On Tuesday, the Supreme Court heard oral argument in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust. North Carolina hopes to convince the court that its method of taxing trusts, with jurisdiction based on an in-state beneficiary, passes constitutional muster. The court greeted the state’s arguments with significant skepticism.
As a quick recap, North Carolina’s Department of Revenue is defending tax liability imposed on income earned by the Kimberley Rice Kaestner 1992 Family Trust between 2005 and 2008. During this period, the trust’s beneficiaries were all North Carolina residents, but the trust itself was administered in New York by trustees who were not North Carolina residents, and the trust made no distributions in the relevant period. (The trust concedes, as it must, that distributions actually paid to a North Carolina beneficiary would be taxable in that state as income to the beneficiary.)
North Carolina Solicitor General Matthew Sawchak, representing the Department of Revenue, opened his argument by emphasizing that the trust beneficiaries are the “true owners of trust income” and “the benefits and protections” provided by the state to its residents provided sufficient ground for the state to tax a beneficiary’s income, even while held in trust.
Several justices, however, seemed unpersuaded by Sawchak’s true-ownership argument. Sawchak conceded that the trustee had complete discretion over both the timing of distributions and their allocation among beneficiaries. As Justice Sonia Sotomayor asked Sawchak, “What makes it your right under any circumstance to tax all of the trust income where there’s no guarantee that she is going to receive all of it at any point?”
Justice Stephen Breyer also questioned the fairness of the state’s pro-rata approach, which assumed trust beneficiaries would split trust income equally, even if the trust document granted the trustee discretion as to how to allocate distributions. Breyer was concerned with the possibility that a nonresident would end up with the lion’s share of trust distributions. In that case, North Carolina’s pro-rata division of trust income would overstate the income appropriately attributed to the state. Breyer, somewhat quixotically, also seemed to believe that the state should offer a present-value discount on trust income to reflect the fact that the beneficiary did not immediately receive the benefit of the income.
Finally, the justices also seemed concerned about how North Carolina’s tax would affect other states’ efforts to tax the trust income based on in-state administration or the residence of a trustee. Sawchak argued that North Carolina’s credit system solved any problems of multi-state taxation and tried to pivot to the state’s argument that jurisdiction based on beneficiary residence prevented tax avoidance. Sawchak’s point was that worries about multiple tax burdens on trust income were misguided given the ease with which trusts could move to avoid taxes based on other characteristics.
He was not allowed to linger on this point, however, because Justice Neil Gorsuch and Sotomayor both wanted to know how North Carolina’s position squared with existing precedent. Both justices suggested that the state’s position required the court to overrule prior decisions on state jurisdiction over trusts. Sawchak tried to distinguish two of these cases, Safe Deposit Trust Co. v. Virginia and Brooke v. Norfolk, as property tax cases. Gorsuch made clear that he was not persuaded, observing that Sawchak was “slicing the baloney a little too thinly.” Sawchak then fell back on the argument that the cases had been implicitly overruled by the court’s modern due process jurisprudence. Addressing questions about the court’s decision in Hanson v. Denckla, Sawchak argued that Hanson was about adjudicative and not tax jurisdiction. Sawchak returned to this point in his rebuttal, though Gorsuch seemed to remain skeptical.
David O’Neil, representing the trust, began by arguing that trust income does not belong to the beneficiary. As he observed, Kimberley Kaestner “didn’t possess it or control it. She didn’t access it. She couldn’t use it. … She didn’t receive any of it, and she had no guarantee that she would ever receive a penny of it in North Carolina or anywhere else.”
Justice Elena Kagan emerged as the justice most skeptical of the trust’s position. She flatly rejected O’Neil’s argument that the beneficiary does not benefit from undistributed trust income, noting that “a person in North Carolina who’s making $ 100,000 a year and a person in North Carolina who’s making that exact same amount of income and has a $ 20 million trust are really in two different positions.” As a result, Kagan suggested that as among establishing jurisdiction based on trust administration, trustee residence and beneficiary residence, beneficiary residence had the most compelling claim. As she noted, “all the benefit of this trust is going to this person who lives down in North Carolina.”
Other justices expressed far less skepticism, and O’Neil took several opportunities to rebut the state’s claims. For example, in response to Chief Justice John Roberts’ questions about the taxation of trust distributions, O’Neil addressed North Carolina’s concern that a taxpayer victory here would open the doors to tax abuse. O’Neil suggested that states already have a constitutional mechanism to solve this problem: throwback statutes that allow states to tax “income that had accumulated in previous years and that the trustee did not pay tax on.”
At one point, several justices engaged O’Neil in a colloquy about the constitutional limits of a state wealth tax, before Breyer concluded that “I can’t reach [this] really interesting legal question” because it wasn’t presented in this case.
O’Neil concluded by addressing the state’s argument that last year’s decision in South Dakota v. Wayfair, in which the court ruled that states can require retailers who don’t have a physical presence in the state to collect tax on sales to state residents, changes the result in this case. Noting that Wayfair focused on the taxpayer’s own conduct in the state, he suggested the proper analogy to that case would be the claim of jurisdiction over Wayfair’s income based on the residence of a beneficial shareholder.
Prior to the oral argument, court observers (including me) had suggested that this case offered the court an opportunity to clarify its due process doctrine in state tax cases. The court’s questions, focused as they were on the particular problems of trust taxation, suggest interest in a narrower opinion. And states hoping the court would bless the taxation of trust income based on in-state beneficiaries should probably start considering other ways of taxing this income. Now, about the state wealth tax …
Editor’s Note: Analysis based on transcript of oral argument.
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