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Tax Update: Will the Kaestner Decision Have Ripple Effects?

The Supreme Court's Kaestner decision is welcome news for taxpayers, but the ruling will likely have material impact only in limited circumstances.

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  • The Supreme Court ruled this morning on the highly anticipated North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust case.
  • The court ruled in favor of the trustee, affirming that taxing trust income based solely on an in-state discretionary beneficiary's residence is a violation of due process.
  • The highly specific circumstances of the case are likely to limit its precedential influence.

 

What is fundamentally fair? Specifically, what is fundamentally fair when deciding whether a state may tax the income of a trust? That is the question the U.S. Supreme Court answered in its June 21, 2019 decision in favor of the taxpayer in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust.1

The issue before the Court, as presented by the North Carolina Department of Revenue, was whether the Due Process Clause under the Fourteenth Amendment prohibits states from taxing trusts based on trust beneficiaries’ in-state residence. The Trustee framed the question slightly differently, focusing on the unique facts of the case, specifically the taxation of the worldwide income of a trust to which the State “had no connection, based solely on the domicile of a discretionary beneficiary who might never in fact become entitled to receive a distribution from the trust.” The Court, in ruling that the North Carolina statute was unconstitutional as applied to the Kaestner Trust, focused on the issue as framed by the Trustee, and in so doing, in essence limited the broader impact of its decision.

Kaestner Background

In 1992, Joseph Lee Rice III, a resident of New York, created the Joseph Lee Rice III Family 1992 Trust by written agreement in the State of New York, naming a New York trustee, and specifying that the trust would be governed by New York law. The trust agreement granted the trustee broad discretion to control all trust matters, including investments and distributions to beneficiaries. The interests of the beneficiaries in the trust were entirely discretionary; the beneficiaries had no present right to trust income or principal or any guarantee that they would ever receive either. In 2005, Mr. Rice appointed a resident and domiciliary of Connecticut as successor trustee, who remained in this position during the time period at issue. In 2006, the sub-trusts that had been created in 2002 for each of Mr. Rice’s three children were decanted into new separate trusts for each child, including the Kaestner Trust for the benefit of Mr. Rice’s daughter, Kimberley Kaestner.

Ms. Kaestner moved to North Carolina in 1997. From 2005 to 2008, the Trustee of the Kaestner Trust filed North Carolina income tax returns for the Trust as a resident trust in accordance with the terms of the North Carolina statute that taxes a trust on income for the benefit of a resident beneficiary. For those years, North Carolina taxed the worldwide income of the Kaestner Trust although none of the income had been generated in North Carolina nor distributed to Ms. Kaestner. The Trust then filed a claim for a refund for the tax paid, which amounted to over $1.3 million. The North Carolina Department of Revenue denied the refund claims. In June, 2012, the Trust brought suit against the North Carolina Department of Revenue, claiming that the North Carolina General Statute authorizing the State to tax trust income benefitting a state resident is unconstitutional under the United States Constitution and the North Carolina State Constitution.

Case Summary

It was the position of the North Carolina Department of Revenue that Ms. Kaestner’s residence in North Carolina provided sufficient nexus between the Trust’s income and the State for the State to tax the Trust as a North Carolina resident trust. The State argued that North Carolina provided benefits to Ms. Kaestner and her family and therefore could tax the income of the Trust regardless of its source and regardless of whether or not it was actually distributed to Ms. Kaestner while she was a resident of North Carolina. The Trustee argued that there was insufficient nexus between the Trust and North Carolina to tax the worldwide income of the Trust. Ms. Kaestner had no right to demand the income from the Trust and, in fact, never received any income while she was a resident of North Carolina. In short, the taxpayer argued that attributing any benefits provided to Ms. Kaestner as a state resident to the Trust was inapposite because those benefits were not provided with respect to the Trust itself. Rather, in their view, the only contacts relevant to the constitutional nexus of the Trust and its income to the state are those related to the Trustee, such as the domicile of the Trustee or the place of the administration of the Trust.

