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U.S. Supreme Court: In-state beneficiary, taxation of undistributed trust income

U.S. Supreme Court: In-state beneficiary

The U.S. Supreme Court today decided in favor of the taxpayer, finding that the presence of in-state beneficiaries alone is insufficient to allow a state (here, North Carolina) to tax undistributed trust income when an in-state beneficiary has no right to demand that income and is uncertain to receive it in the future.

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In the unanimous decision authored by Justice Sotomayor, the Court concluded that the residence of “beneficiaries in North Carolina alone does not supply the minimum connection necessary to sustain the State’s tax.” The case is: North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust, No. 18-457, 588 U.S. ___ (S. Ct. June 21, 2019). Read the Supreme Court’s decision [PDF 153 KB]

The Court’s decision relies on the Due Process analysis employed in Quill Corp. v. North Dakota, 504 U.S. 298 (1992) and dismisses the state’s contention that Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83 (1929) is no longer good law. In affirming the North Carolina Supreme Court’s decision, the U.S. Supreme Court expressly declined to “decide what degree of possession, control, or enjoyment would be sufficient to support taxation.”

Background

Joseph Rice created a trust for the benefit of his children in 1992. The trust was executed in New York, where he resided at the time, and the agreement specified that the trust was governed by New York law. In 2002, the trustee divided the trust into three separate trusts, one for the benefit of each of the settlor’s children, for administrative convenience. The taxpayer in the case is one of these trusts—the Kimberly Rice Kaestner 1992 Family Trust.

No party to the trust resided in North Carolina until one of the beneficiaries moved there in 1997. For the tax years at issue, the trustee was a Connecticut resident and ownership documents and other records were kept in New York. The primary contingent beneficiary of the trust was a North Carolina resident, but two contingent secondary beneficiaries (Joseph Rice’s spouse and sister) resided outside North Carolina. The trustee had broad authority to manage the trust property, and distributions were made at his sole discretion. The beneficiaries had no right to compel a distribution for any reason and were never guaranteed to receive any funds from the trust.  No distributions were made during the years at issue.

North Carolina imposed tax on the income accumulated in the trust, although:

  • No income was distributed to a North Carolina beneficiary during the years at issue.
  • The beneficiary had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue.
  • The beneficiary could not count on necessarily receiving any specific amount of income from the trust in the future.

The sole basis for jurisdiction to tax was the contingent primary beneficiary who lived in the state, and this triggered a statute requiring the trustee to pay tax on the income of the trust property that is for the benefit of a North Carolina resident. The trust paid the tax and then brought this action after its refund request was denied.

The case made its way to the North Carolina Supreme Court, which held that North Carolina’s law violated the Due Process of the U.S. Constitution. The state’s high court held that the taxpayer itself must have purposefully availed itself of the benefits and protections of the state. Therefore, the high court found that the beneficiary's residence in North Carolina did not establish the minimum contact required by the Due Process Clause to tax the Trust.

North Carolina subsequently filed a petition for certiorari, which was granted, and oral argument was held on April 16, 2019. 

Petitioner’s (state’s) argument

North Carolina’s arguments can be narrowed down to two main points.

  • First, the state emphasized that the beneficiary’s presence in North Carolina was sufficient to satisfy the requirements of the Due Process Clause. In its brief, the state argued that “because a trust is just a relationship between multiple people, a trust has no jurisdictional contacts of its own. Instead, its contacts are those of the people in the trust relationship. After all, serving the beneficiary’s interests is a trust’s reason for being. When a state provides benefits and protections to a trust beneficiary, the state benefits her trust.” Therefore, the state argued, the taxpayer had the minimum contacts required by the Due Process Clause to tax the trust income. Further, the tax was “rationally related to values connected with North Carolina” because all of the Trust’s income during the years at issue were for the benefit of the North Carolina resident beneficiary.
  • Second, the state asserted that the North Carolina law should stand to prevent a taxpayer planning a trust around state law to evade taxation. The state noted that Connecticut (the residence of the trustee) and several other states do not impose tax on a trust based on the trustee’s residency. Therefore, a law that imposes tax based on the trustee’s residence creates a tax shelter that allows trusts to avoid tax merely by choosing a trustee that resides in a state that does not tax trusts. 

