Opinion analysis: Presence of in-state beneficiaries alone insufficient for state to assert jurisdiction to tax trust income

In a unanimous opinion, the Supreme Court on Friday held that North Carolina’s efforts to tax the income of a trust based on the trust beneficiary’s residence in the state violated the Constitution’s due process clause.

The case arose when North Carolina attempted to tax the income earned by the Kimberley Rice Kaestner 1992 Family Trust from 2005 to 2008. During this period, the Kaestner trust’s beneficiaries were all residents of North Carolina, but the trust’s grantor was a resident of New York, and the trust was governed by New York law, where its documents and records were kept. The trust’s asset custodians were in Massachusetts.  At no point during the relevant tax period was the trustee a North Carolina resident. Moreover, the trust earned no income in North Carolina.

The trust alleged that North Carolina’s imposition of its tax violated the due process clause because the trust lacked the necessary minimum contacts with the state. North Carolina argued that the presence of in-state beneficiaries was sufficient to satisfy the minimum-contacts requirement under the court’s modern jurisprudence.

The Supreme Court rejected the state’s arguments in an opinion written by Justice Sonia Sotomayor. The opinion begins its analysis by observing that tax due process cases are analyzed under a two-step framework that requires (1) “some minimum connection” between the taxpayer and the state and (2) a rational relationship between the income the state seeks to tax and the state.  The opinion focuses on the first part of this test, which is determined under the same framework, derived from the court’s 1945 decision in International Shoe Co. v. Washington, used to analyze questions of personal jurisdiction.

In applying the International Shoe framework to trust cases, the opinion remarks on the legal complexity of trusts, which are not themselves legal entities but rather a fiduciary relationship between a settlor, a trustee and a beneficiary. In cases like this one, the hard question is not whether the beneficiary’s contacts are sufficient, but rather whether they matter at all for the minimum-contacts analysis. Drawing on two seminal cases about the taxation of trusts,  Safe Deposit & Trust Co. of Baltimore v. Virginia and Brooke v. Norfolk, the opinion suggests that whether a beneficiary’s in-state contacts are relevant depends on “the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets.”

Applying this test to the Kaestner trust, the court concludes that the in-state beneficiaries lack the requisite control or possession for their contacts with North Carolina alone to establish jurisdiction. The beneficiaries neither received money from the trust during the relevant period nor had any right to demand trust distributions. Furthermore, because the trust gave the trustee sole discretion over distributions, there was not even a guarantee that a particular beneficiary would ever receive a distribution.

In addressing the state’s concerns about existing tax regimes and tax avoidance, the court repeatedly emphasizes the narrowness of its holding. Furthermore, the opinion notes that if settlors wish to provide more certainty to beneficiaries, rather than entrusting distributions to the sole discretion of the trustee, tax-avoidance opportunities will be more limited. The opinion concludes that “mere speculation about negative consequences cannot conjure the ‘minimum connection’ missing between North Carolina and the object of its tax.”

When the Supreme Court agreed to review this case, many observers hoped that the court might use it as an opportunity to address tax jurisdiction and provide guidance to taxpayers and states, especially in the wake of last summer’s decision in South Dakota v. Wayfair to allow states to impose a sales tax obligation on vendors who lack a physical presence in the state. Oral argument made clear that the justices were more interested in the particularities of trust law, and this opinion is decided quite narrowly. At multiple points within the opinion and its footnotes, the opinion explicitly withholds judgment, both about states’ claims of jurisdiction over trusts on other bases and about states’ jurisdiction over trusts whose distribution regimes differ from that of the Kaestner trust.

In a concurrence, Justice Samuel Alito, joined by Chief Justice John Roberts and Justice Neil Gorsuch, attempts to clarify that the narrowness of this holding does not mean there is no governing standard. Alito writes, “The Court’s discussion of the peculiarities of this trust does not change the governing standard, nor does it alter the reasoning applied in our earlier cases.” Although this concurrence suggests more certainty for trust cases going forward, it remains to be seen how the court will deal with other due process challenges to state tax regimes.