The North Carolina Business Court heard arguments on February 24, 2015 in a tax refund action challenging how North Carolina taxes a trust.¹ N.C. Gen. Stat. § 105-160.2 imposes a tax on the undistributed income of a trust that is for the benefit of a North Carolina resident, even if the trust has no other connections with the state. The trust contends the statute violates the Due Process Clause and the Commerce Clause of the United States Constitution.

History of the Trust

The Kimberly Rice Kaestner 1992 Trust (the “Trust”) originated from the Joseph Lee Rice, III Family 1992 Trust (the “JLR Trust”) created in 1992. The JLR Trust was created in New York when its initial trustee and settlor were residents of New York. In 2006, the JLR Trust was divided into three separate trusts, one of which is the Trust in this refund action. The current beneficiaries of the Trust are Kimberly Rice Kaestner (“Ms. Kaestner”) and her three children (collectively the “Beneficiaries”), all of whom were residents of North Carolina during tax years 2005 through 2008 (“years at issue”). During the years at issue, the Trust held only intangible assets (for example, equities, mutual funds and investments in partnerships) and no distributions were made to any of the Beneficiaries. Ms. Kaestner did, however, engage in multiple loan transactions with the Trust. In addition, although Ms. Kaestner was entitled to distributions from the Trust as of her 40th birthday, she affirmatively declined to receive any distributions and instead decided to have the Trust “decanted” into a new trust. Ms. Kaestner then conferred with the Trust’s settlor and trustee to discuss the structuring of any future distributions.

Position of the Trust

In its brief filed with the Court, the Trust first argues that, in the absence of physical presence, a trust must purposefully avail itself of the economic benefits of the taxing state. The Trust contends this test is not met because:

• the Trust was not created in North Carolina;
• the Trust was not governed by the laws of North Carolina;
• the settlor and trustee were not residents of North Carolina;
• none of the Trust’s assets were located in North Carolina;
• none of the Trust’s legal or financial records were located in North Carolina;
• the custodian of the Trust’s assets and the investment advisor to the Trustee were not located in North Carolina;
• the trustee never met with the Beneficiaries in North Carolina; and
• no distributions were made to the Beneficiaries.

According to the Trust, the fact that the Beneficiaries moved to North Carolina is not sufficient to satisfy this test because the Trust and the Beneficiaries are separate legal entities.

The Trust also argues the statute violates the Due Process Clause because the tax imposed on the Trust is not rationally related to the benefits provided by the state. In support of this position, the Trust maintains that the Beneficiaries had no ownership interest in the accumulated income of the Trust, that all of the Trust assets were located outside North Carolina and that none of the Trust income was directly derived from North Carolina assets or labor. 

The Trust finally argues that the statute violates the Commerce Clause. Specifically, the Trust contends that it did not have sufficient connections with North Carolina to provide the “substantial nexus” required under the Commerce Clause. The Trust also argues the tax is not fairly apportioned or fairly related to the services provided by the state.

Position of the Department of Revenue

The North Carolina Department of Revenue (“Department”) responded by first asserting the Trust cannot meet its burden to overcome the presumption of constitutionality afforded all legislative enactments.

The Department argues the statute does not violate either the Due Process Clause or the Commerce Clause because the Beneficiaries were residents of North Carolina, which provides a sufficient connection or “nexus” to tax the Trust. The Department contends the location of the Trust’s assets is irrelevant in determining the constitutionality of the statute because the assets are intangible. It similarly takes the position that the “situs” of the Trust is immaterial.

The Department disputes the Trust’s contentions that the Beneficiaries had no ownership interest in the Trust, asserting that the Beneficiaries have interests and rights to the Trust’s assets as equitable owners under basic tenets of trust law. The Department further contends that Ms. Kaestner’s multiple loan transactions with the Trust and the fact that she participated in the structuring of future distributions for the Beneficiaries demonstrates that the Beneficiaries did, in fact, have a measure of control and management over the Trust.  

Arguments at the North Carolina Business Court

At a hearing before the North Carolina Business Court, the Trust argued the state had not provided any benefits or protections to the Trust, emphasizing that the Trust was distinct from the Beneficiaries. The Trust also relied on the fact that the trustee had discretion whether to make any distributions of income to the Beneficiaries. During the years at issue, no distributions were made to any of the Beneficiaries, all residents of North Carolina. 

One of the first questions posed by the Court involved the definition of a “contingent beneficiary,” specifically, whether the fact that the trustee had discretion over distributions made the Beneficiaries contingent beneficiaries.  The Trust responded that it did. The Department disagreed. The Trust maintained, however, that characterization of the Beneficiaries as “contingent” or “noncontingent” was irrelevant to the statute’s constitutionality. The Department again disagreed, stating that it does make a difference. 

The Department explained that states have wide discretion in structuring their taxation schemes and North Carolina, like some other states, had chosen to tax a trust based on the residence of the beneficiaries. The Department took issue with the Trust’s position that the Beneficiaries had no interest in the Trust, stating the trustee and the beneficiary were both important parts of a trust and, traditionally, a beneficiary’s equitable interest was thought to be more important than a trustee’s legal interest. 

The Court asked a number of questions about the “decanting” of the Trust after the years at issue and the decision not to distribute the corpus of the Trust to Ms. Kaestner on her 40th birthday, as the Trust instrument directed. The Department responded that Ms. Kaestner had participated in those decisions. The Trust refused to provide the documents regarding the decanting of the Trust during discovery, however, so some of the Court’s questions regarding the terms of the new trust remained unanswered. The Department told the Court that the Trust had not filed any North Carolina tax returns after the years at issue. The Department therefore presumed there was no North Carolina beneficiary based on its assumption that the new trust was not violating North Carolina law (by not filing tax returns).

The Court also asked where the “situs” of the Trust was. The Trust responded that the situs was New York, where it was administered.  During discovery, however, the Department located a tax refund claim the Trust had filed with New York contending that the Trust was not present in New York. The Department responded that the situs of the Trust was irrelevant under North Carolina law. The Department also explained that the Trust had paid no taxes in New York, prompting the Court to ask whether the Trust paid taxes to any state. The Department responded that it had not. 

One of the Court’s final questions was whether the Due Process Clause could be satisfied by something other than physical presence or purposeful availment. The Trust responded that it could. 

The Court did not indicate when it would rule.

_____________________________
¹ Kaestner v. North Carolina Department of Revenue, 12-CVS-8740 (filed N.C. Sup. Ct. June 21, 2012).