When There Really Isn’t Any There There: The Supreme Court in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust

When the Supreme Court speaks we expect some broad pronouncement, a grand statement settling an intractable problem going to the very essence of the function and application of law in an ordered society.  Particularly so in matters of taxation, not only because I am a tax lawyer, but because taxation is where Government and the citizenry interact most frequently, most universally, sometimes most grindingly, and with the most variety.  As much as we (or some of us) might want a select group of Solons to resolve every question and achieve perfect balance, sometimes the courts, even the Supreme Court, is constrained to simply decide the case in front of it, and thus there may be no greater meaning to be imparted except the resolution of the immediate dispute.  This was the case in Kaestner Family Trust, decided by the Court on June 21, 2019.¹

            This case starkly demonstrates the dichotomy between a common sense view of how the law should be interpreted and applied, and a hyper-technical legalistic approach.  This was a fairly easy case, from a common sense point of view.²  North Carolina was seeking to tax income of a trust that had almost nothing to do with North Carolina, except for the accident of a beneficiary of the trust moving to North Carolina years after the trust was created.  On the other hand, the Department of Revenue had a fairly straight-forward argument: the North Carolina courts had held that this tax could be imposed if a trust merely had a North Carolina resident as a beneficiary. 

            The problem with trusts (or is it their glory?) is that one can create one’s own legal universe; the idiosyncratic provisions one might choose are limited only by the settlor’s imagination.³ In Kaestner Family Trust, an idiosyncratic trust met a fairly idiosyncratic law⁴ and produced a result of extremely narrow application.

            The original trust was formed nearly 30 years ago by a New York resident for the benefit of his three children, and its trust instrument provided that it was to be governed by New York law.  The initial trustee was a New York resident, succeeded along the way by a Connecticut resident.  The trust’s documents and records were maintained in New York, and the custodians of the trust’s property were located in Massachusetts.  The trust instrument granted the trustee “absolute discretion” to distribute the trust’s assets to the beneficiaries “in such amounts and proportions” as the trustee might “from time to time” decide (as quoted by the Court).  In other words, the beneficiaries had no right to receive income or principal, no power to demand any distributions, and no expectation whatsoever as to whether or when any distributions of income or principal would be made by the trustee.⁵ 

            One of the beneficiaries, Kimberley Rice Kaestner, moved to North Carolina with her minor children in 1997, and a few years later, the trustee divided the original trust into three separate trusts, one for each of the original settlor’s children.  One of these trusts was the taxpayer in this case.  Each of the separate trusts had the identical terms of the original trust, most importantly the absolute discretion on the part of the trustee as to amounts and timing of distributions; and the same controlling arrangements, residence of trustee, location of trust papers, location of trust property custodians, and so on.

            The relevant North Carolina statute taxes trust income that “is for the benefit of” a North Carolina resident, which the North Carolina courts had interpreted to authorize a tax on a trust on the sole basis that a trust beneficiary resides in the State.  Accordingly, the North Carolina Department of Revenue assessed a tax on the full amount of the Trust’s income for the tax years 2005 through 2008.  The trustee paid the tax under protest and sued for a refund in state court arguing that the tax as applied to the Trust violated the Due Process clause of the 14th Amendment to the U.S. Constitution.

            The trial court held in favor of the Trust, concluding that “the Kaestners’ residence in North Carolina was too tenuous a link between the State and the Trust to support the tax…,” under the standards of the Due Process clause.⁶ Both the North Carolina Court of Appeals and the North Carolina Supreme Court affirmed, and the Department of Revenue appealed to the U.S. Supreme Court.⁷

            The North Carolina Supreme Court decided in favor of the Trust on the principal grounds that the Trust and its beneficiaries had separate legal existences for tax purposes, and the connection between the beneficiaries and North Carolina could not by itself establish a sufficient taxable connection between the Trust and North Carolina.  The U.S. Supreme Court’s take was slightly different.  It saw the question as “whether the Due Process Clause prohibits States from taxing trusts based only on the in-state residency of trust beneficiaries.”

