SCOTUS Highlights and Insights From the Kaestner Oral Arguments

The United States Supreme Court Hears Oral Arguments for North Carolina v. Kaestner

On April 17, 2019, the United States Supreme Court heard the oral arguments in perhaps the most significant trust case in 100 years: North Carolina Department Of Revenue, Petitioner, V. The Kimberley Rice Kaestner 1992 Family Trust, Respondent. 

The crux of the Kaestner case is whether the state of North Carolina should be able to constitutionally tax trusts where the only connection to the state is that the beneficiary is a resident.

In the state of North Carolina, the taxpayer won throughout the entire court system, but North Carolina appealed successfully to the U.S. Supreme Court.

Matthew W. Sawchak, North Carolina Solicitor General, argued on behalf of the Petitioner and David A. O’Neil, Esq., of Debevoise & Plimpton LLP  on behalf of the Respondent.

In the hour-long arguments, the Justices actively participated, frequently interrupting the counsels. Overall, based on our initial analysis of the transcript, the line of questioning from the majority of the Justices seemed to be slightly more sympathetic to the Respondent. However, there were several times the Justices were challenging the Respondent’s arguments.

As always with the Supreme Court, it is difficult to tell the outcome until the decision is published.

Hypothetical Outcomes

More Context By Including the Fielding Case?

The central argument seems to focus on what is the connection of a trust to a location – trustee, place of administration or the beneficiary. Interestingly, there was no discussion over the location of the grantor – which is the central argument in the Fielding case from Minnesota.

We are closely watching to see if SCOTUS will hear Fielding as well providing more context to taxing resident trusts.

In this case, there are many ways the court could decide whether to grant for the respondent, rule for the petitioner, or the send the case back to North Carolina for further analysis.

Michael Redden, Redden Law, PLLC, Provides Insight

We reached out to an estate planning attorney in Minnesota with whom we have been closely monitoring the Fielding case which carries similar trust taxation issues as the Kaestner case.

Click here to see our summary of both cases.

Michael Redden shared his insights with the oral arguments with us:

“The Court took note that the state was essentially asking the Court to overturn 100 years of tax precedent to reach the conclusion that the beneficiaries residence alone should determine. It is essentially a personal jurisdiction question. Who owns the trust assets? When do they own the trust assets? Traditionally, it has always been the trustee and not the beneficiaries.

“This is analogous to the legal fiction that a corporation is a person. A corporation is a separate person from the shareholders. The shareholders ultimately benefit from the economic activity, but the corporation is separately taxed and has separate legal character. The same principle applies here but is even more powerful.

“Why?

“Because there is an actual person there: the trustee. The beneficiaries may ultimately benefit, but the ownership is held in the personhood of the trustee.

“Discretionary trusts further embody this. The court seemed to look to this ownership question: When does the beneficiary own the property?

“It’s when they control the property. Just like when stock options and incentives vest. The Court focused on this question.

“Interestingly enough, the Court also spent time considering the ability of a beneficiary to change tax residency and how that might affect the state of taxation. This topic will be central to any consideration of the Fielding case should the Court decide to hear it. One way or another, either 100 years of tax precedent will be adjusted or the tax regimes of 33 states will.”

Expectations and Speculations

Based on the arguments, we were pleased that the Court seems to be settling in that this is a Due Process case (and not a Commerce Clause case) and seems to be set on deciding either way based on the arguments.

Our expectation, given the arguments, is that we don’t think the Court will give practitioners broad constitutional direction on all state trust taxation laws, but narrower guidance on the taxation of beneficiaries.

It is possible that the Court could solely rule regarding the taxation of discretionary trusts as the arguments centered around them.

Much Chatter Regarding Throw-Back Taxes

It would not be unreasonable for the court to opine that current state income taxation of undistributed trust income would be unconstitutional, but throw-back taxes would be permissible.

A combination of a narrow ruling on Kaestner and the Court not granting a writ of certiorari on Fielding could lead to an interesting situation for practitioners.

Furthermore, given the discussion surrounding adjudication v. taxation, it will be interesting to see whether the Court’s opinion will impact out-of-state asset protection trusts, specifically states’ arguments over jurisdiction of trusts.

Highlights from the Oral Arguments

Below, we highlight some of the exchanges and questions from the discussion yesterday. For those who are interested in the full transcript, it is 69 pages.

You may check the transcript out here.

All text within quotations is taken from the SCOTUS transcript linked above.

Initial Questions from Justices Ginsburg and Sotomayor

Right away, Justice Ginsburg asked Mr. Sawchak: “But you couldn’t – you couldn’t tax the beneficiaries on that accumulated income when they haven’t received it?”

Justice Sotomayor chimed in a bit later to the Petitioner: “But it still begs the question. What makes it your right under any circumstance to tax all of the trust income where there’s no guarantee that she is going to receive all of it at any point?”

Justice Breyer weighs in

Justice Breyer had one of the most extended remarks from Mr. Sawchak: “Look, the trustee lives in New York, okay? The settlor is in New York. All the administration is in New York. There is one thing that’s going to happen in North Carolina. The thing that’s going to happen in North Carolina is if she is there when it’s distributed, she’ll get some money. Okay? Which you’re totally free to tax. But that isn’t what want to tax. You want to tax all these things which are everyone except her is in New York, and moreover, we don’t even know if she’ll ever get the money.

