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North Carolina Business Court Rules Tax on Trust Unconstitutional

    Client Alerts
  • May 12, 2015
The North Carolina Business Court held North Carolina’s taxation of a trust unconstitutional in Kaestner v. North Carolina Department of Revenue.1  N.C. Gen. Stat. § 105-160.2 imposes a tax on the undistributed income of a trust for the benefit of a North Carolina resident, even if the trust has no other connections with the state. The trust filed a refund action, claiming the statute violates the Due Process Clause and the Commerce Clause of the United States Constitution.

The Kimberly Rice Kaestner 1992 Trust (“Trust”) originated from the Joseph Lee Rice, III Family 1992 Trust (“JLR Trust”) created in 1992. The JLR Trust was created in New York when its initial trustee and settlor were residents of New York. The JLR Trust was subsequently divided into three separate trusts, one of which is the Trust in this refund action.  The beneficiaries of the Trust were Kimberly Rice Kaestner and her three children, all of whom were residents of North Carolina during tax years 2005 through 2008. The initial trustee resigned in 2005 and a Connecticut resident was appointed as the trustee. During the years at issue, the Trust held only intangible assets and no distributions were made to any of the beneficiaries. The custodian of the assets was located in Massachusetts.  The Trust was governed by New York law. 
The Court’s Ruling
The North Carolina Business Court held the statute, as applied to the facts of this case, violated the Due Process Clause. The court first determined there were no minimum connections between the Trust and North Carolina. The court found the Trust did not have a physical presence in the state. The Trust never owned any real or personal property located in North Carolina and its administration occurred outside the state. The court also concluded the Trust had not “purposefully availed” itself of the benefits of an economic market in North Carolina. It stated the Trust and the beneficiaries were “separate legal entities” and, as such, the beneficiaries’ contacts with the state were irrelevant. The court found significant that the beneficiaries had no power to compel a distribution from the Trust and had no actual control over the Trust. The Court also held the statute, as applied, violated the Due Process Clause because there was no rational relationship between the income attributed to the state for tax purposes and the values connected to the state.

In addition, the court held the statute violated the Commerce Clause because there was not a substantial nexus with North Carolina. It concluded the presence of beneficiaries was not enough to create nexus. The court further held the statute violated the Commerce Clause because the tax was not fairly related to the services provided by the state.

Interesting Fact
In the North Carolina litigation, the trust argued the situs of the trust was in New York and that its connections were with New York, not North Carolina. For one of the years at issue, however, the Trust filed a claim for refund in New York contending it lacked sufficient contacts with New York to be taxed there.

Potential Appeal
The time for appeal to the North Carolina Court of Appeals has not yet expired.

Potential Legislation
Senate Bill 468 was filed in March, before the decision of the Business Court. The proposed legislation would alter the way North Carolina taxes trusts.

1Kaestner v. North Carolina Department of Revenue, 12-CVS-8740 (N.C. Sup. Ct. Apr. 23, 2015).