Justices Hear Debate Over Taxation of Trust Income

WASHINGTON (CN) – As the federal government stands to collect billions from trust and estate incomes this tax season, the U.S. Supreme Court heard arguments Tuesday in a dispute over whether states have a right to tax residents who are beneficiaries of trusts established in another state and did not receive any distributions from the trust. 

The question in the case North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust originated when North Carolina taxed a trust beneficiary on income earned from 2005 to 2008. 

On its face, the premise seems simple – in North Carolina, generally speaking, income tax is imposed on any trust for the benefit of a Tar Heel State resident.  

Kimberley Kaestner’s father, Joseph Kee Rice III, originally established the family trust in 1992 in New York. An Empire State resident, he split the trust into three parts, with one designated for each of his children.

Kaestner later moved to North Carolina and she drew loans from the trust for various business investments but never actually received any discretionary distributions.

North Carolina nonetheless taxed her income from the trust, forcing Kaestner to eventually fork over $1.3 million in taxes to the state.

She later sued, claiming the state did not have jurisdiction to tax the trust under the rules of due process because it failed to establish a definitive link between itself and the trust income. 

The North Carolina Supreme Court ruled in favor of Kaestner last year, finding that income tax leveled on trusts beyond state lines violates the Fourteenth Amendment’s due process clause because, in this instance, North Carolina failed to prove “minimum contacts” existed.

Typically, due process demands a definitive connection between a state and the person or entity being taxed.

Though Kaestner was a resident of North Carolina when the trust income tax was assessed, her attorney, David O’Neil of Debevoise & Plimpton, argued Tuesday before the U.S. Supreme Court that the trust itself had no ties to North Carolina because no funds were ever distributed there.

The court must find a more “substantial nexus” between state and taxpayer to establish jurisdiction, O’Neil argued, saying the state’s entire argument against Kaestner hinges on its assumption that it knows exactly what she will do with the trust funds once dispersed. She could keep them for herself, or they could be given to her children.  

“It’s not known how many beneficiaries there are or who will actually receive the money. It’s not known where they will live when they receive the money or how many people it’s shared with,” O’Neil said.

But as the trust grows, no matter where money may end up or where Kaestner moves to, she gets wealthier, Justice Elena Kagan noted.

The implication gave her pause.

“If she moves from state to state, then each state for those particular years where she lives in the state can tax… for these tax years, North Carolina is providing services to a person who – and the only person who – is going to benefit from the income growth of this trust,” Kagan said.

O’Neil pushed back, asking Kagan to weigh what benefits are actually being provided to Kaestner by North Carolina. She already paid income taxes there for years, he argued, but now a trust in her name that was not established or used in that state is being taxed anew.

Justice Brett Kavanaugh appeared to side with Kaestner on Tuesday, noting that if she moved and funds were actually distributed, the state where she lived could rightfully tax it.

“That’s exactly right,” O’Neil said. “And if she no longer lives in North Carolina, then North Carolina, with no legitimate basis whatsoever, will have… taken property from the corpus of the trust.”

North Carolina laws governing trustee tax liability are “crystal clear,” O’Neil argued, noting that the statute at issue states that the “fiduciary shall pay the tax.”

“Well, the fiduciary should pay the tax, but wouldn’t the state say the tax is on the trust itself?” Justice Kagan asked.

The state could say that, O’Neil said, but it ignores practicality.

“If this tax is not paid, the state is going to come after the trustee, not the beneficiary, for the consequences,” he said.

If the justices were to side with Kaestner, North Carolina Solicitor General Matthew Sawchak warned it might force the high court to overturn existing case law outlining principles of trust possession and control and could invalidate trust tax criteria in 33 states.

“That would be an aggressive deployment of the due process clause,” Sawchak said.

While Kaestner may not have actually received distributions, she was eligible to and during the time she was eligible to, both her and other potential beneficiaries lived in North Carolina.

Justice Sonia Sotomayor tested Sawchak’s theory with a hypothetical.

“The trust instrument says that the trustee has absolute discretion to give her something or nothing… the trustee could chose to, if she had a disabled child, give it all to the child or divide it among [for argument’s sake] her other three children because she’s very rich and they’re not. The trustee has a lot of discretion,” Sotomayor said.

“But you are changing the terms of the trust instrument now, by saying that each of them must still pay 25 percent,” she added.  

In the eyes of North Carolina, Sawchak said, that is correct.

“First of all, throughout the period in question, those people had true ownership of the accumulating assets. Secondly, on a pro rata basis, North Carolina is protecting each of them,” he said.

It is unclear when the justices will issue a decision in the case.

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