The North Carolina Supreme Court (the Court) recently ruled in Kaestner 1992 Family Trust ¹ (Kaestner) that it was unconstitutional for the state to tax a trust whose only connection to the state was the residence of the beneficiary.

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, Kimberly Rice Kaestner, 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, and 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 actually made to the resident beneficiary during the years at issue. For tax years 2005–2008, the Trust paid over $1.3 million in tax on its accumulated income to the North Carolina Department of Revenue (NC DOR). The terms of the Trust provided that the trustee was to distribute the assets to Kimberly Kaestner when she reached a specified age, which did not occur until after the tax years at issue in the case.

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." Furthermore, the NC DOR has provided guidance that certain computations as part of the statute be based on the "beneficiary's state of residence on the last day of the taxable year of the trust."

The Trust sought a refund of tax previously paid for the tax years 2005 through 2008, arguing that the relevant portion of the North Carolina statute imposing a tax on trust income was unconstitutional. The North Carolina Business Court and the North Carolina Court of Appeals ruled in favor of the Trust (see Tax Alerts 2015-0864 and 2016-1293). The state appealed those rulings to the Court.

The Court held that the statute as applied to the Trust in this case violated the Due Process Clause of the US Constitution, as well as the North Carolina Constitution. Specifically, the Court held that the Trust did not have sufficient minimum contacts with the state. Under US Supreme Court precedents construing the Due Process Clause, the Court concluded that, to be constitutionally subject to tax in a state, a taxpayer must purposefully avail itself of the benefits of an economic market in the taxing state. The Trust did not have any connection to the state other than the fact that the primary beneficiary was a North Carolina resident. The beneficiary's contacts with the state could not be attributed to the Trust, as the Trust was a separate legal and taxable entity.

Implications

The case involved a specific fact pattern in which the Trust had no connection with the taxing state other than the beneficiary's residence. Trusts that have as their only connection to North Carolina the residence of the beneficiary, and that paid income tax to the state, may want to evaluate whether they should apply for refunds on any open years, and cease paying taxes to the state in future years.

While the case was pending before the Court, taxpayers were encouraged to file Form NC-14, Notice of Contingent Event or Request to Extend Statute of Limitations, pending resolution of a "contingent event." If approved by the NC DOR, the filing of NC-14 allowed taxpayers to wait to file refund claims until the Kaestner case was completely resolved in the courts. However, taxpayers have only six months after a "contingent event" concludes to request a refund of an overpayment. The NC DOR has not yet issued official guidance as to whether the recent Court ruling is considered to have "concluded" the Kaestner case for purposes of starting the six-month filing deadline. Based on written correspondence from the NC DOR, however, the six-month period should start at the latest of: the date of the Court decision (June 8), the date the US Supreme Court denies certiorari (TBD), or the date the US Supreme Court decides the case should it grant certiorari (TBD). According to the rules of the US Supreme Court, a writ of certiorari to review a judgment in any case entered by a state court of last resort must be filed within 90 days after entry of the judgment. Although it is unclear whether the NC DOR will request certiorari, it seems likely this would be known within the six-month time frame from the end of the Court decision for completing any Form NC-14 refund claims. Affected trusts should consider all the facts and circumstances to determine whether to file a refund claim now or to wait to determine whether the state will further appeal the Court's decision, thus continuing the "contingent event."

Taxpayers should also stay tuned for potential legislative changes resulting from the Kaestner decision. In 2015, legislation was proposed in the North Carolina Senate to tax trusts based on principal place of administration rather than the residence of the beneficiaries. Although it never became law, there is discussion of this proposed statute change recirculating in the legislature in the coming months.

Interestingly, two weeks after the Kaestner decision, the US Supreme Court decided the Wayfair case. See Tax Alert 2018-1269. In Wayfair, the Court overturned the landmark 1992 Quill decision, which required a remote seller to have a physical presence in the state before the state could require the seller to collect sales and use taxes from in-state customers. It is unlikely that Wayfair will have much effect on the Kaestner decision. Wayfair was a Commerce Clause case, while the NC Supreme Court in Kaestner based its decision on the Due Process Clause.

Trusts that pay taxes in other states based upon the residence of the beneficiary, such as in California, may want to cite the Kaestner decision as persuasive authority in arguing that the state's law is unconstitutional in that it violates the Due Process Clause as applied to the trust, depending on the particular facts and circumstances.

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ENDNOTES

¹ Kaestner 1992 Family Trust v. N.C. Dept. of Rev., No. 307PA15-2 (N.C. S.Ct. June 8, 2018).