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July 2, 2019

U.S. Supreme Court Rules on North Carolina’s Ability to Impose Tax on an Out-of-State Trust

Tax on Out-of-State trust

On the one-year anniversary of the U.S. Supreme Court’s decision in South Dakota v. Wayfair, the Court issued yet another decision regarding a state’s ability to impose tax on an out-of-state taxpayer. Unlike the Wayfair decision, where the Court ruled in favor of the state’s ability to expand its tax reach to include companies with no physical presence in the state, in North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust (“Kaestner”), the Court limited the state’s ability to reach out-of-state taxpayers. Other effects of the decision may be limited, but the Kaestner ruling means taxpayers may now have state tax refund opportunities in North Carolina.

Background

Kaestner involved a trust that was founded in 1992 by a New York resident for the benefit of his three children, who were at that time also New York residents. Several years later, one of the beneficiary children relocated to North Carolina. The original trust was split into three separate trusts – one for each child beneficiary. The trust belonging to the North Carolina resident child, Kimberly (and her minor children), is the subject of this case. 

Significant factors involved in the Supreme Court’s analysis included the following:

  • The settlor of the trust was a New York resident;
  • New York law governed the trust;
  • The trustee was at first a New York resident, and then a Connecticut resident;
  • The books and records of the trust were maintained in New York; and
  • The trust custodian was located in Massachusetts.

Only the beneficiary, Kimberly, was located in North Carolina. The North Carolina Department of Revenue taxed the proceeds from the Kaestner trust from 2005 to 2008, and the resulting bill was more than $1.3 million. North Carolina’s sole reason for taxing the trust’s proceeds was that the trust’s beneficiary was a resident of the state. North Carolina relied on its own tax law, which provides that the trust income is presumed to be “for the benefit of” the resident beneficiaries. However, during the tax period, the beneficiary did not receive any distributions from the trust, the trust had no activity or assets in North Carolina, and the trust was wholly managed by an out-of-state trustee. 

The trustee had exclusive control over all decisions regarding the trust’s investments and distributions. Although the trust expired on the primary beneficiary’s 40th birthday, the trustee had the authority to (and did) roll over the trust assets into a new trust, in lieu of terminating the existing trust and distributing the assets to the beneficiary. Given the trustee’s power to roll the trust assets upon termination of the trust, the beneficiary had no confidence that she would ever receive any benefit or distribution from the trust. 

The Court’s Analysis

The Court reasoned that the beneficiary’s state of residence alone does not provide a sufficient minimum connection (required by the Due Process Clause) between the state and the person (trust) upon which a tax is assessed.      

Based on the facts that the beneficiary did not receive any income from the trust, did not have the right to claim any income from the trust, could not control or possess any of the trust assets, and had no definite future income from the trust, the Court found North Carolina’s tax on the trust to be in violation of the Due Process Clause. The Court deemed the interests of the beneficiary as “contingent,” because the trustee had absolute control over all of the trust’s investment and distribution decisions. 

Furthermore, the trial court held that North Carolina’s tax on the trust also violated the Commerce Clause; however, neither the appellate court nor the Supreme Court addressed that issue.

There is legal precedent to support taxing a trust in situations where the trust is created within the state, or when the trust distributes income to an in-state resident, or when the trustee is an in-state resident. The primary factor used to determine whether there are sufficient minimum contacts with the taxing state is the relationship that the trust assets have to the taxing state. In the Kaestner decision, the North Carolina beneficiary had no possession, control or enjoyment of the trust assets; therefore, the Court determined there was no basis for North Carolina to impose a tax on the trust. The Court did not provide any guidance on how much activity would constitute a substantial connection, or to what degree of possession, control or enjoyment constitutes a sufficient connection that authorizes a tax. The Court simply ruled that the connection did not exist under these particular facts.

Implication of this Decision

Unfortunately, the impact of this decision is rather limited. Only a few states consider a beneficiary’s state of residence as a factor when taxing a trust, and even fewer impose a tax when it is the sole factor. According to the opinion of the Court, 10 states consider the beneficiary’s state of residency as a factor when imposing a tax on a trust. Of the 10 states, only California relies solely on beneficiary’s state of residency, and even in that case, it is specific to  a non-contingent beneficiary. 

While the decision clearly states that the in-state residency of a “contingent” beneficiary does not provide, by itself, the minimum connections required under the Due Process Clause, the Court did not provide any further guidance as to what would create such minimum connections. This leaves open the question about whether a similar tax is lawful in situations where the beneficiary receives only small distributions from a trust, or when the beneficiary is certain only to receive some future benefit. 

Due to the limited number of states that rely on a beneficiary’s state of residency as a basis for taxation in a manner similar to North Carolina, and due to the specificity of the facts analyzed in this case, the effect of this case is not terribly far-reaching. However, taxpayers with similar facts – particularly in North Carolina – may now have a tax planning or refund opportunity.

For More Information

If you have any comments, questions, or concerns about the changes to Colorado sales and use tax, please contact the author of this article, Mary Jo Zuelsdorf.

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