On cross motions for summary judgment, the Business Court division of the Superior Court of Wake County, North Carolina (the Court) held that the State violated the Due Process and Commerce Clauses of the United States Constitution and Article 1, Section 19 of the North Carolina Constitution by taxing a New York resident trust on income accumulated for, but never distributed to, a beneficiary in North Carolina. See In Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue.¹

The facts of the case were largely undisputed. The Kimberly Rice Kaestner 1992 Family Trust (the Trust) was created in New York and governed by New York law. At the time the Trust was created, none of the beneficiaries resided in North Carolina. In 1997, a daughter of the settlor and a primary beneficiary of the Trust became a resident of North Carolina. The Trust documents, financial books and records, and legal records were kept in New York and all tax returns and Trust accountings were prepared in New York. The custodian of the Trust's assets was located in Boston, Massachusetts. The assets held by the Trust consisted of various financial investments. All income of the Trust was generated from investments located outside of North Carolina. For the years at issue, the trustee was a Connecticut resident. The resident beneficiary had no absolute right to the Trust's assets or income, as distributions were made at the sole discretion of the trustee. Furthermore, no distributions were made to the resident beneficiary. For tax years 2005—2008, the Trust paid over $1.3M in tax on its accumulated income to the North Carolina Department of Revenue (the Department). The Trust sought a refund of tax previously paid, arguing that the relevant portion of the North Carolina statute imposing a tax on trust income was unconstitutional.

Under North Carolina General Statute Section 105-160.2, North Carolina imposes a tax on the taxable income of trusts. The statute reads, in part:

The tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State.

The Trust argued that the clause is unconstitutional on its face and as applied under the Due Process and Commerce Clauses. The Court agreed. Citing Quill v. North Dakota,² the Court noted that the Trust did not perform any activity to seek out the protection, opportunities, and benefits conferred by the State, and the State did not provide anything to the Trust for which it could ask in return. The beneficiary's residence in North Carolina, standing alone, was not a sufficient contact by the Trust and was not a "substantial nexus" between the Trust and the State to support the State's taxation of the Trust's income. Furthermore, the Court determined that the tax was not fairly related to services provided by the State. As a result, the Court granted the Trust's motion for summary judgment and ordered the Department to refund all taxes and penalties paid by the Trust, with interest.

Implications

The decision provides taxpayers with a potential opportunity to file protective refund claims with the State. Taxpayers should compare their own facts and circumstances to those of this case to decide whether a refund claim is viable.

The Court determined that the statute, as applied to taxpayers whose only connection to the State is a resident beneficiary, was unconstitutional. The case involved a very specific fact pattern in which the Trust had no connection with the State outside of the beneficiary's residence. As such, taxpayers should consider any and all activities of the trust and trustee that may constitute substantial nexus with the State before pursuing a refund claim. Additionally, it is reasonable to expect that the Department may appeal the decision. Taxpayers should closely monitor any future developments resulting from the Court's order.

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ENDNOTES

¹ The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 12 CVS 8740 (2015)

² Quill v. North Dakota, 504 U.S. 298 (1992)