            Due process can be a relatively slippery concept, but its provenance is deadly serious: the Fourteenth Amendment to the Constitution provides that “[n]o State shall … deprive any person of life, liberty, or property, without due process of law.”  In the area of taxation, the Court, in a unanimous decision authored by Justice Sotomayor (with a concurring opinion by Justice Alito joined by Chief Justice Roberts and Justice Gorsuch), pointed out that the touchstones of due process are whether there is “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax…,” and whether “the income attributed to the State for tax purposes … [is] rationally related to ‘values connected with the taxing State.’”  Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992).⁸  In other words in other words, in order for a tax to be sustained, the State must have given something for which it can ask return, Wisconsin v. J. C. Penney Co., 311 U.S. 435, 444 (1940); and the imposition of the tax must comport with “fundamental fairness.” Quill at 312.

                As suggested above, there are a lot of ways in which basically the same idea can be expressed, and in the ensuing pages of the Opinion, the Court employed many of them.  At the end of the day, the Court held in favor of the Trust.  Two extensive quotes from Justice Sotomayor’s opinion clearly explain the Court’s rationale:

                        “We hold that the presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain ever to receive it.  In limiting our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.”                                      

                        “When a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset.  Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83, 91-92 (1929).  Otherwise, the Stat’s relationship to the object of the tax is too attenuated to create the                     ‘minimum connection’ that the Constitution requires.  See Quill, 504 U.S., at 306.”

            To say that the Court intends this to be a narrowly-construed, fact-specific decision would be putting it mildly indeed.  The Court’s litany of those matters, issues or questions that it was specifically not passing on is almost comical: while the Kaestner beneficiaries did not have the requisite relationship with the Trust property to justify the tax, “[w]e do not decide what degree of possession, control, or enjoyment would be sufficient” to support taxation; after pointing out that the Kaestner beneficiaries had no right to assign their interest in the Trust, the Court declined to address whether the right to assign would afford the beneficiary the requisite control, possession or enjoyment to justify taxation; after pointing out, repeatedly, that the Kaestner beneficiaries received no income, could demand no distributions, and were uncertain of ever receiving any distributions, the Court demurred: ”We have no occasion to address, and thus reserve for another day, whether a different result would follow if the beneficiaries were certain to receive funds in the future;” after noting the Trust’s broader argument that only the trustee’s contacts with the taxing State should determine the State’s power over a trust, including its power to tax the trust’s property or income, the Court said: “Because the reasoning above resolves the case in the Trust’s favor, it is unnecessary to reach the Trust’s broader argumemt….”⁹

            It seems that, having been hoisted on the petard of stare decisis in Wayfair¹º, the Court was going to be sure that there would be no reason to accord any stare decisis effect to Kaestner Family Trust.  There will be absolutely no reason to cite the case in any future decision for any substantive point of law except as a reminder of what the Kaestner Family Trust Court told us it was not deciding.  Also, I think, as a reaction to the mess the Court made of stare decisis in Wayfair, Justice Alito in his concurring opinion (joined in by Justice Gorsuch and Chief Justice Roberts), hoped to squelch any supposition that there would be a reason to question the continued vitality of any case relied on:

                  “I write separately to make clear that the opinion of the Court merely applies our existing precedent and that its decision not to answer questions not presented by the facts of this case¹¹ does not open for reconsideration any points resolved by our prior decisions.”

            It is said that hard cases make bad law, and Kaestner Family Trust seems to prove that an idiosyncratic set of facts piled upon an idiosyncratic trust instrument to which an idiosyncratic taxing scheme is applied, makes … no law.  So why did the Supreme Court feel it had to issue a decision in this case?  It was a unanimous decision, a mere affirmance of the North Carolina Supreme Court would have reached the correct result, take the afternoon off.  The Court must have been sufficiently uncomfortable with the North Carolina Supreme Court’s stated grounds – that “the Trust and its beneficiaries had separate legal existences for tax purposes, and the connection between the beneficiaries and North Carolina could not by itself establish a sufficient taxable connection between the Trust and North Carolina.” (quoting from above)  To the extent that “substance” should be preferred to mere “form” in matters of taxation,¹² the North Carolina Supreme Court’s approach might have felt a little too “form-y” when compared to the more “substance-y” failure to achieve minimum contacts and “rational relation” of the Due Process clause jurisprudence.  Or maybe they just wanted to prove, in these contentious times, that they could reach unanimity on something.

