SCOTUS Sides with Family Trust Over the State of North Carolina

The United States Supreme Court ruled on June 21st, 2019 that the taxation of The Kimberley Rice Kaestner 1992 Family Trust by the North Carolina Department of Revenue is unconstitutional.

The much-anticipated ruling stated that the presence of in-state beneficiaries alone does not empower a state to tax trust income. Beneficiaries experience more protection before a trust distribution and when the beneficiaries have no right to demand, nor are they sure to receive the income.

Click here to download SCOTUS Opinion on the North Carolina Dep’t of Rev. v. Kimberley Rice Kaestner 1992 Family Trust.

New Precedent. New Opportunities.

This ruling creates many planning opportunities for both states with high-income tax laws and states with no income tax.

For those with estate plans in high-income tax states, reviewing your estate and how it is structured is exceptionally prudent. Prudent because it may be advantageous to move assets to a trust jurisdiction with no income tax. And, prudent because many estates could be entitled to refunds.

For states like Nevada with no income and corporate taxes, there is an obvious opportunity to acquire new business from higher income tax states. The key is to structure the trusts properly so that they fall outside of “substantial” nexus — more on this below.

We encourage anyone potentially affected to consult with their advisors to discuss their particular situation.

The Facts

See pages 3 and 7 of the SCOTUS opinion for further details.

  • The Kaestner Trust was established in New York and subjected to New York Tax Law.
  • The Grantor of the Trust was a New York resident.
  • No Trustee lived in North Carolina.
  • The Trustee domiciled the Trust Documents and records in New York.
  • The Trust Asset Custodians resided in Massachusetts.
  • The Trust also carried no physical presence in North Carolina.
  • The Trust made no direct investments in the state of North Carolina.
  • The Trust held no property in the state of North Carolina.

The only connection between the State of North Carolina and the Kimberly Rice Kaestner 1992 Family Trust is that the beneficiary lives in the state of North Carolina – but this is not enough of a reason to tax the Trust.

Nexus Between a Trust and A State: “Minimum” v. “Substantial”

As anticipated by some SCOTUS followers, and hinted at during the oral arguments, the Court did not place any weight on the Wayfair case from 2018.

Last year (2018), SCOTUS analyzed the differences between the “minimum contacts” nexus (Due Process Clause) and the “substantial” nexus (Commerce Clause) in Quill Corp. v. North Dakota (91-0194), 504 U.S. 298 (1992) and South Dakota v. Wayfair, Inc., 585 U. S. ___ (2018). 

The Wayfair case overruled Quill regarding sales tax collections and physical presence giving states more authority in out-of-state taxation.

However, the Court relied on the original Quill, Brooke and Safe Deposit precedent for state taxation. The Court opines that the relevance of in-state contacts depends on “the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets.”

More on Wayfair and Quill (Forbes) here

How the SCOTUS Decision Impacts Self-Settled Asset Protection Trusts

In a Self-Settled Asset Protection Trust, the Grantor and Beneficiary are the same person. State taxing authorities could argue that the Grantor/Beneficiary retains control over assets which could amount to a source of wealth for the Grantor/Beneficiary.

The Court Argued:

“Although the Court’s resident-beneficiary cases are most relevant here, a similar analysis also appears in the context of taxes premised on the in-state residency of settlors and trustees. In Curry, for instance, the Court upheld a Tennessee trust tax because the settlor was a Tennessee resident who retained “power to dispose of” the property, which amounted to “a potential source of wealth which was property in her hands.” 307 U. S., at 370. That practical control over the trust assets obliged the settlor “to contribute to the support of the government whose protection she enjoyed.” Id., at 371; see also Graves v. Elliott, 307 U. S. 383, 387.”

