On June 21, 2019, in a unanimous decision, the U.S. Supreme Court held as unconstitutional a North Carolina statute that had been interpreted by North Carolina to mean that a trust owed income tax to North Carolina whenever a beneficiary of the trust lived in the state, even if, in the relevant year, the beneficiary received no income from the trust, had no right to demand income from the trust, and could never count on receiving income from the trust. N.C. Dep’t of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 588 U.S. ___ (2019) (No. 18-457).
Summary of the Case
North Carolina taxes any trust income that “is for the benefit of” a North Carolina resident. N. C. Gen. Stat. Ann. §105-160.2. The North Carolina Supreme Court had interpreted the statute to permit North Carolina to tax a trust on the sole basis that a beneficiary resided in the state.
In Kaestner, Kimberley Rice Kaestner was the beneficiary of a trust established by her father, a New York resident. The trust was governed by New York law, and the trustee had “absolute discretion to distribute the trust’s assets to the beneficiaries in such amounts and proportions as the trustee might from time to time decide.” The dispute arose when, between 2005 and 2008, North Carolina required the trustee, a resident of Connecticut, to pay more than $1.3 million in taxes on income earned by the assets in the trust, solely because Kaestner was a resident of North Carolina at the time. During those years, the trustee had not distributed any of the income to Kaestner or her children, did not make any investment or hold real property in North Carolina, and did not maintain a physical presence in North Carolina.
The U.S. Supreme Court, in affirming the North Carolina Supreme Court, held that “presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiary, where the beneficiary has no right to demand that income, and is uncertain to ever receive it.” In so holding, the U.S. Supreme Court relied on the lack of minimum contacts between the residence of the beneficiary in North Carolina and the assets of the trust, as defined in International Shoe Co. v. Washington, 326 U.S. 310 (1945). The Supreme Court focused on the extent of the in-state beneficiary’s right to control, possess, enjoy or receive the trust assets (citing Safe Deposit & Trust Co. v. Virginia, 280 U.S. 83 (1929) and Brooke v. Norfolk, 277 U.S. 27 (1928)). It indicated that, to allow a state to base its tax on the residence of the beneficiary, the beneficiary needs to have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the state can tax the asset.
The Court found that, because Kaestner did not receive any income between 2005 and 2008, did not have a right to demand trust income or otherwise control, possess, or enjoy the trust assets during those years, and could not count on receiving any specific amount of income from the trust in the future, the minimum contacts required were lacking. Accordingly, North Carolina was precluded from taxing the trust assets solely on the basis of Kaestner’s status as an in-state resident.
Click here for the full GT Alert, which explores Kaestner’s impact on drafting California trusts.