North Carolina cannot tax a trust when the trust's only connection to the state is the residence of a beneficiary, the U.S. Supreme Court held Friday in a unanimous decision (North Carolina Dep't of Rev. v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. 6/21/19)). The court's opinion, written by Justice Sonia Sotomayor, held that such a tax would violate the Due Process Clause of the 14th Amendment because the trust lacked minimum contacts with the state.
The North Carolina statute at issue in the case (N.C. Gen. Stat. §105-160.2) allows a trust to be taxed solely because it has a North Carolina beneficiary. The statute was held to be unconstitutional by the North Carolina Supreme Court during the earlier stages of litigation (Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Dep't of Rev., 814 S.E.2d 43 (N.C. 2018), aff'g 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'g 12 CVS 8740 (N.C. Sup. Ct., Wake Cty. 4/23/15)).
The trust involved in the case had no connections to North Carolina other than the beneficiary's residence, and the trustee had absolute discretion over distributions to the beneficiaries. Nonetheless, North Carolina assessed a tax of more than $1.3 million on income earned by assets in the trust for tax years 2005 through 2008 — a period during which the beneficiary had no right to, and did not receive, any distributions. The trustee paid the tax under protest and then filed suit in state court arguing that the tax violated due process.
In holding that the North Carolina tax violated due process, the Supreme Court explained that the beneficiary "received no income from the trust in the relevant tax year, had no right to demand income from the trust in that year, and could not count on ever receiving income from the trust" (slip op. at 1). The Court agreed with the North Carolina courts that the assertion of tax in these circumstances violated due process.
N.C. Gen. Stat. Section 105-160.2 taxes any trust income that "is for the benefit of" a North Carolina resident. North Carolina has interpreted the phrase "for the benefit of" to include beneficiaries regardless of whether they actually receive income from a trust (slip op. at 15).
To determine whether the imposition of tax in that situation violates due process, the Court applied a two-step analysis. First, there must be "some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax" (Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992)). Citing International Shoe Co. v. Washington, 326 U.S. 310 (1945), the Court explained that a state has the power to tax an entity only when it has certain minimum contacts with the state so that the tax does not violate notions of fairness (slip op. at 6).
The second test, which the Court said was less relevant in this case, is whether the income attributed to the state for tax purposes is rationally related to values connected to the taxing state (slip op. at 6).
The Court explained that there are many types of contact a trust can have with a state that could reach the level of fairness to assert a tax, including a trustee's residing in the state or a beneficiary receiving income. Those circumstances were not present here, however.
Instead, the Court said, "When a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset" (slip op. at 10). Therefore, the Court held that "the presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain ever to receive it" (slip op. at 7). The Court emphasized that its holding was limited to these specific facts.
— Sally P. Schreiber, J.D., (Sally.Schreiber@aicpa-cima.com) is a JofA senior editor.