More SCOTUS Decision Highlights With Insights

Justice Sotomayor-

“The Due Process Clause provides that “[n]o state shall . . . deprive any person of life, liberty, or property, without due process of law.” Amdt. 14, §1. The Clause “centrally concerns the fundamental fairness of governmental activity.” Quill Corp. v. North Dakota, 504 U. S. 298, 312 (1992), overruled on other grounds, South Dakota v. Wayfair, Inc., 585 U. S. ___, ___ (2018) (slip op., at 10). In the context of state taxation, the Due Process Clause limits States to imposing only taxes that “bea[r] fiscal relation to protection, opportunities, and benefits given by the state.” Wisconsin v. J. C. Penney Co., 311 U. S. 435, 444 (1940). The power to tax is, of course, “essential to the very existence of government,” McCulloch v. Maryland, 4 Wheat. 316, 428 (1819), but the legitimacy of that power requires drawing a line between taxation and mere unjustified “confiscation.” Miller Brothers Co. v. Maryland, 347 U. S. 340, 342 (1954). That boundary turns on the “[t]he simple but controlling question . . . whether the state has given anything for which it can ask return.” Wisconsin, 311 U. S., at 444.”

According to Justice Alito

Justice Alito filed agreed with Justice Sotomayor, in which Chief Justice Roberts and Justice Gorsuch also joined, to clarify that existing precedents still stand. He concluded his opinion with:

“The Due Process Clause requires a sufficient connection between an asset and a State before the state can tax the asset. For intangible assets held in Trust, our precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry. The opinion of the Court rightly concludes that the assets in this Trust and the Trust’s undistributed income cannot be taxed by North Carolina because the resident beneficiary lacks control, possession, or enjoyment of the trust assets. The Court’s discussion of the peculiarities of this Trust does not change the governing standard, nor does it alter the reasoning applied in our earlier cases. On that basis, I concur.”

Implications of SCOTUS Opinion on Universal Tax Law

SCOTUS did not universally rule that all beneficiaries no longer need to pay state income taxes. Instead, states should analyze the totality of connections.

Justice Sotomayor Stated:

“We hold 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. In limiting our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.”

The Court declined to address discretion on distributions:

“We have no occasion to address, and thus reserve for another day, whether a different result would follow if the beneficiaries were certain to receive funds in the future.” It sounds like the Court is preparing to address this issue in the future, but it could be a long time until the Supreme Court accepts another trust taxation case.”

In footnote 11 on page 13 of the SCOTUS Opinion, the Court opines that the location of the Trustee does not universally create the nexus to tax the Trust which would have changed many of the state laws.

The Court says:

“Because the reasoning above resolves this case in the Trust’s favor, it is unnecessary to reach the Trust’s broader argument that the trustee’s contacts alone determine the State’s power over the Trust.”

In Footnotes 8 & 11, the Court Leaves the Door Open for States to Create Their Own Laws:

“Even if beneficiary contacts—such as residence—could be sufficient in some circumstances to support North Carolina’s power to impose this tax, the residence alone of the Kaestner Trust beneficiaries cannot do so for the reasons given above.” In footnote 8, the Court states: “As explained below, we hold that the Kaestner Trust beneficiaries do not have the requisite relationship with the Trust property to justify the state’s tax. We do not decide what degree of possession, control, or enjoyment would be sufficient to support taxation.”

The Impact of SCOTUS Opinion on Various State Law

What the Court Says:

“The state directs the Court’s attention to 10 other state trust taxation statutes that also look to trust beneficiaries’ in-state residency, see Brief for Petitioner 6, and n. 1, but five are unlike North Carolina’s because they consider beneficiary residence only in combination with other factors, see Ala. Code §40–18–1(33) (2011); Conn. Gen. Stat. §12– 701(a)(4) (2019 Cum. Supp.); Mo. Rev. Stat. §§143.331(2), (3) (2016); Ohio Rev. Code Ann. §5747.01(I)(3) (Lexis Supp. 2019); R. I. Gen. Laws §44–30–5(c) (2010). Of the remaining five statutes, it is not clear that the flexible tests employed in Montana and North Dakota permit reliance on beneficiary residence alone. See Mont. Admin. Rule 42.30.101(16) (2016); N. D. Admin. Code §81–03–02.1–04(2) (2018). Similarly, Georgia’s imposition of a tax on the sole basis of beneficiary residency is disputed. See Ga. Code Ann. §48–7–22(a)(1)(C) (2017); Brief for Respondent 52, n. 20. Tennessee will be phasing out its income tax entirely by 2021. H. B. 534, 110th Gen. Assem., Reg. Sess. (2017) (enacted); see Tenn. Code Ann. §67–2–110(a) (2013). That leaves California, which (unlike North Carolina) applies its tax on the basis of beneficiary residency only where the beneficiary is not contingent. Cal. Rev. & Tax. Code Ann. §17742(a); see also n. 10, supra. 13The Trust also raises no challenge to the practice known as throwback taxation, by which a State taxes accumulated income at the time it is actually distributed. See, e.g., Cal. Rev. & Tax. Code Ann. §17745(b).

