On June 8, the North Carolina Supreme Court affirmed the Court of Appeals’ 2016 decision in the matter of the Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue , upholding the Court of Appeals’ (and Business Court’s) finding that North Carolina General Statute Section 105-160.2 is unconstitutional as applied to the Kimberly Rice Kaestner 1992 Family Trust. As highlighted in McGuireWoods’ July 8, 2016, alert, the trust challenged the state of North Carolina’s imposition of income tax on the basis that the trust’s sole tie to the state is the residency of the trust’s beneficiary, which connection is insufficient to allow taxation under the due process and commerce clauses of the U.S. Constitution.
The trust sought a refund of over $1.3 million in income taxes paid to the state of North Carolina for tax years 2005 – 2008. Upon denial of the claim, the trust brought suit challenging the constitutionality of the statute, both on its face and as applied to the taxpayer (the trust). Each of the Business Court, Court of Appeals, and North Carolina Supreme Court focused on the unique facts of the case in finding that the statute is unconstitutional as applied to the trust.
As previously highlighted in McGuireWoods’ 2016 alert, the trustee, during the period taxes were assessed, was a resident of Connecticut, the trust was governed by New York law, and North Carolina’s only connection to the trust was the residence of the beneficiary. Further, all custodians of the trust’s assets were located in Massachusetts, while all documents related to the trust, such as ownership documents and financial and legal records, were kept in New York. Finally, distributions from the trust were in the discretion of the trustee, and no distributions were made to the beneficiary in North Carolina during the relevant period.
The North Carolina Supreme Court emphasized that its opinion is limited to an “as applied” standard, meaning the court considered only whether the statute is constitutional as applied to the trust. In responding to the trust’s continued challenge to the constitutionality of the statute, on its face, the North Carolina Supreme Court noted the presumption that “any act passed by the legislature is constitutional” and “any individual challenging the facial constitutionality of a legislative act must establish that no set of circumstances exists under which the [a]ct would be valid” (emphasis added). Because the trust presented only facts and evidence relevant to it, the North Carolina Supreme Court did not (and could not) consider whether the statute is unconstitutional on its face.
It has long been settled that a trust has a separate existence from its beneficiary, and therefore income to the trust is separately attributed. In determining whether the statute is constitutional, as applied to the trust, the North Carolina Supreme Court evaluated the requirements of the due process clause, specifically that the entity being taxed must “purposefully direct its activities” at the state, and the activities must be sufficiently abundant that the entity invokes the benefits and protections of that state’s laws. Therefore, in order to withstand this challenge, the presence of the trust beneficiary in the state must satisfy the “purposeful” requirement to allow taxation of the trust. The North Carolina Supreme Court concluded that the unilateral activity of the beneficiary did not satisfy this requirement.
Interestingly, Justice Sam Ervin, in dissent, noted the advancements of modern technology related to online and telephone communications, rather than in person. He opined a traditional analysis of physical presence in a state may need to be amended to reflect those changes in determining whether a taxpayer purposefully directs its activities to a state.
Conclusion: With the North Carolina Supreme Court’s limited scope decision, as applied solely to the trust, taxpayers and advisers should carefully evaluate whether tax is due by a trust in North Carolina. For taxes already paid, and to the extent that a trust’s sole connection with North Carolina is the residence of a trust beneficiary, the trustee should consider filing a claim for refund.