“Now there’s something wrong with that. I don’t know, it doesn’t say specifically about trusts in the Constitution, but, thus, I mean, lots of trusts say there are 10 beneficiaries, each one lives in a different state, and I, the trustee, have total discretion as to who give this money to and maybe I’ll give it to none of them.

“So here’s a woman who might get none of it, and you want to tax that. Is that right? Do I have the facts right?”

Justice Breyer later looked to simplify his line of questioning: “Let me make it simpler. There are five beneficiaries. One lives in North Carolina. As it turns out, that one in North Carolina gets $3. The others get $999,997. But North Carolina does not tax $3. What it taxes is 20 percent or $200,000. Do I have my facts right?”

Justice Sotomayor: is unequally taxing beneficiaries leading to changing grantor’s intent

Justice Sotomayor’s line of questioning is asking whether unequal state taxation could be interpreted as potentially changing the settlor’s intent and if the trustee needs to take that into account in distribution decisions.

Justice Sotomayor asks: “But you’re changing the trust instrument because you as a state are saying the trust must give them 20 percent each, because, regardless of what the terms of the trust are, I’m going to tax you on that 20 percent even though you might get none, even though you might get more. You’re still a trust, you’re being charged for 20 percent because you should have given her 20 percent. That’s really what you’re saying, isn’t it?”

Mr. Sawchak: “That –you’re right, Your Honor, to say there is a –assuming nothing’s in the trust instrument, there would be a full –”

Justice Sotomayor: “No, there is something in the trust instrument here. The trust instrument says that the trustee has absolute discretion to give her something or nothing, to give three people–I think there’s two or three children; I don’t know how many there are here, but let’s assume there’s four of them, her and three children, for using even numbers.

“The trustee could choose to –if she had a disabled child, to give it all to the disabled child or to divide it among the three because she’s very rich and they’re not. The trustee has a lot of discretion. But you, the state, are changing the terms of the trust instrument in saying each of them must still pay 25 percent.”

Mr. Sawchak: “That is correct, that nothing else appearing, we make the pro rata. And here’s why that’s fair. First of all, throughout the period in question, those people had true ownership of the accumulating assets. Secondly, also essentially on a pro rata basis, North Carolina is protecting each of them.”

Back-and-Forth Between Justice Gorsuch and Mr. Sawchak regarding overruling SCOTUS precedents

Justice Gorsuch: “And, counsel, along those lines, if I’m –if I’m understanding your position correctly, because you think that rule is inequitable, you’d have us overrule Safe Deposit and Brooke, two decisions of this Court that suggest that that’s the correct rule, is that right?”

Mr. Sawchak: “Not overrule them, Your Honor. They could be –”

Justice Gorsuch: “Well, what would you have us do with them if it’s not overruling them?”

Mr. Sawchak: “Two things, Your Honor. First of all, they can be distinguished in terms of being property tax cases versus income tax cases, because this Court –”

Justice Gorsuch: “Let’s say I don’t find that distinction particularly significant. It’s slicing the baloney a little too thinly. Then what?”

Mr. Sawchak: “Then we would be really within the proposition of the due process part of Quill, where these are decisions that have been superseded by the movement –”

Justice Gorsuch: “Right. You’re -you’re asking us to overrule them. I mean, it’s a polite way of saying overrule, isn’t it?”

Mr. Sawchak: “They’ve probably, frankly, already been laid aside by other –by the due process decisions, as this Court’s noted in -”

Justice Gorsuch: “But that’s a -that’s a really nice way of saying overrule them.”

(Laughter.)

Justice Gorsuch: “Right?”

Mr. Sawchak: “They’ve probably already been -”

Justice Gorsuch: “I’ve already been overruled; we just haven’t said so.”

Mr. Sawchak: “That’s probably right, Your Honor, and let me say why that’s –”

Justice Gorsuch: “Okay. All right. And –and you’d have us overrule them in the name of fundamental fairness, is that right?”

Mr. Sawchak: “In the name of fundamental fairness because –”

Justice Gorsuch: “And –and Justice Breyer’s problems notwithstanding, that–that fundamental fairness problem, we shouldn’t take into account?”

Mr. Sawchak: “No, there are criteria, a variety of criteria out there, and every one of them –”

Justice Gorsuch: “That’s more fundamentally fair than the existing rule of this Court that’s almost 100 years old?”

Mr. Sawchak: “So query whether that really is the existing rule, first of all. Those are –”

Justice Gorsuch: “Well, right, except for the fact that we haven’t overruled it, but we really have. Okay. But assuming we thought those were still precedents of the United States Supreme Court –let’s just spot me that for the moment.”

(Laughter)

Justice Gorsuch: “–you think it’s more fair to overrule them and proceed down the track we’ve just illuminated with Justice Breyer than to maintain them?”

