Politics & Government

NC says it’s fighting ‘tax shelter’ for wealthy trust funds, but it’s lost at every step

The U.S. Supreme Court will review a North Carolina law that allows the state to tax trust beneficiaries if they live in this state even if their assets and disbursements are out of state.
The U.S. Supreme Court will review a North Carolina law that allows the state to tax trust beneficiaries if they live in this state even if their assets and disbursements are out of state. AP

North Carolina’s revenue-collection agency is fighting to defend a state tax on out-of-state trusts whose beneficiaries live in the state, saying it keeps wealthy people with large trust funds from avoiding state income taxes.

The U.S. Supreme Court has agreed to review a ruling that found the tax unconstitutional.

The Department of Revenue says North Carolina and other states stand to lose hundreds of millions of dollars in tax revenue annually if the ruling by the N.C. Supreme Court in June is upheld. The state says $120 billion flows through trusts nationally, and that more than 2.7 million federal tax returns were filed by trusts in 2014.

States that tax in-state residents’ undistributed income from out-of-state trusts could be hit with massive tax refund claims, they argue. That is already happening in North Carolina, the attorneys say, where the state has received more than 450 income-tax returns from trusts waiting for the outcome of the case.

State attorneys argue that the case could resolve longstanding conflicts over trust law across the country, making it a landmark case, and that it entails the power of states to impose taxes.

State courts have found the tax an unconstitutional violation of due-process protections. Attorneys for the trust say the state is exaggerating the importance of the outcome of the lawsuit, which they contend deals only with narrow legal questions specific to this case.

“This case presents a unique, fact-bound dispute that does not raise any significant questions of federal law,” trust attorney Thomas Myrick wrote in a response opposing a Supreme Court review.

The U.S. Supreme Court agreed on Friday to review the case. A business court judge, the state appeals court and the state Supreme Court all ruled against the state.

“We are pleased that the U.S. Supreme Court has granted the state’s petition, and we are grateful to the court for agreeing to decide this important issue of tax fairness,” state revenue spokesman Schorr Johnson said in an email Tuesday.

The case has gained the attention of former state Supreme Court Justice Robert Orr, a constitutional law expert who along with the attorney general’s office and lawyers from the Poyner Spruill law firm is representing the state. Attorneys for the Moore and Van Allen firm represent the Kimberley Rice Kaestner Trust.

The trust was created in New York in 1992 for the benefit of Kaestner and her three children. Its trustee lived in Connecticut. Kaestner moved to North Carolina in 1997, and was living here during a three-year period that is the subject of the dispute. She has subsequently moved to California.

During that period, the trust had more than $13 million in assets. The trust was taxed $1.2 million on undistributed income, which it paid under protest and then sued for a refund. Under current law, a beneficiary is taxed on income distributed by a trust; but if the trust earns income that it holds for beneficiaries, then the trust is taxed, according to the state’s filings.

Kaestner’s trust earned income from investments made outside of North Carolina, according to court records.

The trust argued Kaestner did not have a sufficient connection to North Carolina for her trust to be subject to the tax. The state argued she benefited from state resources while she lived here, including when she earned a master’s degree at UNC-Chapel Hill.

Six of the seven state Supreme Court justices agreed with the trust; Justice Sam Ervin dissented.

Courts in nine states, including North Carolina, have addressed the dispute; five have concluded the due process clause prevents them from taxing trusts based on residency, while four have ruled just the opposite, according to the state’s filings. That split allows people to shelter their income.

North Carolina’s revenue agency attorneys say the split decisions allow wealthy people with large trust funds to avoid paying state taxes altogether.

The state’s brief, quoting a previous unrelated case, says the practice facilitates “an extraordinary stratagem by which wealthy individuals are able to avoid all state income taxes on investment income through the use of a carefully crafted out-of-state trust.”

“Beneficiaries like Ms. Kaestner can now accumulate income in their trusts over several decades, avoid taxes on that income and then, before taking a distribution from their trusts, simply move — even temporarily — to a state like Florida that does not assess income taxes,” the brief signed by North Carolina Solicitor General Matthew Sawchak says. “Nothing would stop these beneficiaries from returning the following year to their home state to resume residence after taking tax-free distributions from their trusts.”

The brief says that would be a “judicially created tax shelter.”

The state compares the dispute to a U.S. Supreme Court ruling last year that allows states to tax online retailers even if they don’t have a substantial physical presence in the state. North Carolina has begun to collect those taxes.

Craig Jarvis is in his seventh year covering politics for The N&O. He has been a reporter and editor here covering crime, legal affairs, general assignment, arts and real estate. Contact him at cjarvis@newsobserver.com or (919) 829-4576.


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