The circuit court, the appellate court and the North Carolina Supreme Court all concluded that taxing the Trust violated the Due Process Clause.2

Before the U.S. Supreme Court, the State argued that holding the application of the tax unconstitutional amounted to a “judicially created tax-shelter,” allowing the Trust to avoid tax on the income altogether and creating a serious hardship for the State, which provided significant benefits to the Trust beneficiaries. 

In reality, as the Trust highlighted, very few states use a resident-beneficiary paradigm as the sole basis for determining the residence of a trust, although a number of others include it as one factor among others used to determine nexus.3 This resident-beneficiary approach could result in significant tax being paid to North Carolina when no income would be distributed to a North Carolina resident. Ms. Kaestner did not “own” the Trust or its assets, she did not control the investment of the Trust and she could not demand distributions from the Trust. Furthermore, as other states tax trusts as residents based on criteria including the residence of the settlor, the residence of the trustee and the place of administration, the specter of a “judicially created tax-shelter” is ill-conceived. In short, the Trustee argued, the assets and income did not have sufficient nexus with the State for the statute as applied to the Trust to pass constitutional muster.

Conclusion and Impact

The Supreme Court unanimously ruled in favor of the Trust. The Court affirmed the decision from the North Carolina Supreme Court under the Due Process Clause as applied, ultimately holding that North Carolina seeking to tax the Trust’s income, whether distributed or not, based solely on the in-state beneficiary’s residence is a violation of due process in the context of this case. In its reasoning, the Court relied primarily on three points in reaching its decision: (1) the beneficiaries did not receive any income from the Trust during the years in question; (2) the beneficiaries had no right to demand trust income or control, possess, or enjoy the trust assets in the tax years at issue; and (3) not only were the beneficiaries unable to demand distributions in the tax years at issue, but they also could not count on receiving any amount of income from the Trust in the future. As such, the Court stated, “given these features of the Trust, the beneficiaries’ residence cannot, consistent with due process, serve as the sole basis for North Carolina’s tax on trust income.” Justice Alito issued the concurring opinion, ultimately agreeing with the Court, but further emphasizing the narrow scope of the Court’s decision as one that does not change the governing standard or alter the reasoning applied in earlier cases. In effect, this conveyed the message that in spite of the decision, the precedent and reasoning for trust taxation remains consistent and unchanged.

What ripple effects will the Kaestner decision have? For the taxpayer, the outcome is certainly welcome. However, the Supreme Court’s “statute as-applied” ruling, specific to the facts of the case, limits the greater impact of the decision – it may be persuasive, but it will be precedential in very limited circumstances. States tax trust income under different paradigms. Very few states base the taxation of a trust as a resident singularly on the residence of a beneficiary. The North Carolina approach is quite simply an uncommon one. For states that determine the status of a trust as a resident for state income tax purposes on other criteria, such as the residence of the settlor, the residence of the trustee or the place of administration, the Kaestner North Carolina decision itself is not expected to have a material impact. Even in the few states that determine trust tax residence on the basis of beneficiary residence alone, it will be important to consider the particular circumstances of any given situation. Recall that in Kaestner, there were reportedly no contacts with the State other than the beneficiary’s residence.

Yet, with the Kaestner decision, there is now one more ruling, and a ruling of the U.S. Supreme Court, that scrutinizes the relationship of a trust with a state sufficient to justify the taxation by the state of the trust as a resident. State tax authorities and trust taxpayers will continue to posture on the issue of state income taxation.

 

1. North Carolina Dept. of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, 588 U. S. (2019).

2. Because the North Carolina courts ruled based on the Due Process Clause, the issue of whether the Commerce Clause of the U.S. Constitution also prohibited the application of the tax was not addressed and the issue was dropped on the appeal to the U.S. Supreme Court.

3. North Carolina, Tennessee, Georgia, and California impose a tax of trusts based on the residence of a beneficiary in the state. Only North Carolina and Tennessee impose a tax based on the residence of contingent beneficiaries with no vested right to receive trust income or principal.

 

© 2019 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S.

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

 

Suzanne L. Shier

Wealth Planning Practice Executive & Chief Tax Strategist/ Tax Counsel
Suzanne L. Shier is the Wealth Planning Practice Executive and Chief Tax Strategist/Tax Counsel for Wealth Management at Northern Trust and serves on the Wealth Management Operating Group.

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