The U.S. Supreme Court has granted the state of North Carolina’s petition for a writ of certiorari to hear another state tax nexus case following its seminal decision in South Dakota v. Wayfair. The case, Kaestner 1992 Family Trust v. North Carolina, addresses whether or not the state of North Carolina has a sufficient connection with a trust to impose an income tax on it. The Supreme Court of North Carolina ruled that the state violated the due process rights of the trust because its only connection to the state through a resident beneficiary did not create nexus to tax. We reported on the case when North Carolina appealed the ruling in October.
The Kaestner trust’s only connection with North Carolina during the 2005 through 2008 tax years at issue was a resident beneficiary. The settlor was located in New York, the trustee was a Connecticut resident, and the trust held financial instruments located in Massachusetts. The beneficiary did not receive any distributions from the Trust during the tax years at issue.
The North Carolina Department of Revenue imposed the tax under the authority of a state law that levies the income tax on trust income earned “for the benefit of a resident of this State.” The court case ensued after the Kaestner trust paid the tax for tax years 2005 through 2008 and later filed a refund claim on the basis that the state statute is unconstitutional for violating due process. In other words, the trust argued that its resident beneficiary did not create a sufficient connection with North Carolina for the state to impose the income tax.
Supreme Court of North Carolina Strikes Down Tax
The Supreme Court of North Carolina ruled in the trust’s favor because it found that that the in-state presence of a resident beneficiary alone does not establish jurisdiction to tax. The court stressed that the trust is an entity separate from individual beneficiaries and distinguished cases in Connecticut and California that reached contrary results under similar facts.
In dissent, Justice Samuel Ervin argued that the trust did subject itself to North Carolina’s taxing power consistent with the due process clause because it purposely availed itself to the state through the beneficiary. Justice Ervin noted that the beneficiary was a North Carolina resident when the trust was created for her benefit and that the trustee communicated with her in the state, in reliance upon benefits, protections, and opportunities that the state provided.
The divided opinion in Kaestner Trust reflects the State of North Carolina’s argument in its petition for certiorari that state courts are split on this issue. The state argued to the Supreme Court that courts in California, Missouri, Connecticut, and Illinois allow taxing a trust merely due to an in-state beneficiary, but courts in New York, New Jersey, Minnesota, Michigan, and North Carolina do not. The case now heads to the U.S. Supreme Court for a resolution to this issue.
The Kaestner Trust case could have important implications for tax planning and state tax policy. Trusts are a common tax planning tool and subjecting them state income taxation based only upon an in-state beneficiary could have significant consequences. In its petition for cert, the state of North Carolina stated that over “$120 billion of our nation’s income flows through trusts.” From the State’s perspective, a loss in the Kaestner Trust case could nudge them away from income taxation and towards the sales and use taxes for which the Court blessed economic nexus in Wayfair.
On the merits, the fact pattern here is favorable to the taxpayer though it remains to be seen how the Supreme Court will rule. Had the Kaestner trust held assets transferred to it by a resident settlor, for example, the State of North Carolina would have a more compelling case to impose the tax. Another case that we have been following out of Minnesota with facts more favorable to the state taxing authority currently awaits the High Court’s ruling on a petition for cert as well.