SCOTUS rules states need a stronger connection to tax a trust

U.S. Supreme Court
U.S. Supreme Court

The U.S. Supreme Court decided unanimously Friday in favor of the taxpayer in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, holding that North Carolina violated the Due Process Clause of the Constitution by taxing a trust based solely on the residence of a beneficiary. Justice Sonia Sotomayor delivered the unanimous opinion, while Justice Samuel Alito, joined by Justices John Roberts and Neil Gorsuch, filed a concurring opinion.

David O’Neil, a partner at Debevoise & Plimpton, argued the case before the Supreme Court in April.

“The decision was very gratifying,” he told Accounting Today. “We were confident based on the lower courts’ decisions, but it’s always a different ballgame when you go before the Supreme Court.”

“The ruling emphasizes the Constitution’s most profound guarantee,” he added. “The government cannot order a citizen to do something that is fundamentally unfair, and that includes forcing someone who has nothing to do with a state to pay taxes for services they didn’t use.”

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 1997, Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina. The trustee later divided Rice’s initial trust into three separate subtrusts, and North Carolina sought to tax the Kimberley Rice Kaestner 1992 Family 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. The state assessed a tax of more than $1.3 million for 2005 through 2008. During that time 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 sued the Department of Revenue in state courts. Representatives of the trust argued that applying the tax to the trust violated the Fourteenth Amendment’s Due Process Clause. The state courts agreed, holding that the connection between North Carolina and the trust was insufficient to satisfy the requirements of due process.

The Supreme Court agreed, and 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 case will impact states that have a law similar to North Carolina’s, where tax is imposed based solely on the residence of a beneficiary, as well as states where residence is one factor among many, O’Neil observed. “But the real next battle will be where tax turns on the state the settlor lived in when the trust was created,” he added.

Debevoise partner David Bernstein, the trustee of the Kaestner Family Trust since 2005, said, "A contrary ruling would have wreaked havoc on trust administration, forcing trustees to track the travel and temporary residence of all contingent beneficiaries, and opening trusts up to duplicate taxation in potentially all 50 states.”

Mark Powell, a partner at Dorsey & Whitney in the firm’s Tax, Trusts & Estates Practice Group, agreed. “As society becomes increasingly mobile and trustees deal with beneficiaries who move from one state to another, the spectre of taxes being due based simply on beneficiary residence haunts everyone involved with a trust,” he said.

“This is particularly true in high-tax states like California, where complicated plans are frequently implemented to avoid state income tax,” said Powell. “Planners and beneficiaries alike have learned to live with complications like distribution committees that may no longer be necessary or appropriate. The Kaestner case means participants in such plans should consult their advisors to see if their plans can be simplified.”

“The potential for trusts and beneficiaries to evade tax under this decision was not reason enough for the court to impute the minimum contact between the state and the trust,” observed Reed Smith associate Megan Miller. “Justice Sotomayor said that the fact that this was a potential consequence was not a factor to be considered.”

Although the concurring opinion would apply more broadly, the majority opinion was more narrow, according to Michael Lurie, also a Reed Smith associate. “The majority addressed the issue of taxation of a contingent beneficiary,” he said. “It left open the question of whether a state can tax a trust if the beneficiary is a noncontingent beneficiary.”

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