Kaestner: Applying a Minimum Connections Test to State Taxation of Trusts

Blog Post | 108 KY. L. J. ONLINE | November 11, 2019

Kaestner: Applying a Minimum Connections Test to State Taxation of Trusts

J. Conner Niceley[1]

The rise in popularity of the revocable inter vivos trusts as a form of nonprobate succession has revolutionized the estate planning industry. The use of trusts provide a way by which individuals can maintain freedom of disposition but avoid the costs and complexities of the probate court.[2] Due to its popularity, a majority of states, as well as the federal government,[3] have passed legislation imposing taxes on trusts.[4] North Carolina is among these states, and its Department of Revenue has been the recent subject of Supreme Court review in North Carolina Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust.[5] This decision affirmed the judgment of the state’s highest court that struck down a provision in North Carolina’s tax code imposing a tax on trusts based solely on a beneficiary’s residence in the state.[6]

Kaestner is the first iteration by the Supreme Court in several decades of a state’s limited power to tax trusts, but follows a growing number of state court cases that have rejected state trust taxation on constitutional grounds.[7] In Kaestner, writing for a unanimous court, Justice Sotomayor concluded that an examination of the facts relating to the trust in question did not reach the required minimum connection with the state to permit North Carolina’s Department of Revenue to impose such a tax on a trust beneficiary.[8] To better understand why the Court reached this conclusion, it is important first to evaluate the facts of Kaestner. 

The original trust that eventually prompted this litigation was formed nearly thirty years ago when Joseph Lee Rice, III, executed a trust governed by New York law for the benefit of his children, none of whom at the time lived in North Carolina.[9] It was not until Rice’s daughter, Kimberley Rice Kaestner, moved to the state and resided there with her children from 2005 until 2008, that this issue arose.[10] In the interim, the original trust was divided into three separate trusts, including the Kimberley Rice Kaestner 1992 Family Trust.[11] Because North Carolina taxes any trust income “for the benefit of” its residents, the state’s Department of Revenue assessed a tax on the accumulated proceeds of the trust from 2005 until 2008 while Kaestner’s children—the beneficiaries of the trust—were living in the state.[12] Even though there were no distributions made, the state imposed the tax merely because beneficiaries of the trust were North Carolina residents.[13] Nevertheless, the trustee paid the $1.3 million-plus bill before filing suit, in which it claimed that the imposition of a tax violated the Due Process Clause of the Fourteenth Amendment.[14]

The Court’s analysis of whether the imposed tax violated due process rights will make one happy that they paid attention in first-year civil procedure. To determine whether the imposition of the tax complies with due process, the Court identified that there must be some nexus—a minimum connection—between the state and entity or individual being taxed.[15] The sufficiency of the connection with the state seeking to impose the tax applies the minimum contacts test from International Shoe Co. v. Washington[16] that has more frequently been used in solving issues of  personal jurisdiction.[17] In addition, in order to comply with due process, the “income attributed to the State for tax purposes must be rationally related to ‘values connected with the taxing state.’”[18] The Court never addressed this second part of the analysis, though, because the tax fails under the first, minimum connections prong.[19]

Applying the minimum connections analysis in Kaestner revealed that the beneficiary’s connections with the state were insufficient for a number of reasons. Among them were the lack of distributions made to any beneficiary living in North Carolina during the taxable period, the inability of beneficiaries to possess trust income (because distribution was in the trustee’s “absolute discretion”), and the potential for the trust’s future termination.[20] The Supreme Court’s decision in Kaestner adds to an increasingly long list of state court judgments striking down taxes imposed on trust beneficiaries based on their residence in the state imposing the tax.[21] The trend in these cases, reaffirmed for the first time recently by Kaestner, is that residence alone in a state is not sufficient minimum connections to comply with due process and justify, constitutionally, the assessment of a tax on trust beneficiaries.[22]

So, what significance does Kaestner have on the future of state taxation of trusts? Because the nation’s highest court did not identify cases in which these taxes would pass muster of a due process analysis, we can expect to see continued efforts by states to push the limits of trust taxation. Moving forward, the important consideration is this: if a trust is being taxed merely because a beneficiary resides in the state, the tax is likely unconstitutional. 

[1] Staff Editor, Kentucky Law Journal, Vol. 108; J.D. Candidate, University of Kentucky College of Law (2021); B.A., Political Science, Eastern Kentucky University (2017). 

[2] John H. Langbein, Major Reforms of the Property Restatement and the Uniform Probate Code: Reformation, Harmless Error, and Nonprobate Transfers, 38 ACTEC L.J. 1, 10 (2012). 

[3] I.R.C. § 641 (2019). 

[4] Steve R. Akers, Bessemer Trust, Estate Planning: Current Developments and Hot Topics 135-36 (2014), https://www.bessemertrust.com/files/portal_orig/Advisor/Presentation/Print%20PDFs/2014%20Hot%20Topics%20and%20Current%20Developments_FINAL.pdf (As of December 2014, forty-three states and the District of Columbia imposed taxes on revocable trusts). 

[5] 139 S. Ct. 2213 (2019). 

[6] Id. at 2217.

[7] Steve R. Akers & Ronald D. Aucutt, Bessemer Trust, North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust 6, 9 (2019), https://www.bessemertrust.com/sites/default/files/2019-07/Kaestner_Sup_Ct_Case_Summary_07_09_19.pdf. 

[8] 139 S. Ct. at 2223. 

[9] Id. at 2218. 

[10] Id. 

[11] Id. 

[12] Id. at 2219.

[13] Id. at 2218.

[14] Id. at 2219; U.S. Const. amend XIV.

[15] Kaestner, 139 S. Ct. at 2220 (citing Quill Corp. v. North Dakota ex rel. Heitkamp, 504 U.S. 298, 307 (1992). 

[16] 326 U.S. 310 (1945). 

[17] Kaestner, 139 S. Ct. at 2220. 

[18] Id. (quoting Quill, 504 U.S. at 306). 

[19] Id. at 2220 n.5. 

[20] Id. at 2223. 

[21] A comprehensive list of cases dealing with this issue can be found at Steve R. Akers, Bessemer Trust, Heckerling Musings 2012 and Other Current Developments 91-93, https://www.bessemertrust.com/files/portal_orig/Advisor/Presentation/Print%20PDFs/Heckerling%20Musings%202012_MASTER.pdf.

[22] Id.; Kaestner, 139 S. Ct. at 2221.