Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue

On April 23, 2015, Judge Gregory P. McGuire of the Business Court division of the Superior Court of Wake County, North Carolina, issued a decision in the matter of theKimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue(12 CVS 8740), holding application of North Carolina General Statute (N.C.G.S.) Section 105-160.2 unconstitutional as applied to the income taxation of the Kimberly Rice Kaestner 1992 Family Trust (Trust). The decision was issued on motion for summary judgment. The facts of the case were not in dispute and were determinative in the court’s conclusion that N.C.G.S. Section 105-160.2 (Statute) violates both the due process and commerce clauses of the U.S. Constitution when applied to the Trust, as taxpayer.

Facts: The facts are undisputed by the taxpayer and the Department of Revenue. A New York resident created the Trust for the benefit of his descendants and appointed a New York resident as initial trustee. In 1997, the beneficiary of the Trust, Kimberly Rice Kaestner, moved to North Carolina and established residency. The parties conceded that the Trust had no connection or activity in North Carolina:

  • All records of the Trust were maintained in New York.
  • The custodian of the investments of the Trust was located in Boston, Massachusetts.
  • The tax returns for the Trust were prepared in New York.
  • The trustee did not travel to North Carolina.
  • The trustee did not make any distributions to the beneficiary.
  • Pursuant to the terms of the Trust, the beneficiary cannot compel the trustee to make a distribution from the Trust.

The trustee filed North Carolina state fiduciary income tax returns and paid state income taxes on the undistributed taxable income of the Trust based on the provisions of the Statute, which states that tax is imposed on the taxable income of a trust that is for the benefit of a resident of North Carolina. Subsequently, the Trust filed claims for refund of the tax paid for the years 2005 through 2008 on the basis that the Statute violates the due process and commerce clauses of the U.S. Constitution.

Analysis: Judge McGuire’s opinion applies the requirements of both the due process and commerce clauses of the U.S. Constitution to the facts of the case. In essence, to withstand scrutiny, there must be nexus and voluntary connectivity between the taxing state (North Carolina) and the taxpayer (the Trust). Throughout the opinion, Judge McGuire stresses that the relevant entity in the analysis is the Trust, who is the taxpayer, and reviews the activities of the Trust (through the trustee) in determining whether there are sufficient contacts between the Trust and the taxing state, North Carolina, stating that “[the Trust’s] contacts with North Carolina are relevant here, but not those of its beneficiaries” (page 11, paragraph 27).

The court reviewed, specifically, the lack of activities by the trustee to the taxing state, North Carolina. Citing the U.S. Supreme Court case of Quill v. North Dakota (504 U.S. 298) (1992), the court emphasized that the taxpayer “must ‘purposefully avail itself of the benefits of an economic market in the forum state.’” Both the due process and commerce clauses require a relationship between the tax imposed and the benefits provided by the state. The Trust is controlled by the trustee, not the beneficiary; therefore, the analysis of the connection between North Carolina, as the taxing authority, and the taxpayer, the Trust, is based on the activities of the trustee.

In this case, the court found the trustee had no connections with North Carolina, and did not purposefully or voluntarily avail the Trust of the benefits of the state of North Carolina. Noting that the actual control of the Trust remained with the trustee, the court stated that the “infrequent contact as reflected in the record, contact driven by the beneficiary and not [the Trust], cannot, as a matter of law, constitute sufficient contact of [the Trust] with the State such that all of [the Trust’s] undistributed income is subject to taxation in North Carolina” (page 12, Paragraph 30). Accordingly, the lack of any physical presence or voluntary activity of the Trust, as the taxpayer, in North Carolina was determinative in the court’s holding that the Statute, when applied to the Trust, is unconstitutional.

Conclusion: While a significant decision, it is certain to be appealed by the Department of Revenue. Further, while the Trust sought a determination that the Statute is unconstitutional on its face, as well as when applied to the Trust, as taxpayer, the court’s opinion ruled only that the Statute is unconstitutional as applied to the Trust, as taxpayer. Trustees in situations in which the only nexus to North Carolina is the residency of a beneficiary should file protective claims for refund, as the court’s opinion states that “the beneficiary’s residence in North Carolina, standing alone, is not a sufficient contact by [a trust] with this State to support the imposition of the tax at issue” (page 16, Paragraph 37). However, given the specific and unique facts of the case and heavy reliance on such facts in reaching its decision, the application of the opinion to any situation should be analyzed to determine if a claim for refund is appropriate. Typically, activities of a trustee will cross state lines and into the jurisdiction where the beneficiaries reside, in which circumstances the factual differences may yield a different conclusion regarding the constitutionality of the Statute.