Tuesday, June 25, 2019
Last year, the U.S. Supreme Court decided South Dakota v. Wayfair, 138 S. Ct. 2080 (2018), upholding 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. Based on that opinion, some states with an income tax took an aggressive stance against trust beneficiaries residing in their states. These states claimed that Wayfair meant that the mere presence in the state of a trust beneficiary allowed the state to tax the beneficiary’s trust income. North Carolina was one of those states.
The Supreme Court unanimously rejected North Carolina’s position. In so holding, the Court outlined Due Process limitations that apply to a state’s ability to tax.
The limitations on a state’s taxing authority – that’s the topic of today’s post.
The “Nexus” Requirement
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in Quill Corporation v. North Dakota, 504, U.S. 298 (1992), the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. That’s what got North Carolina (and some other states) excited – the ability to tax trust income on the basis that a beneficiary’s presence in the state satisfied the nexus requirement. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; 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?
In the North Carolina case, the trust at issue was a revocable living trust 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. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 248 N.C. 212, 789 S.E.2d 645 (N.C. Ct. App. 2016). 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. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 371 N.C. 133, 814 S.E.2d 43 (N.C. Sup. Ct. 2018). The state Supreme Court noted 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. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, 139 S. Ct. 915 (2019).
U.S. Supreme Court Decision
In a unanimous decision, the U.S. Supreme Court affirmed, holding that the North Carolina law violated Due Process. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, No. 18-457, 2019 U.S. LEXIS 4198 (U.S. Sup. Ct. Jun. 21, 2019). The Court noted that a taxpayer must have “some minimum connection” with the state, and that a rational relationship must exist between the income the state wants to tax and the state. There must be a fiscal relationship to benefits that the state provides. That’s a Due Process limitation. As applied to a trust, and based on Brooke v. Norfolk (cited above), the Court seemed to suggest that whether a trust beneficiary’s in-state contacts are relevant on the nexus question is tied to whether the beneficiary has a “right to control, possess, enjoy or receive trust assets.” Applying that rationale to the trust at issue, the court determined there was an insufficient nexus between the North Carolina beneficiary and the state for the state to have jurisdiction to tax the trust. The beneficiary never received an income distribution from the trust for the years at issue and didn’t have a right to demand trust distributions and had no power of assignment. It was the trustee, under the terms of the trust, that had the sole discretion over distributions. Indeed, the trust assets could ultimately end up in the hands of other beneficiaries. But, the Court did not foreclose the ability of a state to tax trust income where the trust gives the resident beneficiary a certain right to trust income.
Implications. The Court’s decision does leave in its wake considerations for drafters of trust instruments. For starters, a purely discretionary trust (e.g., a trust giving the trustee sole discretion over trust distributions) can bar a state from taxing a beneficiary’s income distribution. That’s especially true when combined with “spendthrift” language that bars the beneficiary from assigning their beneficial interest in the trust. This type of trust language typically works well when there is a need to place limitations on a beneficiary’s rights and access to trust assets. While the Court didn’t address the impact of a giving a beneficiary a power of appointment over trust assets in a discretionary trust, it would seem that if such a power is present and exercised, the state would have the ability to tax the beneficiary at least in the year the power is exercised.
The facts of the case indicated that the beneficiary had the right to receive either a share or all of the trust assets upon reaching a particular age, but the right was contingent. What if the trust language had made the future right not contingent? Would the Court have concluded that a state has the ability to tax the beneficiary then?
The Court also pointed out that nexus means something different depending on whether it is being applied to the grantor/settlor of the trust, the trustee or a beneficiary. A resident trustee satisfies the nexus requirement as does a resident grantor/settlor (with respect to a revocable trust). But, does that mean that a trust grantor/settlor can be taxed based solely on having created the trust in that particular state? Maybe that challenge will be forthcoming in the future.
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. 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). That last point makes the Court’s decision relevant even to those practitioners in states without an individual income tax.