Does the Due Process Clause of the Fourteenth Amendment permit states to tax the undistributed income of non-resident trusts based solely on the trust beneficiaries’ in-state residency?
In this case, the Supreme Court will determine whether a state in which a trust’s beneficiaries reside has the power to tax that trust’s income. Under the Due Process Clause of the Fourteenth Amendment, a state has the authority to tax an individual or entity—such as a trust—if that entity has “minimum contacts” with the state. North Carolina Department of Revenue argues that a beneficiary’s residence in a state provides sufficient minimum contacts between a trust and a state to authorize the state to tax the trust’s income. Kimberley Rice Kaestner 1992 Family Trust, on the other hand, contends that a state does not have the authority to tax a trust’s income based solely on the fact that beneficiaries reside in that state. The outcome of this case will determine the limits on state power to tax trusts and will have implications for all those involved in trust creation, management, and benefits.
Questions as Framed for the Court by the Parties
Whether the due process clause prohibits states from taxing trusts based on trust beneficiaries’ in-state residency.
In 1992, Joseph Lee Rice III, created the Joseph Lee Rice, III Family 1992 Trust in New York. On December 30, 2002, the single trust was divided into three sub-trusts, with each of Rice’s three children serving as a beneficiary for one of the sub-trusts. In 2006, the trustee, David Bernstein, a Connecticut resident, separated the three sub-trusts into three separate trusts.
Respondent, the Kimberley Rice Kaestner 1992 Family Trust (“Kimberley Rice”), was one of these trusts formed for the benefit of Rice’s daughter, Kimberley Rice Kaestner, and her children, all of whom resided in North Carolina during the relevant tax years. Although Kimberley Rice’s beneficiaries live in North Carolina, New York law holds that the trust is governed by New York law because it was first created in New York.
From 2005 to 2008, Petitioner, North Carolina Department of Revenue (“North Carolina”), taxed Kimberley Rice on all of the trust’s accumulated income even though North Carolina beneficiaries received no income distributions from Kimberley Rice during those tax years. Additionally, the trustee, Bernstein, retained control over the distribution of Kimberley Rice’s income during these years.
Kimberley Rice requested a refund of the North Carolina taxes, which amounted to over $1.3 million, but North Carolina refused. Consequently, on June 21, 2012, Kimberley Rice filed suit against North Carolina, claiming that North Carolina’s General Statute §§ 105-160.2 (“N.C.G.S. §§ 105-160.2”), under which North Carolina has the authority to tax trust income benefitting a state resident, is unconstitutional under both the United States Constitution and the North Carolina State Constitution. Kimberley Rice argued that the trust did not have the necessary minimum contacts with North Carolina to provide the state with the authority to tax Kimberley Rice under the Due Process Clause. Kimberley Rice also claimed that North Carolina’s tax violated the Commerce Clause. Kimberley Rice requested that the court order North Carolina to refund the taxes it collected during the relevant tax years and stop North Carolina from collecting any taxes on the trust in the future. North Carolina moved to dismiss the case.
The North Carolina Business Court granted North Carolina’s motion to dismiss with regard to Kimberley Rice’s request for an injunction, but denied North Carolina’s motion to dismiss with regard to Kimberley Rice’s constitutional claims. Kimberley Rice and North Carolina both filed motions for summary judgment. The Business Court granted Kimberley Rice’s motion for summary judgment, holding that N.C.G.S. §§ 105-160.2 violates both the Due Process and Commerce Clauses of the United States Constitution.
On appeal, the North Carolina Court of Appeals affirmed the Business Court’s decision, holding that N.C.G.S. §§ 105-160.2 violates the Due Process Clause because the fact that beneficiaries of Kimberley Rice reside in North Carolina does not provide North Carolina with sufficient minimum contacts to tax Kimberley Rice in accordance with due process requirements. The Court of Appeals did not decide whether this taxation scheme violates the Commerce Clause.
