Reproduced with permission from Tax Management Estates, Gifts, and Trusts Journal, Vol. 44 No. 3, 05/02/2019. Copyright 2019 by The Bureau of National Affairs, Inc. www.bna.com
It has been some time since the U.S. Supreme Court took up a case that will have a significant impact on the estate planning community. On April 16, 2019, the U.S. Supreme Court did just that when it heard arguments on North Carolina Dept. of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust. The issue in the case is whether North Carolina can tax the income of a trust based solely on the fact that a beneficiary of the trust is a resident of North Carolina. The decision in Kaestner could have ripple effects on if, when, and how some states tax a trust’s income, and as a result, impact both the administration of existing trusts as well as planning around creation of trusts going forward.
VARIED STATE TAXATION
In many ways, state taxation of trust income is the ‘‘wild west’’ — if and when a state will tax a trust’s income varies from state to state. For example, Illinois taxes the income of a trust created under a will of an Illinois decedent, or an inter vivos trust created by an Illinois resident. New Mexico taxes the income from a trust with a resident trustee (even if there is a co-trustee in another state), or a trust administered in New Mexico. California taxes the income of a trust with a resident beneficiary or with a resident trustee or fiduciary. Florida does not have an income tax, and therefore does not tax a trust’s income. Consequently,
consider the following:
(1) A non-grantor trust created by an Illinois resident, with New Mexico and Florida co-trustees, administered in New Mexico, and one beneficiary who is a resident of California. Here, three states would tax the income on this trust.
(2) A non-grantor trust created by a California resident, with Illinois and Florida co-trustees, administered in Illinois, and a New Mexico beneficiary. The income of the trust would not be taxed by any state.
As this example illustrates, the state tax burdens on a trust can be significant, or non-existent. As trusts continue to accumulate wealth and continue indefinitely (particularly dynasty trusts in light of states’ extension or repeal of the rule against perpetuities), trustees of those trusts and the estate planners and accountants that advise those trustees must understand the tax implications of changes in the trusteeship, movement of the beneficiaries, and the location of the trust’s assets. The decision in Kaestner will provide some guidance in this regard.
FACTS IN KAESTNER
The facts in Kaestner are relatively straightforward and familiar to estate planners. In 1992, Joseph Lee Rice created the Joseph Lee Rice, III Family 1992 Trust for the benefit of his children, including Kimberley Rice Kaestner. At the time the trust was created, the settlor and the trustee were New York residents. None of the primary and contingent beneficiaries were residents of North Carolina and all of the assets were located outside of North Carolina. The trust agreement provided that the trust was to be governed by the laws of New York.
Ultimately, in December 2002, the Joseph Lee Rice, III Family 1992 Trust divided into separate trusts per the trust agreement, one for each of the settlor’s three children. One such trust was named for one of the settlor’s children, Kimberley, and became known as the Kimberley Rice Kaestner 1992 Family Trust (Kimberley Trust). Kimberley and her three children, the current beneficiaries of the Kimberley Trust, moved to North Carolina in 1997. The contingent remainder beneficiaries (the settlor’s other children and spouse) were residents of New York and Connecticut. The Kimberley Trust held financial investments, the custodians of which were located in Boston, Massachusetts. Its books and records were all kept in New York. Its tax returns and accountings were all prepared in New York. In 2005, the initial trustee was replaced by a successor trustee, who was a resident of Connecticut.
North Carolina imposes a tax on a trust based ‘‘on the amount of taxable income of the . . . trust that is for the benefit of a resident of [North Carolina].’’ In compliance with North Carolina’s statute, the Trustee of the Kimberley Trust filed income tax returns, and paid tax, in North Carolina on behalf of the trust for tax years 2005, 2006, 2007, and 2008.
Pursuant to the trust agreement, the trustee of the Kimberley Trust (Trustee) had broad discretion to make — or not make — distributions of income and/or principal to the beneficiaries. The Kimberley Trust also required the Trustee to distribute the trust assets to Kimberley when she reached the age of 40. However, in 2009, before her 40th birthday, Kimberley had conversations with the settlor and the Trustee about whether she wished to receive the trust assets. As a result of those conversations, the Trustee ultimately transferred the assets to a new trust, thereby
extending the term of the trust. The transfer, which occurred after the tax years in question, is not at issue and the new trust is not a party to the case.
During the tax years in question, and all years the current beneficiaries resided in North Carolina, no trust distributions were made to the beneficiaries. Thus, during the tax years in question, North Carolina taxed the trust on income accumulated, but not distributed, to the beneficiaries. In 2009, the Trustee subsequently sought a refund of those taxes — totaling $1.3 million — which the North Carolina Department of Revenue (Department of Revenue) denied.
