A portion of N.C. Gen. Stat. Section 105-160.2 providing that a trust may be taxed on income “that is for the benefit of a resident of this State” was found to be unconstitutional as applied to the Plaintiff Trust in The Kimberly Rice Kaestner Trust v. North Carolina Department of Revenue. The sole basis for imposition of the tax by North Carolina was the beneficiaries’ residence in North Carolina. The North Carolina Supreme Court affirmed in an opinion filed on June 8, 2018 that the portion of N.C. Gen. Stat. Section 105-160.2 providing that a trust may be taxed on income “that is for the benefit of a resident of this State” is unconstitutional under the Due Process Clause of the U.S. Constitution and Article 1, Section 19 of the North Carolina Constitution as applied to the Plaintiff Trust when the only basis for the imposition of the tax is the beneficiaries’ residence in North Carolina.
The Kaestner case involved North Carolina beneficiaries of a trust having its principal place of administration and its trustee in New York. The custodians of the assets of that trust were in Boston, Massachusetts and all documents and records were kept in New York. In addition, all tax returns for the trust were prepared in New York. During the tax years in question, no beneficiary had an absolute right to the trust’s assets nor were any distributions made to the beneficiary from the trust. The beneficiary had a few meetings with the trustee to discuss different items involving the trust, but all meetings were in New York.
During the tax years of 2005 through 2008, the North Carolina Department of Revenue attempted to tax the income of the trust to the trust based on N.C. Gen. Stat. Section 105-160.2, which states in part “[T]he tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State….”
The trust (the “Plaintiff Trust”) responded by filing a complaint claiming that the N.C. Department of Revenue wrongfully denied the Plaintiff Trust’s claim for refund of taxes paid and that N.C. Gen. Stat. Section 105-160.2 was unconstitutional on its face and as applied to the Plaintiff as it violated the Due Process and Commerce Clauses of the U.S. Constitution as well as Article I, Section 19 of the North Carolina Constitution.
In the initial phases of litigation, the North Carolina Business Court opined that when, as was the case here, a plaintiff is not physically present in the state, that plaintiff must have “purposefully availed” itself of the economic benefits of the state in order to be taxed by that state in accordance with due process requirements. The North Carolina Business Court concluded that the Plaintiff Trust did not purposefully avail itself of the benefits of North Carolina based solely on the beneficiaries’ residence in the state but nothing more. Therefore, the North Carolina Business Court held that N.C. Gen. Stat. Section 105-160.2 violated the Due Process and Commerce Clauses of the U.S. Constitution and Article I, Section 19 of the North Carolina constitution as applied to the Plaintiff Trust. The N.C. Department of Revenue appealed the North Carolina Business Court’s decision.
The North Carolina Court of Appeals affirmed the decision of the North Carolina Business Court and held that the Plaintiff Trust has a separate legal existence from the beneficiaries, and therefore the beneficiaries’ location within the state, alone, was insufficient to satisfy due process requirements needed in order for North Carolina to tax the income of the trust. The Court of Appeals did not address whether the Commerce Clause was also violated. The N.C. Department of Revenue again appealed to the North Carolina Supreme Court.
North Carolina Supreme Court Decision
On June 8, 2018, the North Carolina Supreme Court issued an opinion affirming the decision of the North Carolina Court of Appeals. On appeal, the N.C. Department of Revenue maintained that the Plaintiff Trust had purposefully availed itself of the economic benefits of North Carolina through certain actions of the trustee where the Plaintiff Trust benefitted from “the ordered society maintained by taxation in North Carolina.” The Court disagreed.
Reviewing the case de novo, the Court first reasoned that it would not analyze whether the statute in question was unconstitutional on its face or not. Following the presumption that statutes passed by the legislature are constitutional, the Court stated that in order for a statute to be unconstitutional on its face, there must not be any circumstance in which the statute could be constitutionally valid. The Court stated that due to his heightened standard and the allegations involved, it would not analyze the constitutionality of the statute in question on its face.
Turning to the analysis of whether N.C. Gen. Stat. Section 105-160.2 was unconstitutional as applied to the Plaintiff Trust, the Court stated that its analysis of whether this statute violated the Due Process Clause of the U.S. Constitution also was applicable to whether it violated the North Carolina Constitution. Like the North Carolina Business Court and Court of Appeals, the North Carolina Supreme Court stated that in order to be taxed by the state the Plaintiff Trust must have “minimum contacts” with the state in a form such that the Plaintiff Trust purposefully availed itself of the economic benefits of the state. Even though this is a situation-by-situation analysis, there must be some act by the taxed party to which it purposefully availed itself of the privilege of conducting activities within the state and invoking the benefits and protections of its laws. In the situation of a trust, the Internal Revenue Code and North Carolina tax laws specifically treat the income taxation of a trust as separate from the income taxation of a beneficiary of that trust. The income of the trust is not conflated with the income of the beneficiary. This was deemed critical to the Court’s analysis as it reasoned that the Plaintiff Trust and its beneficiaries were legally separate, taxable existences and a taxed entity’s minimum contacts with the state cannot be established by a third party’s minimum contacts with the state. In this case, it was the Plaintiff Trust’s beneficiaries and not the Plaintiff Trust itself that were afforded the benefits of North Carolina. Therefore, the Court affirmed the Court of Appeals and held that due process was not satisfied to tax the Plaintiff Trust solely based on the beneficiaries’ contacts with North Carolina.
The Court continued to analyze other cases and arguments presented by the N.C. Department of Revenue but reached the same conclusion. The Court pointed out that the location of the trustee of a trust may lead to a different conclusion than was reached here. In addition, in response to the N.C. Department of Revenue’s argument that due process was satisfied because the Plaintiff Trust “reached out to North Carolina by purposefully taking on a long-term relationship with the trust’s beneficiaries, even though the trustees … never entered the state” the Court reasoned that during the tax years in question the trustee of the Plaintiff Trust and the beneficiaries only met two times and both meetings occurred in New York. In addition, the minimum contacts that must be established must be the Plaintiff Trust’s contacts with the state itself and not with a person who resides there. Therefore, the Court ruled that the mere presence of a beneficiary of a trust in North Carolina does not satisfy due process requirements and North Carolina may not tax the Plaintiff Trust based on the beneficiary’s presence within the state. N.C. Gen. Stat. Section 105-160.2 is unconstitutional as applied to this situation.
The outcome of this case is important for practitioners as it shows that an out-of-state trust in which a beneficiary of that trust resides in North Carolina cannot be taxed by North Carolina without any additional contacts with the state. It is noteworthy that if a trust has other connections or involvement with North Carolina this conclusion may not be the same. In particular, this case seems to point to at least a strong possibility that if the trustee or a trust’s assets are located within North Carolina the income of the trust may be taxed by the state. However, the North Carolina Supreme Court did make it clear that if the only contact with the state is the location of the beneficiary, the income of the trust may not be taxed by North Carolina.
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