The U.S. Supreme Court has held in favor of the taxpayer in North Carolina Department of Revenue v. Kaestner. The court ruled that North Carolina can’t tax trust income based solely on the presence of in-state beneficiaries, when the beneficiaries had no right to demand the income and weren’t certain to receive it. Sometimes unanimous opinions are referred to as sweeping, but Kaestner was designed to be a narrow and limited opinion.
Violation of Due Process Clause
The court noted that the Due Process Clause requires—quoting the 1992 Quill opinion—"some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax." The minimum contacts test was established in the court’s International Shoe opinion in 1945; the court applied it here, stating: “[u]ltimately, only those who derive “benefits and protection” from associating with a State should have obligations to the State in question.” So far, that sounds favorable for North Carolina, which argued before the court that in-state beneficiaries certainly derive benefits and protection from the state.
Not so fast. No income was distributed to the beneficiaries, and, the court held, they had no right to demand any income. The Due Process Clause also requires that there be a connection between the taxing state and the trust asset being taxed. Because the beneficiaries didn’t receive or have a right to income, the court concluded there was no such connection.
The court wasn’t intending to make new law. The opinion notes earlier cases in which, in the context of beneficiary contacts specifically, the court focused on the extent of the in-state beneficiary’s right to control, possess, enjoy or receive trust assets and stated:
"The Court’s emphasis on these factors emerged in two early cases, Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U. S. 83 (1929), and Brooke v. Norfolk, 277 U. S. 27 (1928), both of which invalidated state taxes premised on the in-state residency of beneficiaries. In each case the challenged tax fell on the entirety of a trust’s property, rather than on only the share of trust assets to which the beneficiaries were entitled.
On the other hand, the same elements of possession, control, and enjoyment of trust property led the Court to uphold state taxes based on the in-state residency of beneficiaries who did have close ties to the taxed trust assets. The Court has decided that States may tax trust income that is actually distributed to an in-state beneficiary. In those circumstances, the beneficiary “own[s] and enjoy[s]” an interest in the trust property, and the State can exact a tax in exchange for offering the beneficiary protection. Maguire, 253 U. S., at 17; see also Guaranty Trust Co. v. Virginia, 305 U. S. 19, 21–23 (1938)."
If residency alone is insufficient for a state to tax, does the court give us any guidance about other connections that may pass muster? The test will be the same for any “position” within a trust. The court states:
"In sum, when assessing a state tax premised on the in-state residency of a constituent of a trust—whether beneficiary, settlor, or trustee—the Due Process Clause demand attention to the particular relationship between the resident and the trust assets that the State seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee."
As if that weren’t sufficiently oblique, footnote 8 is quite specific: “[a]s explained below, we hold that the Kaestner Trust beneficiaries do not have the requisite relationship with the Trust property to justify the State’s tax. We do not decide what degree of possession, control, or enjoyment would be sufficient to support taxation.”
What We’ve Learned From Ruling
Accordingly, what we know for certain is that if a beneficiary has no control over trust income, the state where the beneficiary resides can’t tax the undistributed trust income and that distributed income can be taxed (as decided in Maguire noted above). How Kaestner might apply to trustees, advisors and, perhaps, deceased settlors, remains to be considered and, likely, litigated. Further, what would the Court make of multifactor tests? Kaestner is a pointed decision but is far from either a law review article or a road map.