WASHINGTON—North Carolina’s solicitor general told the Supreme Court that his state is entitled to tax residents who are beneficiaries of trusts created outside the state, even if they haven’t received payments from the trust.

How the Supreme Court rules in the case, known as North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust, might have an impact on the nation’s trust industry, which generates more than $120 billion in earnings every year.

Many lawyers have difficulty mastering the law of trusts, which is considered to be extraordinarily complex. To be helpful, in its petition to the court seeking review, the state defined a trust as “a legal abstraction: a fiction created to represent the tripartite relationship among a settlor, a trustee, and a beneficiary. For this reason, a trust’s physical location is debatable.”

States rely on the tax revenue they collect from trusts. Of the 44 states that levy an income tax on trusts, 12 “use the location of the trustee as the primary consideration in determining residency, 27 tax “based on either the location of the beneficiary or the location of the grantor, without reference to the location of the trustee,” and six use multiple factors, a group of states said in a friend-of-the-court brief filed in support of North Carolina.

North Carolina imposes taxes on trusts that are for the benefit of a resident of that state.

In the case before the court, Joseph Lee Rice III, father of the woman the trust is named after, created the family trust in New York in 1992. He divided the trust into three parts for his three children. Kimberly Rice Kaestner moved to the Tar Heel State and took loans from the trust for business opportunities, which she paid back.

Although she never received any discretionary distributions, North Carolina still taxed income from the trust. She paid more than $1.3 million under protest to the state and sued to get it back, arguing that the Fourteenth Amendment’s due process guarantees were denied because the state didn’t demonstrate a sufficiently strong connection—sometimes called a nexus—between itself and the income from the trust to justify the tax.

The Supreme Court of North Carolina ruled in Kaestner’s favor on June 8, 2018, holding that income tax applied to trusts beyond state lines, and without a valid nexus between the taxing body and the taxpayer, violates the Fourteenth Amendment.

During oral arguments April 16, justices questioned North Carolina Solicitor General Matthew Sawchak aggressively.

Justice Stephen Breyer was particularly testy.

“Look, the trustee lives in New York, OK?” he told Sawchak.

“The settlor is in New York. All the administration is in New York. There is one thing that’s going to happen in North Carolina … [which] is if she is there when it’s distributed, she’ll get some money … which you’re totally free to tax.”

“But that isn’t what [you] want to tax. You want to tax all these things which are everyone except her is in New York, and moreover, we don’t even know if she’ll ever get the money. Now, there’s something wrong with that.”

Justice Sonia Sotomayor told Sawchak, “I don’t know how you can tax somebody you have no jurisdiction over, especially if they haven’t done anything like pay any money over or have no contacts with the person in your state.”

The attorney for the trust, David A. O’Neil, told the justices that the trust had no connection to North Carolina because no funds from it were distributed there.

The trustee manages the trust and there is no guarantee that Kaestner will receive distributions from the trust, he said. The money in the trust “was not really the beneficiary’s money during the tax years,” O’Neil stated.

Kaestner “didn’t possess it or control it,” he said.

“She didn’t access it. She couldn’t use it. She couldn’t buy anything with it, promise it to someone else. She couldn’t have any say in how it was invested. 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,” O’Neil said.

But by taxing her, the state has made assumptions, which could prove to be wrong, about what she will do with the trust funds when they are distributed, he said. Kaestner could keep the money or give it to her children.

“It’s not known how many beneficiaries there are or who will actually receive the money. It’s not known where they will live when they receive the money or how many people it’s shared with,” O’Neil said.

This article by Matthew Vadum appeared April 17, 2019, in The Epoch Times.