In a recent opinion, the U.S. Supreme Court cited the Restatement of the Law Third, Trusts, in support of its conclusion that the presence of in-state trust beneficiaries alone did not empower a state to tax trust income that had not been distributed to the beneficiaries when the beneficiaries had no right to demand that income and were uncertain ever to receive it.
North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18?457 (June 21, 2019), arose from the termination of a trust that was originally created under New York law by a New York resident. The trust provided that the trustee, who was also a New York resident, had absolute discretion to distribute the trust’s assets to the beneficiaries. After the settlor’s daughter and her three children, who were all beneficiaries of the trust, moved to North Carolina, the North Carolina Department of Revenue assessed a tax on the proceeds that the trust accumulated during the years that the beneficiaries lived in North Carolina. The trustee paid the tax under protest and then sued in state court, arguing that the tax as applied to the trust violated the Due Process Clause of the Fourteenth Amendment, because, among other things, the trustee, who had exclusive control over the allocation and timing of trust distributions, made no distributions to the beneficiaries or any other North Carolina residents during the tax years in question. The trial court ruled in favor of the trustee, finding that the state lacked the minimum connection with the object of its tax that the Constitution required, because the beneficiaries’ “residence in North Carolina was too tenuous a link between the State and the Trust to support the tax,” and the trust maintained no physical investments in North Carolina, made no direct investments in the state and held no real property there. The North Carolina Court of Appeals affirmed, as did the North Carolina Supreme Court.
In a unanimous decision, the U.S. Supreme Court affirmed, holding that the North Carolina statute at issue, N.C. Gen. Stat. Ann. § 105-160.2 (2017), which imposed a tax on any trust income that was “for the benefit of” a North Carolina resident, violated the Due Process Clause of the Fourteenth Amendment when the trust beneficiary received no income from the trust during the relevant tax year, had no right to demand income from the trust in that year, and could not count on ever receiving income from the trust. Associate Justice Sonia Sotomayor, writing for the Court, explained that the beneficiaries in this case had “no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue.” While Restatement of the Law Third, Trusts § 50 provided that “the trustee of a discretionary trust ha[d] a fiduciary duty not to ‘act in bad faith or for some purpose or motive other than to accomplish the purposes of the discretionary power,’” in this case, the trust agreement, by “reserving sole discretion to the trustee . . . nevertheless deprived [the beneficiaries] of any entitlement to demand distributions or to direct the use of the Trust assets in their favor in the years in question.”
The Court rejected the state’s argument that, under Greenough v. Tax Assessors of Newport, 331 U.S. 486 (1947), “a trust and its constituents were always inextricably intertwined,” and, because “trustee residence support[ed] state taxation . . . so too must beneficiary residence,” reasoning that “the State’s argument fail[ed] to grapple with the wide variation in beneficiaries’ interests.” Justice Sotomayor cited Restatement of the Law Third, Trusts §§ 42 and 49 in explaining that, “although beneficiaries [were] commonly understood to hold ‘beneficial interests’ (or ‘equitable title’) in the trust property,” a “beneficiary [might], depending on the trust agreement, have only a ‘future interest,’ an interest that [was] ‘subject to conditions,’ or an interest that [was] controlled by a trustee’s discretionary decisions,” and the “different forms of beneficiary interests counsel[ed] against adopting the categorical rule that the State urge[d].”
Read the full opinion here.