¹  South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018)., discussed herein, another tax case, was decided on this same date in 2018.  I cannot wait to see what happens on June 21, 2020.

² I’ve warned you in prior blogs not to be beguiled by common sense when it comes to taxation.

³  Occasionally, a trust provision will be held to violate some greater interest, such as “public policy” or even the Constitution: see The Girard Trust case, Pennsylvania v. Board of Trusts, 353 U.S. 230 (1957).

⁴  Several times in its opinion the Court was at pains to explain that very few if any other states had a taxing scheme anything like North Carolina’s.

⁵  This might be regarded as an unusual or even an extraordinary provision until one considers that all of the beneficiary’s share of the trust’s property was to be distributed to the beneficiary when he or she turned 40.  This event was to take place after the tax years at issue, 2005 through 2008. In addition, after the tax years at issue, and before Kaestner turned 40, in accordance with Kaestner’s wishes, the trustee rolled the trust assets over into another trust rather than distribute them to Kaestner.

⁶  The trial court also held that the tax as applied violated the dormant Commerce Clause of the Constitution.  Neither of the North Carolina appellate courts nor the U.S. Supreme Court addressed this issue, but it is a fascinating one, and was central to the recent U.S. Supreme Court case South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018).  For those interested in the topic, see my blog The Supreme Court Tackles the Internet – Remote Sellers and the Sales Tax, herein.

⁷  One might wonder why, after being repeatedly rebuffed by the North Carolina courts, the Department of Revenue continued to pursue the matter.  Surely a matter of principle?  Well, the tax involved for the four taxable years amounted to $1.3 million, which at the then-prevailing tax rate means that the Trust was earning nearly $4 million a year.  Certainly dollars worth trying a Hail Mary for.

⁸  As noted by the Court, Quill was overruled by Wayfair, the case cited in note 4, but on different grounds.  The Court here noted the second thing it was not addressing: since the North Carolina tax did not meet the “minimum connection” test the tax would fail, and thus the Court saw no need to address the “rational relationship” test. 

⁹  There are at least two additional questions that the Court surely would not have addressed.  First, is affirmatively abjuring a future right to possess, control or enjoy property, as was done when the Trust property was rolled over to another trust, tantamount to possessing, controlling or enjoyment for purposes of taxation and the Due Process clause?  Second, does the kind of enjoyment no doubt experienced by the Kaestner beneficiaries and the trustee at keeping the Trust property out of the clutches of the North Carolina Department of Revenue sufficient to satisfy the Due Process clause?

¹º  See my blog cited in note 6.

¹¹ There are those who consider that this is what the Supreme Court is always supposed to do.

¹²  A high-sounding doctrine that is often, alas, honored in the breach.  Take as only one example from what may be hundreds, a decision upholding a tax the subject of which was the privilege of doing business in the state and the measure of which was net income, on the basis that the tax was not, after all, a tax on net income.  Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).  The English language can be a dangerous thing in the wrong hands, like a draftsman of a taxing statute or a Department of Revenue.   

Written by E. Morgan Maxwell

E. Morgan Maxwell

Since beginning his own firm, Mr. Maxwell has continued a tax-law oriented practice encompassing a wide range of transactions, planning and dispute resolution. His dispute resolution experience includes involvement at all levels of the Internal Revenue Service (Examinations, Appeals, Collections, Office of Professional Responsibility, the U.S. Tax Court), the Pennsylvania Department of Revenue, the Tax Litigation Section of the Pennsylvania Attorney General’s Office, Pennsylvania Commonwealth Court, Common Pleas Court and local taxing jurisdictions in southeastern Pennsylvania.

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