On Friday, June 21, 2019, the U.S. Supreme Court (Court) unanimously upheld the North Carolina Supreme Court's earlier ruling that the state could not tax the income of a trust based solely upon the presence of a contingent beneficiary who moved to the state. The Court's decision in North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust, No. 18-457 (S. Ct. June 21, 2019) (Kaestner Trust) is one of the first opinions in which the Court addresses the state tax nexus limits of the Due Process Clause in the wake of its decision, one year to the day, in South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018). In Wayfair, the Court addressed nexus under the Commerce Clause, and concluded that the Commerce Clause did not require a physical presence to establish nexus for purposes of imposing a state sales tax collection obligation.

In Kaestner Trust, the issue before the Court was the following: "Does the Due Process Clause prohibit states from taxing trusts based on trust beneficiaries' in-state residency?" Ultimately, the Court (with Justice Sotomayor writing for the majority) limited its holding to the specific facts presented and concluded that North Carolina's taxation of a New York-based trust violated the Due Process Clause because "[t]he 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 receive it."

At a high level, the facts of this case are simple. Settlor formed a trust for the benefit of his children in his home State of New York. One of the beneficiaries became a North Carolina resident from 2005 through 2008. The trust was governed by New York law and administrated from New York. Additionally, the trust did not have a physical presence, make any direct investments, or hold any real property in North Carolina. Furthermore, 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 in Boston, Massachusetts, and all trust income was generated from investments located outside of North Carolina. For the years at issue, the trustee was a Connecticut resident. Moreover, under the trust documents, the trustee was granted "absolute discretion" to distribute trust assets and the beneficiary had no right to any distributions during the period she resided in North Carolina. During her residency in North Carolina, she did not receive any distributions. See Tax Alert 2018-1376 for additional factual details.

Under North Carolina General Statute Section 105-160.2, North Carolina taxes the taxable "trust income that 'is for the benefit of' a North Carolina resident." North Carolina courts have interpreted "this to mean that a trust owes income tax whenever the trust's beneficiaries live in the State, even if those beneficiaries 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." North Carolina assessed a tax of more than $1.3 million on the trust's accumulated income, based solely on the beneficiary's residence in the state. The trust paid the assessment but immediately sought a refund of tax previously paid for the tax years 2005 through 2008, arguing that the relevant portion of the North Carolina statute taxing trust income was unconstitutional. See Tax Alert 2018-1376  for additional factual details.

The North Carolina Business Court, the North Carolina Court of Appeals, and the North Carolina Supreme Court each ruled in favor of the trust, holding that the statute as applied to the trust violated the Due Process Clauses of both the US Constitution and the North Carolina Constitution. See Tax Alert 2018-1376 for additional procedural details. The North Carolina Department of Revenue (Department) filed a petition for certiorari with the Court on January 11, 2019 and oral arguments were heard on April 16, 2019.

Both Justice Sotomayor in the majority opinion, as well as Justice Alito in his concurring opinion (in which Chief Justice Roberts and Justice Thomas joined), began their discussions of the Due Process Clause by citing Quill Corp. v. North Dakota, 504 U.S. 298 (1992) (Quill). This was somewhat surprising, as the Court severely criticized Quill when overruling its "physical presence" requirement in last year's landmark decision in South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018) (Wayfair).

In Kaestner Trust, both the lead and concurring opinions favorably cited the observation made in Quill that "[t]he [Due Process] Clause 'centrally concerns the fundamental fairness of governmental activity.'" Citing additional precedent, the Court stated that, although the ability to tax is a fundamental State power, taxation is only legitimate when it directly correlates to opportunities and/or benefits provided by the state. Stated simply, has "[t]he State given anything for which it can ask return?" Additionally, the Court again cited Quill when discussing the process for analyzing if a state tax abides by the Due Process Clause: "First, … there must be 'some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.' Second, the 'income attributed to the State for tax purposes must be rationally related to values connected with the taxing State.'"

Referencing the minimum connection test from the Court's foundational Due Process Clause ruling in International Shoe Co. v. Washington, 326 U.S. 310 (1945), the Court noted that, although the "minimum contacts" inquiry is flexible, "only those who derive 'benefits and protection' from associating with a State should have obligations to the State in question." In the context of in-state beneficiary contacts, the Court focused on the "extent of the instate beneficiary's right to control, possess, enjoy, or receive trust assets." As suggested by the cases the Court cited, "'[w]hen a State seeks to base its tax on the instate residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State's tax.'" The Court also acknowledged that it has previously held that some contacts, either alone or in combination, can provide adequate "minimum contacts" to satisfy the Due Process Clause and justify taxation. For example, the following have been found constitutional: 1) taxation of trust income distributed to an in-state resident; and 2) taxation based on a trustee's in-state residence. Additionally, the Court has suggested that a tax based on the site of trust administration is constitutional.

