On July 5, 2016, the North Carolina Court of Appeals affirmed the Business Court ruling in the matter of Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue.  As noted in our Alert of May 1, 2015, the Business Court held that the application of North Carolina General Statute Section 105-160.2 (the “Statute”) is unconstitutional as applied to the Kimberly Rice Kaestner 1992 family trust (the “Trust”), and ordered refund the Trust had applied for. 

The opinion issued by the Business Court noted that the trust has no connections to North Carolina other than the residence of the beneficiary, which is insufficient to satisfy either the Due Process or Commerce clause of the U.S. Constitution to support state taxation of the trust.  In its July 5, 2016, decision, the Court of Appeals agreed with the Business Court, but analyzed the constitutionality of the statute, as applied to the trust, solely under the Due Process Clause.

Applying the minimum contacts requirement of the Due Process Clause, the Court of Appeals looked to the decisions of Quill Corp. v. North Dakota, 504 U.S. 298 (1992), and International Shoe Co. v. Washington, 326 U.S. 310 (1945), that “it is essential in each case that there be some act by which the [party] purposefully avails itself of the privilege of conducting activities within the forum State.”  The Court of Appeals found that the trust did not maintain any physical presence in North Carolina, never held assets located in North Carolina, did not keep records in North Carolina, and could not otherwise be said to have a physical presence in North Carolina. The only connection between the trust and North Carolina is the residence of the beneficiary. 

In its brief, the Department of Revenue cited Court decisions from California and Connecticut to support a finding that basing taxation of the trust on the state of domicile of the beneficiary is constitutional.  The Court of Appeals rejected the Department of Revenue’s argument, siding with the taxpayer. The taxpayer’s position is that a trust and beneficiary are separate legal entities for tax purposes, and therefore, the residence of the beneficiary (alone) should not form the basis by which a trust is subject to income tax.  In agreeing with the taxpayer’s position, the Court of Appeals not only noted the decision of the Supreme Court in Brooke v. Norfolk, 277 U.S. 27 (1928), but found it controlling. 

In Brooke, the taxpayer, a trust created by a resident of Maryland and administered by a trustee located in Maryland, appealed the assessment of taxes (in that case, ad valorem taxes) by the state of Virginia on the basis that the trust beneficiary was a resident of Virginia.  In finding the assessment of tax on the trust in Brookeunconstitutional, the Supreme Court found that “the [trust] property is not within the state, does not belong to the [trust beneficiary] and is not within her possession or control.  The assessment is a bare proposition to make the [trust beneficiary] pay upon an interest to which she is a stranger.” 

Finding that the application of the statute to the trust did not satisfy the requirements of the Due Process Clause, the Court of Appeals declined to consider the application of the Commerce Clause. 

Conclusion: With the affirmation of the Business Court decision by the Court of Appeals, the Department of Revenue likely will seek further review by the North Carolina Supreme Court.  Additionally, the North Carolina legislature has considered an amendment to the statute that would provide for the taxation of a trust administered in North Carolina to the extent that the beneficiaries of the trust are resident in North Carolina.  As for trusts with resident beneficiaries that have been subjected to North Carolina income taxation, application for a refund may be considered where the onlynexus to North Carolina is the residency of a beneficiary.