The Supreme Court has issued its opinion in North Carolina Dept. Rev. V. Kaestner 1992 Family Trust, 588 U.S. ___ (2019). The Supreme Court held 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 to receive it.”
The Syllabus is as follows:
Joseph Lee Rice III formed a trust for the benefit of his children in his home State of New York and appointed a fellow New York resident as the trustee. The trust agreement granted the trustee “absolute discretion” to distribute the trust’s assets to the beneficiaries. In 1997, Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina. The trustee later divided Rice’s initial trust into three separate sub- trusts, and North Carolina sought to tax the Kimberley Rice Kaestner 1992 Family Trust (Trust)—formed for the benefit of Kaestner and her three children—under a law authorizing the State to tax any trust income that “is for the benefit of” a state resident, N. C. Gen. Stat. Ann. §105–160.2. The State assessed a tax of more than $1.3 million for tax years 2005 through 2008. During that peri- od, Kaestner had no right to, and did not receive, any distributions. Nor did the Trust have a physical presence, make any direct investments, or hold any real property in the State. The trustee paid the tax under protest and then sued the taxing authority in state court, arguing that the tax as applied to the Trust violates the Fourteenth Amendment’s Due Process Clause. The state courts agreed, holding that the Kaestners’ in-state residence was too tenuous a link between the State and the Trust to support the tax.
Held: 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 to receive it. Pp. 5–16.
(a) 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. Compliance with the Clause’s demands “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax,” and that “the ‘income attributed to the State for tax purposes . . . be rationally related to “values connected with the taxing State,” ’ ” Quill Corp. v. North Dakota, 504 U. S. 298, 306. That “minimum connection” inquiry is “flexible” and focuses on the reasonableness of the government’s action. Id., at 307. Pp. 5–6.
(b) In the trust beneficiary context, the Court’s due process analysis of state trust taxes focuses on the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets. Cases such as Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U. S. 83; Brooke v. Norfolk, 277 U. S. 27; and Maguire v. Trefry, 253 U. S. 12, reflect a common principle: When a State seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary con- trols or possesses and how that interest relates to the object of the State’s tax. Safe Deposit, 280 U. S., at 91. Similar analysis also ap- pears in the context of taxes premised on the in-state residency of settlors and trustees. See, e.g., Curry v. McCanless, 307 U. S. 357. Pp. 6–10.
(c) Applying these principles here, the residence of the Trust beneficiaries in North Carolina alone does not supply the minimum connection necessary to sustain the State’s tax. First, the beneficiaries did not receive any income from the Trust during the years in question. Second, they had no right to demand Trust income or otherwise control, possess, or enjoy the Trust assets in the tax years at issue. Third, they also could not count on necessarily receiving any specific amount of income from the Trust in the future. Pp. 10–13.
(d) The State’s counterarguments are unconvincing. First the State argues that “a trust and its constituents” are always “inextricably intertwined,” and thus, because trustee residence supports state taxation, so too must beneficiary residence. The State emphasizes that beneficiaries are essential to a trust and have an equitable interest in its assets. Although a beneficiary is central to the trust relationship, the wide variation in beneficiaries’ interests counsels against adopting such a categorical rule. Second, the State argues that ruling in favor of the Trust will undermine numerous state taxation regimes. But only a small handful of States rely on beneficiary residency as a sole basis for trust taxation, and an even smaller number rely on the residency of beneficiaries regardless of whether the beneficiary is certain to receive trust assets. Finally, the State urges that adopting the Trust’s position will lead to opportunistic gaming of state tax systems. There is no certainty, however, that such behavior will regularly come to pass, and in any event, mere speculation about negative consequences cannot conjure the “minimum connection” missing between the State and the object of its tax. Pp. 13–16.
Note: Thanks to Jim Perna, attorney for bringing this to our attention.
Posted by Lewis J. Saret, Co-General Editor, Wealth Strategies Journal..