WINDING ITS WAY THROUGH THE COURTS
In 2012, the Trustee filed suit in the North Carolina Business Court (Business Court), seeking a refund of the taxes paid, arguing that the tax was unconstitutional as it violated the Due Process Clause of the U.S. Constitution as well as the similar provision of the North Carolina Constitution because the trust did not have sufficient minimum contacts with North Carolina. The Trustee also argued that the taxes on the trust’s income violated the Commerce Clause as the tax was not applied to an activity with a substantial nexus to the taxing state. The Business Court agreed with the Trustee, finding that taxation of the Kimberley Trust based solely on the residence of the beneficiaries violated due process under both the U.S. and North Carolina constitutions and violated the Commerce Clause.
The Business Court’s decision was upheld by the North Carolina Court of Appeals. Citing Quill Corp. v. N. Dakota, 504 U.S. 298 (1992), the Court of Appeals found that ‘‘[t]he Due Process Clause requires (1) some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax, and (2) the income attributed to the State for tax purposes must be rationally related to values connected with the taxing State.’’ To determine whether there were enough minimum contacts, the Court of Appeals determined that ‘‘it is essential in each case that there be some act by which the party purposefully avails itself of the privilege of conducting activities within the forum State, thus invoking the benefits and protections of its laws.’’
On the issue of minimum contacts, the Court of Appeals found, as did the Business Court, that because the record did not indicate that the Kimberley Trust had any physical presence in North Carolina, that no trust records were kept in North Carolina, and that no trust investments were made in North Carolina, there were not enough contacts to satisfy the minimum contacts
criteria of the Due Process Clause.
The Department of Revenue appealed the Court of Appeals’ decision. On appeal to the North Carolina Supreme Court, the Department of Revenue argued that the Kimberley Trust had sufficient minimum contacts with North Carolina to meet the due process threshold based on the presence of the beneficiaries in the state alone because the beneficiaries ‘‘benefitted
from the ordered society maintained by taxation in North Carolina.’’ In June 2018, the North Carolina Supreme Court found in favor of the Kimberley Trust. The North Carolina Supreme Court, citing Quill Corp., stated that the Due Process Clause ‘‘requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’’ In the court’s opinion, the ‘‘minimum connection’’ only exists when the 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.’’
The North Carolina Supreme Court also looked to Brooke v. City of Norfolk, 277 U.S. 27 (1928), where the U.S. Supreme Court considered whether the City of Norfolk and Commonwealth of Virginia had violated the Due Process Clause by taxing a Maryland trust when none of the trust property had ever been present in Virginia. In Brooke, the U.S. Supreme Court recognized that a trust and its beneficiary are legally independent entities. It observed that the property held by the trust ‘‘is not within the State, does not belong to the beneficiary, and is not within her possession or control. The [tax] assessment is a bare proposition to make the beneficiary pay upon an interest to which she is a stranger.’’ Noting the U.S. Supreme Court’s decision in Brooke, the North Carolina Supreme Court concluded that the Kimberley Trust and its North Carolina beneficiaries have legally separate, taxable existences and it could not be established that the Kimberley Trust had minimum contacts with North Carolina. ‘‘Because [the Kimberley Trust] and [its] beneficiaries are separate legal entities, due process was not satisfied solely from the beneficiaries’ contacts with North Carolina.’' The North Carolina Supreme Court limited its decision, however, to the facts of this case and not broadly to the constitutionality of the statute.
The Department of Revenue appealed the decision of the North Carolina Supreme Court and the U.S. Supreme Court granted certiorari on January 11, 2019. Oral arguments were presented on April 16, 2019, and a decision will come down early this summer.
WHAT WILL THE IMPACT BE?
Where the U.S. Supreme Court ultimately comes down on this case will have an impact on trust planning and administration going forward. Whether the U.S. Supreme Court limits its decision to the specific facts in Kaestner or makes a broader statement on state taxation of trusts is left to be seen. Several other states tax a trust’s income if a beneficiary is a resident of that state, and a decision in favor of the taxpayer in Kaestner could have a significant impact on trusts with beneficiaries in those states. If the decision is limited to the specific facts of this matter, many questions will remain, for example, would the decision have been different if the trustee were not required to distribute the assets to the beneficiary at a later point in time, but instead the trust was a dynasty trust? For now, all we can do is wait. In the meantime, a more thorough analysis of the U.S. Supreme Court’s decision in Kaestner and state taxation of trusts, along with related planning considerations, will appear in the next issue of this publication.