The U.S. Supreme Court unanimously held that the due process clause barred North Carolina from taxing the income of an out-of-state trust when the beneficiaries were not in-state, the beneficiaries had no right to demand the income, and the beneficiaries were uncertain ever to receive it.
The trust in N.C. Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust was formed under New York State law by a New York State resident grantor for the benefit of his children. The trust was subsequently divided into separate trusts for each child, among them the Kimberley Rice Kastener 1992 Family Trust for the benefit of Kimberley Kaestner and her children. Kimberley Kaestner moved to North Carolina in 1997, and lived there during the tax years at issue. The trustee was located in Connecticut, and had exclusive control over allocation and timing of trust distributions. The trust administration was split between New York, where the trust documents and records were maintained, and Massachusetts, where the assets were administered by custodians. The trust owned no property in North Carolina. No distributions were made from the trust during the tax years at issue. The trust’s only connection to North Carolina was that Kimberley Kaestner and her children lived there.
North Carolina imposed approximately a $1.3 million tax on the trust’s accumulated undistributed income under a North Carolina law that taxed trust income that “is for the benefit of” a North Carolina resident. N.C. Gen. Stat. Ann. Section 105-160.2. The court held that the tax was unconstitutional in violation of the due process clause. The court, citing Quill, reasoned that the first prong of the due process clause analysis requires a minimum connection between the state and the subject of the tax. Kimberley Rice Kaestner 1992 Family Trust (citing QuillCorp. v. North Dakota). The court looked to the relationship between the beneficiary and the trust assets, and reasoned that the beneficiaries’ residence in the state, alone, was an insufficient connection to the state to justify the tax because the beneficiaries had no control or possession of any of the trust property during the tax years at issue. The beneficiaries had no right to receive or demand income from the trust, and no assurance they would ever receive income from the trust.
Kaestner is compatible with Wayfair. Last year in South Dakota v. Wayfair Inc., the court held that the commerce clause did not bar a state from requiring an out-of-state seller with no physical presence in the state to collect sales tax from in-state purchasers, provided that the sellers’ contacts with the state met the other commerce clause requirements. The Wayfair court did not discuss a due process minimum contacts analysis. While it ultimately overruled Quill’s holding that physical presence is necessary to create substantial nexus required under the commerce clause, it discussed with approval the reasoning in Quill that physical presence is not required to satisfy due process. The Quill court reasoned that due process minimum contacts were created when a business purposefully directed its commercial efforts to residents of a state, even if it did not physically enter the state. Its analysis was rooted in jurisprudence that links minimum contacts to a business or person’s actions that intentionally brought it within the scope of a state’s protections and benefits. National Bellas Hess Inc. v. Dept. of Rev. of Ill. In Kaestner, the trust did not avail itself of the benefits or protections of North Carolina simply because the trust beneficiaries moved there, where they had no control over the trust assets or expectation to receive income from it, and did not receive income in the tax years at issue.
In relying on Quill for its due process analysis, the court reminded practitioners that due process and commerce clause analysis are separate tests for evaluating the constitutionality of a tax. Further, it’s a reminder the due process analysis in Quill and its progeny are alive and well.
In states with statutes similar to North Carolina’s that permit the taxation of undistributed trust income based on the residence of a beneficiary in that state, affected trusts should seek refunds.
Trusts in states that tax trust income based on the residence of a grantor should also consider whether they have grounds to seek refunds. Kaestner stated that minimum connections with a taxing state have been found to be sufficient to satisfy due process when the trustee lives in the state or when the trust assets are administered in the state. The court did not directly opine on whether a state may tax a trust’s income solely based on the residence of the grantor in the state.
Court decisions in other states have also imposed constitutional restraints on states seeking to tax trust income, including restraints on taxes based on the grantor’s residence in the state. The Pennsylvania Commonwealth Court struck down a tax on trust income based on the grantor’s residence in Pennsylvania at the time of the trust’s creation in McNeilv. Commonwealth. The court held that Pennsylvania’s tax on the entire income of two out-of-state trusts was unconstitutional under three prongs of the commerce clause (although, the analysis of the substantial nexus prong may be questionable in light of Wayfair). The trusts’ only connections to the state were that the grantor was a resident of Pennsylvania when the trusts were created, and the discretionary beneficiaries were in Pennsylvania. Trusts whose entire income is subject to tax in another state simply because of the residency of grantor should evaluate whether they are entitled to a refund under the reasoning in Kaestner and the applicable law in that state.
Other state courts have found a trust’s connections to the state insufficient to satisfy due process. In Residuary Trust A v. Director, the court held that a tax on the undistributed income of a testamentary trust whose trustee, assets, and administration were outside New Jersey was unconstitutional because the trust did not have sufficient contact with New Jersey to satisfy due process. This case and other similar cases, combined with Kaestner, provide a framework of authority to challenge states’ attempts to tax undistributed trust income based on insufficient connections to the state.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Heidi Schwartz is an associate and Joe Bright is a member at Cozen O’Connor in Philadelphia.