Can a State Tax a Trust With No Contact With the State?

Overview

Last summer, the U.S. Supreme Court decided South Dakota v. Wayfair, 138 S. Ct. 2080 (2018), where the court upheld South Dakota’s ability to collect taxes from online sales by sellers with no physical presence in the state.  That decision was the latest development in the Court’s 50 years of precedent on the issue, and I wrote on the issue here:   https://lawprofessors.typepad.com/agriculturallaw/2018/06/state-taxation-of-online-sales.html

Does the Supreme Court’s opinion mean that a state can tax trust income that a beneficiary receives where the only contact with the state is that the beneficiary lives there?  It’s an issue that is presently before the U.S. Supreme Court.  It’s also the topic of today’s post – the ability of a state to tax trust income when the trust itself has no contact with the taxing state.

The “Nexus” Requirement

Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”.  That is a rather clear statement – the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.”  As I pointed out in the blog post on the Wayfair decision last summer, a state tax will be upheld when applied to an activity that meets several requirements:  the activity must have a substantial nexus with the state; must be fairly apportioned; must not discriminate against interstate commerce, and; must be fairly related to the services that the state provided.  Later, the U.S. Supreme Court said that a physical presence was what satisfied the substantial nexus requirement.  

The physical presence requirement to establish nexus was at issue in Wayfair and the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction.  But, the key point is that the “substantial nexus” must be present.  Likewise, the other three requirements of prior U.S. Supreme Court precedent remain – the tax must be fairly apportioned; it must not discriminate against interstate commerce, and; it must be fairly related to services that the state provides.  In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce.  The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden. 

Taxing an Out-Of-State Trust?

The U.S. Supreme Court has now decided to hear a case from North Carolina involving that state’s attempt to tax a trust that has no nexus with the state other than the fact that a trust beneficiary is domiciled there.  Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'd., 814 S.E.2d 43 (N.C. 2018), pet. for cert. granted, No. 18-457, 2019 U.S. LEXIS 574 (U.S. Sup. Ct. Jan. 11, 2019).  The trust at issue, a revocable living trust, was created in 1992 with a situs of New York. The primary beneficiaries were the settlor’s descendants. None of the descendants lived in North Carolina at the time of the trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at that time. The trustee was replaced in 2005 with a successor trustee who resided in Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the accumulated trust income, that was distributed to the beneficiaries, including the non-North Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2, which assesses tax on the amount of taxable income of the estate or trust that is for the benefit of a North Carolina resident, was unconstitutional on due process and Commerce Clause grounds. The defendant denied the claim, and the hearing officer later dismissed the case for lack of jurisdiction.

The trial court dismissed the request for injunctive relief with respect to the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The trial court then granted summary judgment for the trust on the constitutional claim and ordered the defendant to refund the taxes paid on its accumulated income.

On appeal, the appellate court affirmed. The appellate court determined that the trust failed to have sufficient minimum contacts (as required by the Due Process Clause) with North Carolina to subject the trust to North Carolina income tax. The court cited both International Shoe Co. v. Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to support its position on this point. The trust did not have any physical presence in the state during the tax years at issue, contained no North Carolina property or investments, had no trust records that were created or kept in North Carolina, and the place of trust administration was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional.

On further review, the state Supreme Court affirmed, also noting that a key to the case was that the trust beneficiary did not receive trust distributions during the years at issue. As such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution.

The North Carolina Supreme Court’s decision was delivered 13 days before the U.S. Supreme Wayfair decision, and was based on the controlling U.S. Supreme Court decision at that time – Quill.  Consequently, the North Carolina Department of Revenue, based on Wayfair, sought U.S. Supreme Court review.  On January 11, 2019, the U.S. Supreme Court agreed to hear the case. 

Conclusion

State taxation of trusts varies greatly from state to state in those states that have a state income tax.  A trust’s situs in a state certainly permits that state to subject the trust to the state’s income tax as a resident.  But, a trust may be tied to a state in other ways via a grantor, trustee, assets, or a beneficiary.  In addition, whether a trust is a revocable or irrevocable trust can make a difference. For instance, the Illinois definition of  “resident” includes “an irrevocable trust the grantor of which was domiciled in this State at the time such trust became irrevocable.”  35 ILCS/1501(A)(20)(D); see also, Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. Ct. App. 2013).  Indeed, a trust may have multiples states asserting tax on the trust’s income. 

However, due process requires that before a state can tax a trust’s income, the trust must have a substantial enough connection (e.g., nexus) with the state.  How the U.S. Supreme Court decides the North Carolina case in light of its Wayfair decision will be interesting.  It’s a similar issue but, income tax is involved rather than sales or use tax.  In my post last summer (noted above) I discussed why that difference could be a key distinction.  In addition, while a trust could be subject to state income tax based on its residency, the trust has grantors and trustees and beneficiaries and assets that can all be located in different states – and can move from state-to-state (at least to a degree). 

The U.S. Supreme Court decision will have implications for trust planning as well as estate and business planning.  Siting a trust in a state without an income tax (and no rule against perpetuities) is looking better each day.