North Carolina appealed this decision to the Supreme Court of North Carolina, arguing that the beneficiaries’ residency in North Carolina is sufficient to satisfy due process requirements. Furthermore, North Carolina asserted that the trustee’s actions, which allowed Kimberley Rice to benefit from North Carolina, established sufficient minimum contacts to allow the state to tax the trust. The Supreme Court of North Carolina, however, disagreed with North Carolina, and instead, affirmed the Court of Appeals’ decision that N.C.G.S. §§ 105-160.2 violated the Due Process Clause when North Carolina used it to tax Kimberley Rice. The Supreme Court of North Carolina held that a trust does not have sufficient minimum contacts with a state to satisfy due process requirements when the trust’s only connection to the state is that the trust’s beneficiaries reside there.
WHOSE CONTACTS MATTER WHEN ESTABLISHING MINIMUM CONTACTS?
North Carolina argues that the Due Process Clause of the Fourteenth Amendment empowers a state to tax those who have minimum contacts to the state. North Carolina contends that there is no “formalistic test” that determines whether such minimum contacts exist. For example, explains North Carolina, a taxpayer may have minimum contacts to a state even though the taxpayer does not maintain a physical presence in the taxing state. This is especially the case with trusts, asserts North Carolina, because trusts are mere “abstractions” that do not have any physical presence. In other words, states North Carolina, a trust can only form contacts with a state through those individuals who constitute the trust relationship, namely, the trust’s settlor, trustee, and beneficiary. North Carolina therefore reasons that it is the contacts of these trust constituents that determine whether the trust itself has minimum contacts with a state. While acknowledging that the Internal Revenue Code treats certain trusts as entities separate from their constituents for tax purposes, North Carolina asserts that a trust should not be viewed as a separate entity for the constitutional purpose of assessing minimum contacts.
North Carolina claims that the Court in Greenough v. Tax Assessors applied the above principles to hold that a trustee’s residency in Rhode Island justified Rhode Island’s taxation of the trust. If a trustee’s in-state residency is sufficient to establish minimum contacts with a trust, reasons North Carolina, then a beneficiary’s in-state residency must also be sufficient. North Carolina contends that beneficiaries are the central component of any trust, because a trust exists “solely for the benefit of its beneficiaries,” who represent the trust’s “reason for being.” Indeed, explains North Carolina, a trust requires beneficiaries in order to exist. North Carolina also points out that beneficiaries—unlike trustees—have a claim to ownership of the trust property. North Carolina thus concludes that a beneficiary’s contacts are the most important contacts that a trust makes with a state. Accordingly, posits North Carolina, a beneficiary’s residency establishes the necessary minimum contacts between a trust and the beneficiary’s state of residence for the state to tax the trust.
In response, Kimberley Rice counters that North Carolina has no authority to tax a trust’s undistributed income solely based on a beneficiary’s North Carolina residency. Kimberley Rice recognizes that a state is entitled to tax trust income that a resident-beneficiary actually receives, but argues that a state has no right to tax a trust’s undistributed income because the beneficiary does not exercise possession or control over that income. Kimberley Rice argues that this lack of control is what distinguishes using a trustee’s residency from a beneficiary’s residency to establish a trust’s minimum contacts with a state, as the Court reasoned in Greenough. Unlike a beneficiary, explains Kimberley Rice, trust assets are under the “immediate control” of the trustee because the trustee is the legal owner of the trust property. In this capacity, maintains Kimberley Rice, the trustee has power to contract on behalf of the trust, and it is the trustee who is responsible for paying the trust’s taxes.
