The end of June is an exciting time in the United States Supreme Court, because the Court issues many of its opinions on the cases heard during that term, before recessing until the first Monday in October. This past term was especially rare, as the Court heard a trusts and estate case. On June 21, 2019 the Court issued its opinion in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust(“Kaestner”). The Kaestner case presented the issue of whether a state can tax the income of a trust where the only connection the trust has to the state is that one of the trust beneficiaries lives in the state.
In Kaestner, Joseph Lee Rice III created a trust for the benefit of his three children. Mr. Rice was a New York resident and the trust he created was a New York trust, governed by New York law. Additionally, Mr. Rice appointed a fellow New Yorker as the initial trustee. Mr. Rice gave his trustee the absolute discretion to make distributions to the trustees, meaning the trustee could make distributions of the trust income and principal as large or small as he wanted, or not make any distributions at all.
When the trust was created none of the trust beneficiaries lived in North Carolina. However, in 1997 Mr. Rice’s daughter, Kimberley Rice Kaestner, relocated to North Carolina. After Ms. Kaestner moved to North Carolina, the trustee split Mr. Rice’s trust into three sub trusts, of which, one sub trust, the Kimberley Rice Kaestner 1992 Family Trust (the “Sub Trust”), was formed for Ms. Kaestner and her minor children. The Sub Trust contained the same terms as Mr. Rice’s original trust, meaning the trustee had complete discretion over distributions from the trust. In fact, during the period in question, 2005-2008, the trustee did not make any distributions to Ms. Kaestner or her children. During that time period, 2005-2008, the Sub Trust remained a New York trust. Further, the Sub Trust did not have a physical presence in North Carolina, did not make any direct investments in North Carolina and did not own any real estate in North Carolina. The sole connection the Sub Trust had to North Carolina was Ms. Kaestner as the trust beneficiary.
The North Carolina Department of Revenue assessed a tax on the Sub Trust’s full proceeds during the period 2005-2008 resulting in the Sub Trust trustee receiving a $1.3 million tax bill for the tax due on the income the trust accumulated during the period 2005-2008; which income, again, the trustee did not distribute to Ms. Kaestner or her children. The North Carolina Department of Revenue’s basis for the assessment is that North Carolina taxes any trust income that is for the benefit of a North Carolina resident and North Carolina’s highest court, the North Carolina Supreme Court, has interpreted that statute to mean North Carolina can tax a trust solely based on the fact that a trust beneficiary lives in North Carolina. The Sub Trust trustee paid the full $1.3 million tax and then sued the North Carolina Department of Revenue in North Carolina state court based on the trustee’s argument that taxing the Sub Trust based on accumulated income violates the Due Process Clause of the Fourteenth Amendment.
State Court History
The North Carolina trial court decided the matter in the favor of the trustee, holding that Ms. Kaestner’s residence in North Carolina was too weak a connection between North Carolina and the Sub Trust to justify the imposition of the tax, so North Carolina’s assessment of the tax violated the Due Process Clause. The North Carolina Department of Revenue appealed to the North Carolina Court of Appeals, who affirmed the trial court’s decision. The North Carolina Department of Revenue then appealed to the North Carolina Supreme Court, which also affirmed the trial court’s decision. The United States Supreme Court then granted certiorari, meaning they agreed to hear the case, “to decide whether the Due Process Clause prohibits States from taxing trusts based only on the in-state residency of trust beneficiaries.”
Supreme Court Decision
In analyzing whether a tax abides by the Due Process Clause, the Court applies a two step analysis. Step one is that there must be “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”The second step in the analysis is that, “the income attributed to the State for tax purposes must be rationally related to ‘values connected with the taxing State.’”In Kaestner, the Supreme Court found that North Carolina’s tax on the Sub Trust did not pass step one, as the court did not find the necessary “minimum contacts,”so, the Supreme Court did not address the second step in the analysis. In applying the “minimum contacts” testthe Supreme Court reasoned that in Kaestner, the trustee of the Sub Trust had not made any distributions to a North Carolina resident, the trustee of the Sub Trust did not reside in North Carolina, the trustee of the Sub Trust did not make any investments in North Carolina, and the person who created the trust did not reside in North Carolina. The only connection the Sub Trust had to North Carolina was the North Carolina residency of the beneficiary.
The United States Supreme 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 to ever receive it.”The Court reasoned that, “[w]hen 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.”
The Court made two clear distinctions as to facts that had they been different could have changed the outcome of the Court’s decision. First, again, in Kaestner the trust beneficiary did not receive any income from the trust. If Ms. Kaestner had received income from the trust that income clearly would be taxable. Second, Ms. Kaestner did not have the right to demand distribution of the trust income, or otherwise control the trust assets. The Sub Trustee had complete discretion over if, when, and to whom the trust assets would be distributed. The Court’s implication is that if Ms. Kaestner could have demanded the trust income, she may have had the requisite control to make the trust income taxable to her.
Further, the Court was clear that its decision only addressed the circumstances in Kaestner, where the beneficiary does not receive trust income, does not have the right to demand trust income, and is uncertain to ever receive a specific amount of trust income. The Court warns that moving forward, when creating a trust, the person creating the trust will need to balance to potential state tax benefits of giving the trustee complete discretion over trust distributions against the cost to the trust beneficiaries of having less control over the trust assets.
The primary effect this decision may have is a chilling effect on state’s attempts to tax undistributed trust income. With more people creating trusts for children that may all live in separate states, the holding in Kaestner is extremely relevant, because the potential burden on administration and the need for state tax planning to avoid the trust income being subject to tax in multiple states, would have been great. Now, Kaestner stands for the proposition that simply having a beneficiary who resides in a state, does not meet the “minimum contact” test to allow the state to tax the trust income. It is important to note, as stated above, had Ms. Kaestner received the trust income, she would have been taxed on that income.
The Trusts and Estates department of Twomey, Latham, Shea, Kelley, Dubin & Quartararo has attorneys admitted to the bars in multiple states outside of New York, who routinely guide clients through state tax planning, and are available at your convenience to answer your questions and to help you best manage your estate.
The Due Process Clause of the Fourteenth Amendment provides that “[n]o State shall … deprive any person of life, liberty, or property, without due process of law.” In the context of state taxes the Due Process Clause provides a limitation on a State’s ability to imposes taxes, by mandating that the tax “bear fiscal relation to protection, opportunities and benefits given by the state.” Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940).
North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 588 U.S. ____ (2019).
Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992).
SeeInternational Shoe Co. v. Washington, 326. U.S. 310 (1945).
North Carolina, 588 U.S. at ___.