And later Justice Sotomayor asks: “Hanson, you would be asking us to overrule because I don’t know how you can tax somebody you have no jurisdiction over, especially if they haven’t done anything like pay any money over or have no contacts with the person in your state. All the meetings were in New York. So add a third case you want to overrule.”

Justice Sotomayor’s exchange on trust location

Justice Sotomayor: “So how is the trust in your state?”

Mr. Sawchak: “Pardon me, Your Honor?”

Justice Sotomayor: “I thought the trust is represented by the trustee. And the trustee is not in your state.”

Mr. Sawchak: “The –the trust has its presence –”

Justice Sotomayor: “It’s not being administered in your state.”

Mr. Sawchak: “True, but its true owner, its central figure, is in North Carolina. Let me offer”

Justice Sotomayor: “So why didn’t we say that in Hanson?”

Mr. Sawchak: “So Hanson, first of all, is a situation where the burden of adjudication, by the way, not taxing, fell on the person of the trustee. This Court in Walden described –”

Justice Sotomayor: “The same thing here. You’re making the trustee liable for paying the tax. You’re doing exactly what happened in Hanson.”

A discussion on discretionary v. non-discretionary trusts with Mr. O’Neil, the counsel for Respondent

Justice Kagan: “Would your position be different if she were–if–if the–if the trustee did not have this discretion as to shares? Suppose that the –the trust instrument simply said, here are the five beneficiaries. The trust will be distributed pro rata. You know, if one dies, then it will be distributed pro rata as to the other four. But –but –but the beneficiaries all know that they’re going to get a fifth of this money. Would your answer be different?”

Mr. O’Neil: “If the trust instrument gave her a vested, current right to the income, then we wouldn’t –”

Justice Kagan: “Not a current right. She’s going to have to wait until she’s whatever years old, 30, 40, whatever. She can’t pull the money now. But she’s going to get the money one day.”

Mr. O’Neil: “No, that –that case would not be different because it would still be based on this speculative possibility that she will ultimately receive the money.”

Justice Kavanaugh brings up whether they can leave some points open

Justice Kavanaugh: “If –I thought we didn’t need to answer the question raised by Justice Kagan’s previous hypothetical, and just raised by you, which is, if we did know, in other words, if it were guaranteed or certain, that might or might not be a different case.

“But this case is one where we don’t know based on the nature of the trust contingent or discretionary beneficiary, and for that case, the answer, I thought you were arguing, should be that the state where the beneficiary resides cannot tax, but we could leave open the question raised by Justice Kagan’s hypothetical.”

Later, Justice Sotomayor added: “So the thing that Justice Kavanaugh and Justice Alito were reserving, and I assume Justice Kagan, was on the question of what happens if she is a guaranteed distributor–distributee, meaning she can’t call it today, but at age 40 or at the end of the trust life, at some point, she’s going to be the 100 percent owner or going to be a fixed 10 percent owner, whatever it might be, they’re saying we should reserve on that question?”

Justice Alito sympathetic to Respondent

Justice Alito: “But I thought this case was simpler than your argument seems to be making it. I thought this was a case about a state imposing a tax on someone for money that that person may never get. And if –and if the person ever gets some money, we’d have no idea how much that money would be. Isn’t that what this case is about?”

Could states impose throw-back taxes as the Federal Government does with offshore trusts?

Mr. O’Neil: “Can the trust? No, at that point, it won’t be trust property. At that point, it will be the beneficiary’s property. And this –you know, the federal government has the same issue. U.S. citizens can have trusts that are located abroad, and what the federal government does is impose a throw-back tax so that when the beneficiary actually receives the money, the beneficiary can be taxed not only on that distribution but also on –on income that had accumulated in previous years and that the trustee did not pay taxes on.”

Justice Kavanaugh: “And throw-back taxes are –are permissible, constitutional? You’re not challenging those in any way?”

Mr. O’Neil: “We are not. [ …] ”

Mr. O’Neil later said: “I’d like to just focus, if I could, on the –on the point of the throw-back tax because I do think –I do think it is an answer to why –to the state’s concern about all of the potential loss of revenue that it may –may –may lose out on here.

“If and when this money is actually distributed to the beneficiary, if she is a North Carolina resident at that time, the state can get all of this income tax back by taxing the beneficiary.”

Alliance Trust Company of Nevada will continue to monitor this case very closely.

State of the Union to Propose Stealth Increase of Estate Taxes

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The Wall Street Journal and numerous other media outlets are reporting that the State of the Union address on Tuesday will outline a proposal by the President to effectively increase estate taxes.  In the proposal, appreciated assets in an estate would not receive an updated or “stepped up” tax basis on death.  Only a small amount of gains, suggested as $200,000 in portfolio assets and $500,000 in a primary residence would be shielded from tax.  Although these numbers may seem large, ask many families what their tax-cost basis is in desirable places to live, such as Silicon Valley and other parts of California, and you will see that this proposal would capture many more families with a taxable event on death even without a formal change to the estate tax rules.  There are many estate planning strategies that can help with families facing estate tax burdens.  Some of the best strategies use Nevada Trusts – the best state for asset protection and tax minimization.  Please call Greg Crawford in Reno at 775-297-4684 for more information.

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