Here, however, the Court was unpersuaded by State's attenuated contacts: "[W]hen assessing a state tax premised on the instate residency of a constituent of a trust — whether beneficiary, settlor, or trustee — the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax. During the period in question, the trust was administered outside of North Carolina, the trustee made no direct investments in the State, the settlor did not reside in the State, and distributions were not made to North Carolina residents. Additionally, "the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets … " because the power to "distribute the trust's assets was left to the trustee's absolute discretion."

Implications: Trusts & estates

It is interesting that the reaction to the Court's decision from practitioners and academics has ranged from yawns to outrage. On one side are those who believe that the Court just got the case wrong. On the other side are those who think this is a nothing because the case was limited to the facts. Somewhere in the middle are those who see the decision as the beginning of decades of future litigation and uncertainty in trust taxation.

Let's start with the most important aspect of the case: a trust like the one considered in Kaestner Trust, in a state with a trust tax regime like North Carolina's, will not be subject to state tax merely because a beneficiary is in the state. Most states determine trust nexus for state income tax purposes on a combination of criterion, including (i) the residence of the settlor/grantor, (ii) the residence of the trustee, (iii) the residence of the beneficiary, and (iv) where administration takes place. Very few states determine trust nexus for state tax purposes based solely on the residence of the beneficiary, as Justice Sotomayor acknowledged in footnote 12 of her opinion. In those states, the Kaestner Trust decision will likely have a significant impact, as trustees will likely file for refunds of trust taxes paid.

Since state income tax situations like North Carolina are not that common, what impact might the case have in other states? By carefully limiting the decision to the facts, the Court creates uncertainty about the constitutionality of other states' trust tax regimes. This uncertainty could prompt trustees to file protective refund claims and litigate state trust income tax laws. This litigation likely will take place on two fronts: (1) whether the state's trust tax regime is invalid under Kaestner Trust; and (2) whether a beneficiary has nexus with the state. For trust tax regimes that rely on multiple factors to determine whether trust income is subject to tax, the issues to be litigated could be even more complicated. In states like California, for example, a trust may be subject to tax based the trustee's residency, the beneficiary's residency and other factors. Similarly, footnote 12 of the opinion references five states that either prioritize the residency of the beneficiary or consider multiple factors and concludes that only California's law was most like North Carolina's.

These critiques and the limited scope of the decision would seem to portend that stakeholders on both sides of the issue will continue to prod and test the contours of the Kaestner Trust decision. Because decades of litigation and new statutes are anticipated, some level of uncertainty might be anticipated. If this is true, trustees should be evaluating their income tax risks. This would include considering protective refunds in states which have trust tax statutes like North Carolina's. Yes, the Kaestner Trust decision provided some certainty for trustees. However, it looks more like Kaestner Trust will be the beginning and not the end of the question.

Implications: SALT

While the Court may have moved away from the physical presence requirements of economic nexus in Wayfair, its prominent reliance on Quill likely demonstrates that the due process considerations of a state tax discussed in Quill are still very much alive and well. Moreover, despite the Court's heavy reliance on the four-prong test¹ articulated in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) (Complete Auto Transit) in its Wayfair opinion, discussion of the test is surprisingly absent in the Kaestner Trust opinion (although it could just indicate that Complete Auto Transit should be considered as a Commerce Clause matter only).

Looking ahead

It is worth noting that yet another, perhaps even more interesting, state trust tax case, Comm. of Rev. v William Fielding, et al., No. 18-664 (Fielding), was just distributed to the Court on June 27, 2019, for a conference on whether to accept the state's petition for certiorari. In Fielding, the Minnesota Supreme Court analyzed the second prong of Quill's Due Process Clause analysis, which was not addressed in Kaestner Trust — whether a "rational relationship" existed between "the income subject to tax and the protections and benefits conferred by the state." The trust in dispute in Fielding had nexus under the first prong of the Due Process Clause analysis identified in Quill: the grantor was a Minnesota resident when the trust was established, the trust was administered in Minnesota, the trust document relied on Minnesota law, all the assets of the trust (i.e., stock of an S corporation that was sold) were in Minnesota and the underlying business was in Minnesota. All the trust's beneficiaries, however, were outside of Minnesota.

Minnesota taxed 100% of the trust's income. Applying the second prong of the Due Process Clause nexus standard, the Minnesota courts concluded that no rational relationship existed and struck down the imposition of state tax on the Fielding trust as a "resident trust." None of the Minnesota courts, however, devised a formula to determine how much income should be apportioned, if any, to Minnesota. It remains to be seen if the Court takes this case.

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ENDNOTES

¹ The Complete Auto Transit four-prong test for the validity of a state tax on interstate commerce requires the satisfaction of all these conditions: 1) the tax is applied to an activity having a substantial nexus with the taxing state, 2) is fairly apportioned, 3) does not discriminate against interstate commerce, and 4) is fairly related to the services provided by the state. Complete Auto Transit, 430 U.S. at 279, See also Wayfair, 585 U.S. at ___ (citing the test.)