Kimberley Rice therefore argues that, when determining whether a state has authority to tax a trust, the relevant question is whether the trustee has minimum contacts with the state. Here, claims Kimberley Rice, the trustee does not have sufficient contacts with North Carolina. Kimberley Rice contends that the trustee, who resided in Connecticut, never “purposely availed” himself of any of North Carolina’s benefits. Furthermore, posits Kimberley Rice, a beneficiary’s contacts with a state cannot be imputed to any other trust constituent such as the trustee. Kimberley Rice states that this is so because a beneficiary has no power to bind the trustee or trust property. Kimberley Rice also points out that North Carolina law considers the roles of trustee and beneficiary as being independent from each other. For one, explains Kimberley Rice, North Carolina statutes enumerate specific powers available to trustees whereas beneficiaries are given only limited statutory rights. In addition, continues Kimberley Rice, North Carolina taxes beneficiaries and trustees separately. Kimberley Rice asserts that while beneficiaries are obligated to pay taxes on income that the trust actually pays out to them, trustees are obligated to pay the taxes on undistributed trust income.
DO THE BENEFITS OF RESIDENCY JUSTIFY TRUST TAXATION?
North Carolina argues that using a trust beneficiary’s residency to justify taxation of a trust is appropriate because the beneficiary derives “benefits and protections” from his or her state of residence.North Carolina claims that these benefits and protections make it possible for the trust to serve the beneficiary. For example, posits North Carolina, the security that a state offers facilitates a reliable local banking infrastructure through which the trust can make distributions. In addition, continues North Carolina, a resident-beneficiary enjoys the privileges of local state government, including protection by the state’s police and fire departments. North Carolina contends that a beneficiary “would be in no position” to enjoy any trust property without this security.North Carolina also asserts that the availability of other state benefits can actually work to preserve a resident-beneficiary’s trust property. For example, maintains North Carolina, a beneficiary who takes advantage of a state’s free public school system can thereby relieve his or her trust from spending trust property for the beneficiary’s education.North Carolina points out that that is what happened here, because one of the Kimberley Rice Trust’s objectives was to support the education of its beneficiaries. North Carolina claims that Ms. Kaestner actually availed herself of the state university system and was also free to educate her children in the state’s free public schools. In effect, North Carolina concludes, these state benefits relieved the trust of having to buy educational services, thereby allowing the trust to invest more property for the ultimate benefit of its beneficiaries.
In response, Kimberley Rice reiterates that North Carolina’s jurisdiction to tax a trust must be based on the trustee’s contacts with North Carolina, not the trust beneficiaries’ contacts. Kimberley Rice analogizes its case to that of Hanson v. Denckla, which, according to Kimberley Rice, supports the proposition that a non-trustee trust constituent’s “unilateral activity” cannot establish a trust’s minimum contacts with a state. Although Kimberley Rice admits that Hanson concerned a state’s authority to adjudicate disputes rather than a state’s authority to impose a tax, Kimberley Rice contends that both of these concepts of jurisdiction are governed by the same due process principles. According to Kimberley Rice, the Court incorporated the due process principles relating to authority to adjudicate into the due process analysis for authority to tax in Quill Corp. v. North Dakota. As such, concludes Kimberley Rice, a beneficiary’s unilateral activity of residing in a particular state cannot be imputed to a trust for purposes of establishing the trust’s minimum contacts. Kimberley Rice likewise asserts that the “indirect” state benefits which a beneficiary enjoys due to his or her residency cannot be attributed to the trust or the trustee. Moreover, maintains Kimberley Rice, the beneficiaries here were independently entitled to enjoy North Carolina’s state benefits because the beneficiaries here paid personal income taxes to North Carolina on all of their other income. Kimberley Rice also claims that North Carolina’s assertion that the state’s educational benefits relieved Kimberley Rice of making certain outlays is misleading, because the trustee was never actually required to distribute any funds to the beneficiaries.
WHO HAS THE POWER TO DECIDE THE LIMITS OF STATE TRUST TAXATION POLICY?
