In the aftermath of the Supreme Court decision in Wayfair, the question that many asked was, “How far can states go in taxing entities with a tenuous connection to the state?” Now, the high court has given a partial answer in its Kaestner decision: “Not this far!”
The court decided unanimously in favor of the taxpayer in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, holding that North Carolina violated the Due Process Clause of the Constitution by taxing a trust based solely on the residence of a beneficiary of the trust. Justice Sonia Sotomayor delivered the unanimous opinion, while Justice Samuel Alito, joined by Justices John Roberts and Neil Gorsuch, issued a somewhat narrower concurring opinion. (For more, see “A deep dive into Kaestner” on page 12.)
U.S. Supreme Court
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“Quill is not dead,” said Steve Wlodychak, principal and state tax leader for the Center for Tax Policy of Big Four firm EY, referring to the 1992 Supreme Court decision requiring physical presence to create nexus for sales and use tax.
The Wayfair decision seemed to subsume Quill, but this points out where SCOTUS sees its remaining importance, according to Wlodychak: “Justice Sotomayor made clear that the opinion is quite narrow and limited to striking down state trust tax laws that apply merely based on the residence of a beneficiary with not more. In Footnote 12, she expressly lists those states … and I believe only California is left as a state to address.”
David O’Neil, a partner at law firm Debevoise Plimpton, argued the case before the Supreme Court in April. “The decision was very gratifying,” he told Accounting Today. “We were confident based on the lower court decisions, but it’s always a different ballgame when you go before the Supreme Court.”
“The ruling emphasizes the Constitution’s most profound guarantee,” he added. “The government cannot order a citizen to do something that is fundamentally unfair, and that includes forcing someone who has nothing to do with a state to pay taxes for services that they didn’t use.”
The details
The original trust was established by settlor Joseph Lee Rice III. Its situs, or location, was New York. The primary beneficiaries of the original trust were Rice’s descendants, none of whom lived in North Carolina at the time of the trust’s creation. In 1997, Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina. The trustee later divided Rice’s initial trust into three separate subtrusts, and North Carolina sought to tax the Kimberly Rice Kaestner 1992 Family Trust, formed for the benefit of Kaestner and her three children, under a law authorizing the state to tax any trust income that is “for the benefit of” a state resident.
The state assessed a tax of more than $1.3 million for 2005 through 2008. During that time Kaestner had no right to, and did not receive, any distributions, nor did the trust have a physical presence, make any direct investments, or hold any real property in the state.
The trustee paid the tax under protest, and sued the Department of Revenue in state courts. Representatives of the trust argued that applying the tax to the trust violated the Fourteenth Amendment’s Due Process Clause. The trust won at three different levels of state courts, which held that the connection between North Carolina and the trust was insufficient to satisfy the requirements of due process.
The Supreme Court agreed. It held that the presence of in-state beneficiaries alone does not empower a state to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain to receive it.
The ramifications
The case will impact states that have a law similar to North Carolina’s, where tax is imposed solely on the residence of a beneficiary, as well as states where residence is one factor among many, O’Neal observed. “But the real next battle will be where tax turns on the state the settlor lived in when the trust was created,” he added.
“This decision is narrow,” said Ed Zollars, a CPA, instructor and author with Kaplan Financial Education. “It was intentionally written not to answer the question in any state that doesn’t do it exactly like North Carolina.”
The decision was not a surprise, according to Diana Zeydel, shareholder at Greenberg Traurig and global chair of its private wealth practice. “Many wondered why North Carolina bothered to appeal to the Supreme Court,” she said. “The outcome seemed quite clear based on the facts of this particular trust. People were hoping that, because the beneficiary did not have a right to mandatory distributions, but instead had a contingent interest to receive a discretionary distribution, that would be sufficient for a broader ruling. But the court was careful to limit its decision to the facts.”
Dave Lehn, a tax partner at Withers Bergman, agreed. “The holding was very narrow in the sense that Justice Sotomayor said it would only apply to these particular facts,” he said. “The trustee was outside the state, and the beneficiary was not receiving distributions in the state. The fact that the beneficiary had the potential to receive distributions in the state was not enough.”
“From a planning perspective, it’s a good idea to review trust documents and see where the trustees are, where the beneficiaries live, and where the trust is being administered,” he said. “You want to limit exposure to state income tax. Trustees are generally a corporation, but individuals can move from state to state.”
“Trusts with multiple generations of geographically mobile beneficiaries could easily be subject to income tax many times over, on the same dollar earned, in many jurisdictions under statutes such as North Carolina’s,” Lehn stated as counsel of record in an amicus curiae brief.
In “Brief for Certain State Trust and Bank Associations as Amici Curiae in Support of Respondent,” Lehn added: “Without carefully crafted tax credit mechanisms, this would run afoul of the internally consistent standard refined under the Commerce Clause’s ‘fairly apportioned’ rule.”
“It is easy to imagine how quickly concurrent taxation may compound if three discretonary beneficiaries live in three different states with such a statute, and each of those first-generation beneficiaries then has children who all live in different states,” he added.
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