On Friday, the North Carolina Supreme Court issued its opinion in a closely watched state tax case, holding the state’s taxation of a trust unconstitutional. In The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, the Supreme Court held that imposition of an income tax on the trust based solely on the North Carolina residence of the beneficiaries violated the Due Process Clause of the United States Constitution and the Law of the Land Clause of the North Carolina Constitution.

Facts

North Carolina 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. A trust with North Carolina beneficiaries filed a refund action, claiming the statute was unconstitutional.

The trust originated from the Joseph Lee Rice, III Family 1992 Trust, which was created in 1992 in New York when its initial trustee and settlor were residents of New York. It was subsequently divided into three separate trusts, one of which is the plaintiff in the refund action. The beneficiaries of that trust were Kimberley 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.

History of Case

The North Carolina Business Court held the statute, as applied to the facts of the case, violated both the Due Process Clause and the Commerce Clause of the United States Constitution. On appeal, in a unanimous opinion, the North Carolina Court of Appeals held that taxation of the trust based solely on the residence of a beneficiary violated both the Due Process Clause of the United States Constitution and the Law of the Land Clause of the North Carolina Constitution. The Court of Appeals did not address the Commerce Clause. The state petitioned the North Carolina Supreme Court for discretionary review, which was granted.

North Carolina Supreme Court Opinion

On discretionary review, the North Carolina Supreme Court affirmed. The Supreme Court held that the statute, as applied, violated due process because the trust did not have the requisite minimum contacts with the state. It specifically rejected the argument that the presence of the beneficiaries in North Carolina was sufficient to satisfy due process. The court found “critical” the fact that the trust and the beneficiaries had “legally separate, taxable existences.” According to the court, a “taxed entity’s minimum contacts with the taxing state cannot be established by a third party’s minimum contacts with the taxing state.”

It therefore concluded that, because the trust and the beneficiaries were “separate legal entities,” the beneficiaries’ presence in the taxing state could not provide the requisite minimum contacts for due process purposes. The court held the trust’s contacts with North Carolina were insufficient to justify the imposition of a tax on the undistributed income.

Conclusion

This case is significant and has potential ramifications beyond the taxation of trusts. For additional information regarding the case or for other state and local tax questions, please contact Parker Poe’s SALT Team.