Taxation of a Trust Based on Residency of a Beneficiary Alone held Unconstitutional by United States Supreme Court
On June 21, 2019, the United States Supreme Court held that a North Carolina statute, which imposed a tax on a trust based solely on the residency of the beneficiary, violated the Due Process Clause of the United States Constitution. In the case, North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, Case No. 18-457 (S. Ct. June 21, 2019), a New York resident created a trust for the benefit of his children and appointed a fellow New York resident as trustee. The trust gave the trustee absolute discretion to distribute the trust’s income and assets to the beneficiaries. At the time the trust was created, none of the beneficiaries lived in North Carolina; however, the trust was later divided into separate subtrusts for each child, one of whom resided in North Carolina and her minor children. Although the child and her children were beneficiaries of the trust, the trust did not actually distribute any income or principal to those beneficiaries. Thus, the trust’s only connection with North Carolina was the mere presence of its beneficiaries within the state. The now unconstitutional North Carolina statute imposed taxes on any trust income that is for the benefit of a North Carolina resident. Accordingly, the North Carolina Department of Revenue assessed a tax on all of the income of the trust, which the trustee was required to pay. The trustee then sued North Carolina for a refund, alleging that the tax was unconstitutional.
In order for a state tax to pass muster under the Due Process Clause of the Constitution, there must be a “minimum connection” between the state and the person or property it seeks to tax (Quill v. North Dakota, 504 U.S. 298 (1992), overruled on other grounds, South Dakota v. Wayfair, Inc., 585 U.S.____ (2018)). The Court ruled that the residency of a beneficiary within the taxing state alone is insufficient to establish the minimum connection required under the Constitution. Notably, the Court limited its ruling to circumstances where the trust’s income is not distributed to the resident-beneficiary and such resident-beneficiary has no right to demand the distribution of the trust income, or be entitled to receive the trust income in the future.
The most immediate significance of this decision is for trustees of trusts with beneficiaries residing in North Carolina or Tennessee, which has a similar taxing statute. Trustees who have been paying income tax to those states with respect to the trust’s undistributed income or capital gains should review those trusts immediately to determine if those taxes can be are recovered by a claim for refund.
The broader application of this decision isn’t clear. The narrow scope of the Court’s analysis, as noted specifically in the decision, leaves unanswered the question of what additional connections may be sufficient to create a link between a state and the trust that supports state taxation.