Respondent’s (trust’s) argument

The main focus of the respondent (trust) was equally simple—the state of North Carolina did not have jurisdiction to tax the trust because the beneficiary lacked control over the trust and had no present right to the trust income or principal and no guarantee of either. The trust agreement gave the trustee absolute discretion over the administration and disposition of the trust property. Further, the agreement explicitly prohibited the beneficiaries from alienating or assigning trust property.

Responding to the state’s minimum contacts argument, the trust pointed out all the ways in which the trust had no contact with North Carolina:

  • The trust agreement was executed in New York and subject to New York law
  • No trust property was located in the state
  • No income was derived directly from a North Carolina source
  • The custodian of the trust assets was located in Massachusetts
  • Records were kept in New York
  • The settlor and the initial trustee were New York residents and domiciliaries
  • The current trustee was a Connecticut resident

In fact, the beneficiary was not even aware of the trust until 2006 (the second of the four tax years at issue). The beneficiary had her first meeting with the trustee in 2007 in New York and had infrequent contact with him for the remainder of the tax period at issue. Most importantly, the beneficiaries neither received nor were entitled to any trust income during the tax years at issue.

In response to the state’s tax shelter argument, the trust’s brief stated that “North Carolina’s grievance is not that the States lack constitutional power to tax, but rather that the States with constitutional power to tax have chosen not to exercise it.” Further, the brief noted that misplaced policy concerns regarding the impact of the lower courts’ decisions on state tax revenues did not justify North Carolina’s jurisdictional overreach.

Limits on state jurisdiction are a consequence of federalism, which promotes and respects the sovereign right of each State to set its tax policy without interference from other States that lack a legitimate interest. North Carolina’s jurisdiction does not expand because it disagrees with the policy choices of other States to refrain from exercising their constitutional power.

U.S. Supreme Court’s decision

The Court’s opinion today 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 ever to receive it.” 

The majority was careful to not overstate the implications of its holding and made clear its decision was limited to the specific facts before the Court and that it was not implying “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.”

In a concurring opinion, Justice Alito emphasized that the decision is to be interpreted narrowly. The concurring opinion,  joined by Chief Justice Roberts and Justice Gorsuch, states:  “I write separately to make clear that the opinion of the Court merely applies our existing precedent and that its decision not to answer questions not presented by the facts of this case does not open for reconsideration any points resolved by our prior decisions.”

The Court analyzed whether due process was met using its two-step analysis summarized in Quill, first looking for “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax” and whether the income attributed to the state for tax purposes was “rationally related to values connected with the taxing State.” Looking to Safe Deposit, the Court emphasized that, in the context of beneficiary contacts, 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 explained that taxation based on the in-state residency of a constituent of the trust—be it the beneficiary, settlor or trustee—the focus must be on the “particular relationship between the resident and the trust assets that the State seeks to tax.”

The Supreme Court’s holding is premised on three findings: (1) the trust beneficiaries received no income during the years in question; (2) the trust beneficiaries had no right to demand trust income and could not control, possess, or enjoy the trust assets during the years in question; and (3) the trust beneficiaries were not guaranteed any future payments from the trust.

The Supreme Court rejected the state’s arguments that the privileges enjoyed by residents were sufficient to establish a minimum connection with the state. The Court pointed out the “wide variation in beneficiaries’ interest” and that this variation “counsels against adopting the categorical rule that the State urges.” Similarly, the Court dismissed the state’s concern that adopting the trust’s position “will lead to opportunistic gaming of state tax systems” and noted that “mere speculation about negative consequences cannot conjure the minimum connection missing between North Carolina and the object of its tax.”

With respect to the state’s argument regarding potential for tax shelters, the Court answered that “mere speculation about negative consequences cannot conjure the ‘minimum connection’ missing between the State and the object of the tax.” 

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