Debevoise assisted its client, a New York-based Trust, in a significant, precedent-setting decision from the North Carolina Supreme Court, invalidating on constitutional grounds North Carolina’s law that taxes trusts based on the residence of its beneficiaries.

The Trust has its origins back to 1992, through a predecessor trust established in New York for one of the firm’s clients. In 2005, Debevoise partner David Bernstein become trustee of the Trust. Bernstein divided the Trust into separate trusts for the benefit of each of the settlor’s children, and later decanted the trust at issue into a new trust with more flexible terms.

In 1997, one of the settlor’s children moved to North Carolina. She and her family were residents of North Carolina until 2015, when they moved to California. In 2005 through 2008, the Trust had substantial income that resulted in income tax liability to North Carolina in light of a North Carolina law that subjected out-of-state trusts to state income tax if the trust’s beneficiary is a North Carolina resident. As required by North Carolina law, the Trust paid the state income taxes to North Carolina (which totaled more than $1.3 million).

Debevoise trustee David Bernstein then sought a refund on the ground that the Trust lacked sufficient contacts with North Carolina to justify taxation under the Due Process Clause of the U.S. Constitution, and also under analogous provisions in the North Carolina Constitution. The Trust pointed out that the settlor was a New York resident, the trustee was a Connecticut resident, the trust’s financial advisors were based in Connecticut, the custodian of the Trust’s assets was based in Massachusetts, the trust’s legal and tax advisors were based in New York, the Trust was administered in New York, and none of the Trust’s property was based in or invested in North Carolina.

In 2012, the North Carolina Department of Revenue denied the refund request. The Trust then sued the State in the North Carolina business court, seeking a declaration that the statute was unconstitutional and that the taxes should be refunded. Following discovery (including Bernstein’s deposition), the trial court in 2014 granted summary judgment to the Trust. That decision was unanimously affirmed by the North Carolina Court of Appeals in 2016. The State, though, petitioned for leave to appeal, which petition was granted, and the North Carolina Supreme Court heard argument on the appeal in 2017.

In June 2018, the North Carolina Supreme Court ruled 6-1 in favor of the Trust. Accepting the arguments that Debevoise has been advancing for nearly a decade, the court held that the statute was unconstitutional as applied to the Trust because the Trust lacked sufficient contacts with North Carolina to satisfy the Due Process Clause. The court held that the residence of the beneficiary is not, by itself, a sufficient contact to justify taxation; the court also rejected the State’s arguments that other contacts between Bernstein, as trustee, and the beneficiary (located in North Carolina at the time) were sufficient to justify the imposition of tax. In addition, the court rejected the State’s attempt to pierce the trust veil; instead, the court reaffirmed that a trust is a separate juridical entity, and any benefits that the State provides to the beneficiary are irrelevant to the question of whether the trust itself has sufficient contacts with North Carolina to satisfy taxation under the Due Process Clause.

In ruling for the Trust, the North Carolina Supreme Court rejected decisions that upheld taxation in similar situations in Connecticut and California. The North Carolina Supreme Court criticized those decisions as inconsistent with controlling U.S. Supreme Court precedent, and also distinguished those cases on the facts. Instead, the court followed decisions from Illinois, Minnesota, New Jersey and Ohio that also have refused to uphold a state’s right to tax a trust based solely on attenuated contacts between a trust and the taxing state. This case provides a conclusive answer in North Carolina and helpful precedent elsewhere that can help trusts and their beneficiaries in their planning and to avoid unconstitutional taxation.

David Bernstein, a litigation and intellectual property partner at Debevoise, has managed this case in his role as trustee, with the assistance of North Carolina tax and litigation counsel.