North Carolina Court Rules That State Can’t Tax Trust Based Solely on Resident Beneficiary

The North Carolina Supreme Court ruled that, pursuant to the Due Process Clause of the Constitution, the state could not tax a trust based solely on the residence of its beneficiaries, opening the door for potential refund claims in North Carolina and other states.

The state taxation of trusts is a complex area because there are many different types of trusts and typically several players involved: the settlor/grantor, the trustee/fiduciary, and the beneficiary.  At the state level, whether a trust is subject to income tax may be dependent on one or more factors, such as the residency of the trustee, settlor, and/or beneficiary, and whether the trust is earning income in the state.  For example, Georgia imposes income tax on all resident fiduciaries as well as any nonresident fiduciary that (1) receives income from business done in the state, (2) manages funds or property located in the state, OR (3) manages funds or property for the benefit of a Georgia resident (i.e., a Georgia beneficiary).[1]

On June 8, 2018, the North Carolina Supreme Court issued an opinion addressing the issue of whether the state could tax a trust for the years 2005-2008 based solely on presence of North Carolina resident beneficiaries.[2]

In that case, a trust was created in 1992 in New York for the benefit of the settlor’s children. The settlor was a resident of New York, and the trust was organized under the laws of New York. An initial trustee was named who resided in New York, but was replaced in 2005 by a Connecticut resident who remained the trustee throughout the relevant time period in question. In 1997, one of the beneficiaries of the trust moved to North Carolina. For ease of administration, the trust was subdivided a couple of times into sub-trusts, one of which was for the benefit of the North Carolina resident and her children.

Throughout the years at issue, the custodians of the trust were in Massachusetts and all legal records and financial documents were in New York. For tax years 2005 -2008, North Carolina taxed the trust on income accumulated even if the income was not distributed to any of the North Carolina beneficiaries, based on its statute that taxes trusts on “income . . . that is for the benefit of a resident of this State.”[3]  The trust filed for a refund of those taxes, which the North Carolina Department of Revenue denied.  The case made its way through a couple of lower courts, where the trust was victorious, before being appealed to the North Carolina Supreme Court.

The trust argued that it did not have sufficient minimum contacts with the state under the Due Process Clause of the United States Constitution (i.e., the 14^th Amendment) based solely on the residence of the beneficiaries. On review, the Court cited a prior United States Supreme Court case stating that there must be some “minimum connection between a state and the person, property, or transaction it seeks to tax.” The Court went on to state that in order to satisfy minimum contacts, each case will vary but “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, thus invoking the benefits and protections of its laws.”

The Court recognized that a trust and its beneficiary are legally independent entities and that property held by the trust is not within the state, it does not belong to the beneficiary, and is not within the beneficiary’s control.  In this case, the North Carolina beneficiaries enjoyed the benefits and protections of North Carolina’s laws because the beneficiaries resided in North Carolina, not the trust.

The state argued that the domicile of the beneficiary is critical to taxation and cited cases from two other states that agreed with that logic. However, the Court distinguished both of those cases, one based on the fact that the court’s analysis did not address that a trust has a legal existence apart from the beneficiary, and the other based on the fact that the beneficiary and trustee were the same entity and resided in the taxing jurisdiction. Alternatively, the state argued that the trust had minimum contacts with the state because it reached out to the beneficiary several times, met with the beneficiary, and restructured the trust.  The Court rejected that argument, concluding that any such contact was infrequent, and noting that there were only two meetings during the years at issue, both of which occurred in New York.

Thus, the Court held that the trust did not have sufficient minimum contacts with North Carolina, and the state’s taxation of the trust violated the Due Process Clause of the United States Constitution.

This case may present a refund opportunity in North Carolina and other states if a trust paid income tax to a state based solely on the residency of the beneficiary.  Trustees should review their income tax filings carefully with their tax advisors to determine whether such refund opportunities exist.

Aprio’s SALT team is experienced in the income taxation of trusts and can assist trustees to ensure that they are minimizing their income tax obligations. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact  Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the July 2018 SALT Newsletter.

[1] O.C.G.A. § 48-7-22(a).

[2] The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Dep’t of Rev., No. 307PA15-2, (N.C. Sup. Ct., June 8, 2018).

[3] N.C.G.S. § 105-160.2.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.