In support of North Carolina, Minnesota and Nineteen Other States (collectively “Minnesota”) assert that state legislators have significant discretion to determine tax policy within their state. Minnesota argues that if the Supreme Court adopts the lower court’s decision, it will infringe on this state power by eliminating consideration of the beneficiary’s contacts for state trust taxation. Indeed, Minnesota emphasizes that twenty-seven states currently tax trust income based on the settlor’s residence or the beneficiary’s residence, rather than the trustee’s location. Moreover, Minnesota contends that the Court’s decision will impact the trust taxation policies of all states that tax trust income based on the residency of beneficiaries or settlors, or a combination of those factors because these states tax trusts managed outside of their own states without regard to the trustee’s contacts with their state. Minnesota further maintains that if the Supreme Court affirms the lower court’s decision, the Court will establish a “uniform national standard for trust taxation,” thereby infringing on state sovereignty.
In support of Kimberley Rice, Certain State Trust and Bank Associations (“Trust Associations”), counter that although states have the power to tax their citizens, the Due Process Clause sets a necessary limit on this power. The Trust Associations argue that, rather than infringing on state sovereignty, upholding the lower court’s decision would simply recognize the constitutional limits on state taxation power in accordance with the goals of federalism. In fact, the Trust Associations contend that the lower court’s decision is consistent with broader tax policy, which, under the Due Process Clause, focuses its taxation inquiry on the “quality and nature of the activity” as it relates to the state. Moreover, explains the Trust Associations, federal and state tax compliance systems already ensure that trust income is appropriately taxed without using the beneficiary’s residence to do so. Finally, Professor Roberta Lea Brilmayer, in support of Kimberley Rice, notes that the lower court’s decision would allow states to overreach by taxing entities located in other states’ jurisdictions.
HOW WILL TRUST SETTLORS, TRUSTEES, AND BENEFICIARIES BE AFFECTED?
A group of Tax Law Professors (“Professors”), in support of North Carolina, assert that affirming the lower court’s ruling will open up the possibility for individuals to avoid state income tax liability for their trusts. The Professors point out that by not allowing a state to base trust taxation on the beneficiary’s residence, states are constrained on the trusts they can tax, and individuals have a greater ability to avoid tax liability. As the Professors explain, an individual could avoid state income tax liability for a trust by establishing a new trust with a trustee in a state that does not tax trust income, thereby eliminating the trust’s income from a settlor’s or beneficiary’s taxable income. The Professors contend that the decrease in taxable income within states could have large impacts on low-income and middle-income tax payers, whose income taxes would increase to compensate for lost trust taxes. Additionally, the Professors note that although upholding the lower court’s decision could result in some individuals facing double taxation, as their trust income could be taxed in multiple states, existing remedies significantly decrease this risk for beneficiaries and settlors.
In response, William Fielding, Trustee (“Fielding”), in support of Kimberley Rice, contends that individuals will not be able to avoid trust tax liability so easily because the majority of states do not limit their tax inquiry to the location of the trustee. Fielding further suggests that states in which a beneficiary resides will not lose out on taxes—they will simply have to wait until the trust income is distributed to the beneficiary before taxing it as income. Moreover, the Trust Associations, in support of Kimberley Rice, assert that allowing a state to tax a trust’s accumulated income that has yet to be distributed allows a state to collect taxes on more income than its residents may ever acquire, inconsistent with income tax policy. The Trust Associations further argue that North Carolina’s rule could make tax compliance particularly burdensome for trustees with beneficiaries located in multiple states, especially considering trustees often have no control over where a trust’s beneficiary chooses to live. . Double taxation, continues the Trust Associations, will likely result from affirming the decision below, which will harm beneficiaries by decreasing the trust’s assets.
- David Herzig, U.S. Supreme Court Considers Proper State to Tax Trusts, Forbes (Mar. 4, 2019).
- Alex Down, Death & Taxes: SCOTUS Grants Certiorari in North Carolina v. Kaestner Trust Nexus Case, Bloomberg (Jan. 22, 2019).
- Ashlea Ebeling, U.S. Supreme Court to Hear Key Income Tax Issue For $120 Billion Trust Industry, Forbes (Jan. 16, 2019).