Location of the Trustee Does Create “Substantial” Nexus

The Court holds that since trustees get the benefit of home state protections, states can tax based on the location of the trustee. Beneficiaries (or settlors) base taxation on the fact pattern of each trust or the totality of the connections.

  • The Trustee is “the owner of [a] legal interest in” the trust property, and in that capacity, he can incur obligations, become personally liable for contracts of the trust, or have specific performance ordered against him.”
  • At the same time, the trustee can turn to his home state for “benefit and protection through its law,” id., at 496, for instance, by resorting to the state’s courts to resolve issues related to trust administration or to enforce trust claims, id., at 495. A state, therefore, may tax a resident trustee on his interest in a share of trust assets. Id., at 498.

“In sum, when assessing a state tax premised on the in-state 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. Because each individual fulfills different functions in the creation and continuation of the Trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or Trustee. When a tax hinges 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. Cf. Safe Deposit, 280 U. S., at 91–92.8 “

“Property in Their Hands” is a Vital Component to Taxability

Distributed income is subject to tax. The key to the Court’s opinion is whether something seems like a source of wealth or property in their hands. For example, the certainty of receiving income or control of investments can trigger even undistributed net income to be taxed by a state.

“First, the beneficiaries did not receive any income from the Trust during the years in question. If they had, such income would have been taxable. See Maguire, 253 U. S., at 17; Guaranty Trust Co., 305 U. S., at 23.”

“Second, the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue. The decision of when, whether, and to whom the Trustee would distribute the Trust’s assets falls to the Trustee’s “absolute discretion.” Art. I, §1.2(a), App. 46–47. The Trust agreement explicitly authorized the Trustee to distribute funds to one beneficiary to “the exclusion of other[s],” with the effect of cutting one or more beneficiaries out of the Trust. Art. I, §1.4, id., at 50. The agreement also authorized the Trustee, not the beneficiaries, to make investment decisions regarding Trust property. Art. V, §5.2, id., at 55–60. The Trust agreement prohibited the beneficiaries from assigning to another person any right they might have to the Trust property, Art. XII, id., at 70–71, thus making the beneficiaries’ interest less like “a potential source of wealth [that] was property in [their] hands.” Curry”

Trustee Discretion ≠ Beneficiary Distributions

The Court implied that the analysis on whether the “property will be in their hands” is the trustee’s discretion. Having a stated schedule of distribution could tip the taxation scale to the wrong side, but the Court thought that having some discretion in the trust document, even if written as “generous,” creates enough uncertainty and that the state cannot tax the trust.

“To be sure, the Kaestner Trust agreement also instructed the trustee to view the trust “as a family asset and to be liberal in the exercise of the discretion conferred,” suggesting that the Trustee was to make distributions generously with the goal of “meet[ing] the needs of the Beneficiaries” in various respects.

By reserving sole discretion to the Trustee, the Trust agreement still deprives Kaestner and her children of any entitlement to demand distributions or to direct the use of the Trust assets in their favor in the years in question.

Not only were Kaestner and her children unable to demand distributions in the tax years at issue, but they also could not count on necessarily receiving any specific amount of income from the Trust in the future.”

Update on the Fielding Case

The U.S. Supreme Court has not decided whether it will hear Minnesota’s Fielding case. The Court pushed the decision on the state taxation of trusts to the October 2019 term.

However, with a sweeping decision with Kaestner, another SCOTUS trust case seems less likely.

We will continue to closely monitor the implications of the Kaestner case and the developments of the Fielding case. More to come!

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