregate of a for-profit business.  The Act creates an exception for a private foundation to own a for-profit business, so long as the following requirements are met:

  1. 100 percent of the voting stock in the business must be held by the private foundation;
  2. The private foundation must have acquired the ownership interest in the business by means other than by purchase;
  3. All of the profits of the business must be distributed to the private foundation;
  4. The private foundation cannot be controlled by a disqualified person (e.g., the family members of the creator of the private foundation or any substantial contributors of the private foundation, or a director, officer, trustee, manager, employee, or contractor of the business);
  5. At least a majority of the foundation’s board are persons that are not directors or officers of the business or family members of a substantial contributor; and
  6. There is no outstanding loan from the business to a substantial contributor or his or her family members.

The Act is known as the “Newman’s Own Exception” because Newman’s Own Foundation had been lobbying for this exception since the death of the foundation’s founder, Paul Newman, in 2008. Newman left his entire interest in Newman’s Own, Inc. to his foundation and under the prior rules, the foundation was required to divest itself of the company within the 10-year extended grace period (which would have expired in November 2018).  Under the Act, the foundation will now be able to retain ownership of the company.