Supreme Court Weighs Constitutionality of State Income Taxation of Trusts

April 29, 2019

On April 16, 2019, the U.S. Supreme Court heard arguments in Kaestner v. North Carolina Department of Revenue. The case will address the extent of the state’s authority to tax the income of certain trusts. The trustees of the Kaestner Trust argued that the North Carolina statute subjecting trusts to income tax based solely on the residency of a beneficiary within North Carolina violates the Due Process Clause of the U.S. Constitution.

Following decisions in various individual states over the past decade — including Fielding v. Commissioner of Revenue (Minnesota), Linn v. Department of Revenue (Illinois) and Residuary Trust A (Kassner) v. Director, Division of Taxation (New Jersey) — taxpayers and practitioners have been awaiting definitive guidance on the application of the Due Process Clause to the state income taxation of trusts on a more general basis. Kaestner, could be that case. The Supreme Court’s decision in Kaestner will at least address whether states, like North Carolina, can constitutionally impose state income tax on a trust’s income solely based on a beneficiary’s residence within the state, and may more broadly address the Court’s view on the Due Process Clause’s application to state fiduciary income taxation, including what ties a trust must have to the state to support the state’s imposition of income tax.  Practitioners are hopeful that the Court’s opinion will have implications beyond North Carolina and help settle important fiduciary income tax issues across the country.

McGuireWoods has been following the Kaestner case through the North Carolina courts, providing updates and analysis of the orders of the North Carolina Superior Court, Court of Appeals and North Carolina Supreme Court.

In June of 2018, the North Carolina Supreme Court ruled that North Carolina General Statute Section 105-160.2, which subjects a trust to North Carolina income tax if a trust beneficiary resides in North Carolina, was unconstitutional as applied to the trust in question. On appeal to the U.S. Supreme Court, the state of North Carolina seeks to overturn the lower court ruling. 

The state of North Carolina opened oral argument with the theory that the beneficiaries of a trust are the true owners of the trust property. This led to immediate questions from Justices Breyer and Sotomayor, who asked whether the trust beneficiaries are certain to receive the trust property, and whether trust distributions are made solely at the trustee’s discretion. Further, the justices inquired as to whether it was certain that the beneficiary would receive a distribution from the trust while a resident of North Carolina.

North Carolina also argued that beneficiary’s residence provides a key connection between the trust and the state, supporting the state’s taxation of the trust.  A number of the justices also questioned the state’s position in this regard. The justices noted that North Carolina is one of only four states that uses the residency of a beneficiary to establish the nexus required to impose tax on a trust. Only Georgia, Tennessee, and California, in addition to North Carolina, tax trusts on the same basis.

While not an issue for the Supreme Court’s determination, the justices challenged counsel for both parties about alternative methods of taxing a trust’s undistributed income. Justices Breyer, Sotomayor and Ginsburg tested the parties on the nature and extent of a state’s authority to tax the trust property under a number of different theoretical frameworks. The justices also noted that a “throwback” tax, already deemed constitutional, could address the issue by taxing the income when distributed in the future to the beneficiary. Justice Kavanaugh noted that if a state imposes a throwback tax, beneficiaries likely would move to a state without an income tax prior to the trust distribution.

Counsel for the trustee argued that the beneficiaries lack control over the trust assets, and this undercuts any argument of nexus between the trust and the state for purposes of tax based solely on the beneficiaries’ residence. Justice Kagan challenged the trustee’s counsel’s assertion, noting the trustee’s fiduciary duties to beneficiaries and the trustee’s lack of ability to use trust assets for the benefit of the trustee. Further, trustee’s counsel suggested that the appropriate jurisdiction for taxing the trust’s income is the state where the trustee resides. However, Justice Kagan seemed to disagree with this suggestion, again, because the trustee cannot use the trust property for himself and suggested that as among the choices for imposing income tax on trust income “I would think North Carolina has by far the greatest interest in taxation.”

The justices did raise underlying due process considerations, asking counsel for both parties to address prior precedent, including, specifically, Quill Corporation v. North Dakota (application of the Due Process Clause to state taxation) and Hanson v. Denckla (whether a state can gain personal jurisdiction over a trustee). Both cases support the taxpayer’s position and the justices focused on the potential lack of North Carolina’s personal jurisdiction over the trustee, in that the trustee is not a resident of North Carolina. While personal jurisdiction is not an issue in the Kaestner case, as the trustee submitted to jurisdiction by filing tax returns for the trust, paying the tax, seeking a refund, and bringing suit against the state, the personal jurisdiction issue is applicable in enforcing the state’s taxing authority on a trust/trustee, and could be an issue that is relevant in other circumstances.

Many practitioners hope that the opinion in the Kaestner case may provide guidance on whether a state can constitutionally impose income tax on a trust in other circumstances, including where the settlor of the trust was a resident of the state.  The Supreme Court’s decision is expected in June and taxpayers, practitioners, as well as other states, will be awaiting the ruling, and its analysis on the Due Process Clause and personal jurisdiction as applied to state taxing statutes.