Supreme Court hears arguments on major state trust tax case

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The Supreme Court heard oral arguments Tuesday in a case involving a state’s ability to tax income from a trust based on the beneficiaries residing there before taking any distributions.

At issue in the case, North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, is whether the Due Process Clause of the Constitution prohibits states from taxing the undistributed income in a trust that has no ties to the state other than a discretionary beneficiary residing in the state.

Withers Bergman LLP partners David Lehn and William Kambas, along with other Withers Bergman LLP partners, authored an amicus brief in support of the trust. In the brief, they noted that the Supreme Court’s holding in Wayfair altered but did not eliminate minimum nexus thresholds. “Reversal of the decision of the North Carolina Supreme Court in this case would eliminate such Constitutional standard, to the detriment of the orderly administration of state and federal tax systems,” they stated.

In a 2016 decision in the Court of Appeals of North Carolina, the North Carolina Department of Revenue lost an appeal from a North Carolina Superior Court decision holding that the state did not demonstrate the minimum contacts necessary to satisfy the principles of due process required to tax an out-of-state trust.

The North Carolina Supreme Court affirmed the lower court’s grant of summary judgment in favor of the trust and upheld the order directing the Department of Revenue to refund taxes and penalties paid by the trust.

The original trust was established by settlor Joseph Lee Rice III. Its situs, or location, was New York. The primary beneficiaries of the original trust were the settlor’s descendants, none of whom lived in North Carolina at the time of the trust’s creation. In 2002, the original trust was divided into three separate trusts, one for each of the settlor’s children. Kimberly Rice Kaestner, Daniel Rice and Lee Rice. At that time in 2002, Kimberley Rice Kaestner, the beneficiary of The Kimberley Rice Kaestner Rice Kaestner Family Trust, was a resident of North Carolina.

Tax returns were filed in North Carolina on behalf of the trust for tax years 2005-2008 for income accumulated by the trust but not distributed to a North Carolina beneficiary. In 2009, the trust filed a claim for refund of taxes paid amounting to $1,303,172.

Representatives of the trust asserted that the department’s contention that a beneficiary’s residence alone is sufficient to satisfy the minimum contacts requirement of the Due Process Clause and allow a state to tax a nonresident trust conflates what the law recognizes as separate legal entities — the trust and the beneficiary. The Court of Appeals of North Carolina and the Supreme Court of North Carolina agreed, holding that the connection between North Carolina and the trust was insufficient to satisfy the requirements of due process.

Lehn, who was present at the oral arguments, observed that the justices were all interested in and engaged in the discussion. Having read the transcript, Kambas added that the justices appeared to carefully consider "the component parts of the trust system.”

Lehn was glad to see the justices’ recognition that “it was a discretionary trust and the State of North Carolina was trying to tax an individual that had no right to anything. One of the justices said to the Solicitor General of North Carolina that he was trying to change the terms of the trust.”

“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,” said Justice Sonia Sotomayor.

“We would like to think that they would uphold the North Carolina Supreme Court,” said Kambas.

"But it’s never a slam dunk," Lehn added. “If they wanted to affirm, they could have simply let stand the lower court’s holding, so the fact that they decided to hear the case makes people nervous,” he said.

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Tax-related court cases Trusts State taxes South Dakota v. Wayfair SCOTUS