North Carolina’s No More: The Fall-out from The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Dep’t of Rev.

A recent decision by the North Carolina Business Court could have significant ramifications for North Carolina’s taxation of trusts. In Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, the court struck down North Carolina’s statute that taxes trust income based upon the residence of the beneficiary, finding that the law violated the Constitution’s Due Process and Commerce Clauses.

Mrs. Rice Kaestner, a resident of North Carolina, was the beneficiary of a trust established by her father, Joseph. The father was a resident of New York and created the trust in New York with an initial trustee who was a resident of New York. The trust’s governing law provision was New York law and New York taxes were paid. His daughter, the named plaintiff, later moved to North Carolina. Based on a North Carolina law that taxes non-source income “of the estate or trust that is for the benefit of a resident of this State,” the trust paid $1.3 million in taxes to North Carolina between 2005 and 2008, even though no trust assets were located in North Carolina and no distributions were made to North Carolina beneficiaries. N.C.G.S. Section 105-160.2.

In 2009, the trustee filed for a refund, arguing that North Carolina’s statute violated the Commerce Clause and the Due Process clause of the United States Constitution as well as Article I, Section 19 of the North Carolina Constitution. In a complete victory for the plaintiffs, Judge McGuire of the North Carolina Business Court granted summary judgment, holding that North Carolina cannot validly tax assets having no “substantial nexus” to the state. Because Mrs. Kaestner’s Trust had no connections to the state other than her residence, Judge McGuire ruled that North Carolina’s law violated the Due Process clause’s requirement that there be “some minimum connection, between a state and a person, property or transaction it seeks to tax.” Quill Corp. v. North Dakota, 504 U.S. 298, 306, 307, 308, 312 (1992). For essentially the same reason, the court found that the law violated the Commerce Clauses requirements that a law be “applied to an activity with a substantial nexus to the taxing state” and be “fairly related to services provided by the state.” Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

Though the court limited its ruling to the specific facts of the case, there is good reason to hope that ultimately the statute will be found unconstitutional on its face. First, the reasoning of the Kaestner court is sound and rests upon well-established Commerce Clause and Due Process Clause jurisprudence. Second, a recent Supreme Court decision in Comptroller v. Wynne striking down a Maryland tax scheme that failed to provide adequate credits for taxes paid in other states as a violation of the Commerce Clause – though based on a different the legal issue – indicates that there is some momentum building in the use of the Commerce Clause to strike down overreaching state tax laws. Finally, though a few states base fiduciary income tax in part on the residence of beneficiaries, North Carolina alone taxes fiduciaries solely on this basis.

If upheld, the implications of the Kaestner decision may be significant both for trusts held for the benefit of North Carolina residents, and, of course, for the state’s coffers. The North Carolina Department of Revenue’s current practice is to tax assets held in trust for the benefit of resident beneficiaries regardless of the situs of the trust, including trusts in which only secondary beneficiaries live in North Carolina. Worse, trusts are taxed on a per capita basis based on the portion of income of the trust which reflects the percentage of trust beneficiaries that are North Carolina residents, even if those beneficiaries never receive distributions. For non-source income of irrevocable, out of state trusts, that could all end.

Should the case survive appeal, it will have both prospective and restrospective ramifications. Like the Kaestner trustees, many similarly situated trustees will file for refunds for overpayments of taxes. Considering that the statute of limitations on a tax refund in North Carolina is three years, it is important for these trustees to take action quickly. While the case is pending appeal, taxpayers would be well advised to take advantage of N.C.G.S. Section 105-241.6(b)(5), which allows for the filing of a form of protective claim “[i]f a taxpayer is subject to a contingent event and files written notice with the Secretary, the period to request a refund of an overpayment is six months after the contingent event concludes.”

Second, should the case stand it will provide a slew of planning opportunities for trusts with North Carolina beneficiaries to disentangle themselves from North Carolina. One article notes that it may be possible to avoid North Carolina fiduciary income tax “to the extent income is trapped in trust and is not distributed via power of appointment from distributable net income to North Carolina resident beneficiaries in that tax year.” Further, trustees may determine that in certain circumstances making a loan to a North Carolina beneficiary is appropriate, as a properly structured loan will not be a taxable distribution.