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North Carolina Appellate Court Affirms that Taxation of Trust’s Income is Unconstitutional

July 18, 2016 By Michael Giovannini

On July 5, 2016, the Court of Appeals of North Carolina affirmed the 2015 decision by the superior court in The Kimberley Rice Kaestner 1992 Family Trust v. N.C. Dep’t of Revenue, which held that North Carolina was constitutionally prohibited from taxing the income of the plaintiff trust.  Essentially, the state asserted jurisdiction to tax the trust’s income based solely on the fact that the beneficiaries of the trust were North Carolina residents (the trust had no other connection with the state).  The superior court rejected this assertion, concluding that the state could not impose the tax under both the Due Process Clause and Commerce Clause of the U.S. Constitution.

In our October 12, 2015 article (published in State Tax Notes), we focused on the superior court’s holding that application of the tax to the trust did not satisfy’ the fairly related prong of the Complete Auto Commerce Clause test.  See Michael M. Giovannini & Matthew P. Hedstrom, “The Fairly Related Prong: Back From the Dead or Flash in the Pan?”, State Tax Notes, Oct. 12, 2015, p. 127.  This prong is generally viewed as having been emasculated by the U.S. Supreme Court and is often overlooked by taxpayers in making constitutional arguments.  Yet, the N.C. superior court found it meaningful that the trust had a complete lack of connection with North Carolina and thus failed to satisfy this prong (in addition to the substantial nexus prong).  We concluded our article by noting that the fairly related argument is worth another look, particularly in light of the increasingly aggressive approach that states are taking regarding Commerce Clause nexus.

The Court of Appeals found that the state’s proposed taxation of the trust violated the trust’s substantive due process rights, and therefore the court did not need to address the Commerce Clause arguments.  The court found that “the connection between North Carolina and the Trust was insufficient to satisfy the requirements of due process.”

In our view, the Court of Appeals’ decision to affirm the superior court was correct, and in particular, we agree with the conclusion that the trust’s connection to North Carolina was insufficient to satisfy the Due Process Clause.  Although the Court of Appeals did not directly tackle the fairly related prong of Complete Auto or the other Commerce Clause arguments (and thus did not shed any further light on the fairly related prong), Kaestner Trust still supports our view that taxpayers should consider the fairly related prong even if substantial nexus is arguably met.

In fact, given that the state’s assessment failed to meet due process, it is still fair to conclude, based on the Court of Appeals’ citation to Quill and the superior court’s ruling, that the Due Process Clause should prevent a state from asserting jurisdiction if the state does not provide any benefits “for which it can ask in return.”  We think that line of argument could prove persuasive on the right facts.

Filed Under: State & Local Tax, State & Local Tax Advisory, State Tax Litigation Tagged With: Commerce Clause, Due Process Clause, fairly related, nexus, North Carolina

About Michael Giovannini

Michael is a senior associate in the firm's State & Local Tax Group, focusing his practice on advising clients and providing practical planning services with respect to various state and local tax and unclaimed property issues.

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