A Constitutional Right To Skirt State Income Tax?

Daniel Hemel
Jun 22 · 7 min read

Imagine this: A multimillionaire private equity investor in New York transfers interests in one of his private equity funds to a trust and appoints as his trustee an attorney who lives in Connecticut. The beneficiaries of the trust are his adult daughter and her three children (his grandchildren), who live in North Carolina. The terms of the trust allow the Connecticut attorney to decide when to distribute money or other trust property to the daughter and the grandchildren, but he can’t distribute the money to anyone else. And of course, the attorney is unlikely to override the wishes of the private equity investor, who — after all — is a major client of the Connecticut attorney’s law firm.

The trust generates income — lots of it. Indeed, it appears that the trust earned more than $13 million in 2007 alone. Presumably it should pay tax on this income to some state. But where?

The trust argues — successfully — that New York can’t tax its income. (Well, of course, the “trust” qua trust doesn’t argue anything, because trusts can’t talk — it’s the Connecticut attorney’s law firm that makes this argument on the trust’s behalf.) The trust points to a 1964 New York Court of Appeals case, which itself relies on an 1929 U.S. Supreme Court case, Safe Deposit & Trust Co. v. Virginia, which held that Virginia couldn’t tax a trust administered by a financial institution in Maryland even though the person who created the trust lived in Virginia.

Connecticut, for its part, decides not to tax the trust. And smartly so. Connecticut knows that if it tries to tax the trust based on the fact that the trustee is a Connecticut attorney, the multimillionaire private equity investor is going to take his business somewhere else (e.g., to Florida, a state with no income tax). All that would come of Connecticut taxing the trust is that lawyers and financial institutions in the state would lose a lot of trust-related business.

North Carolina steps up to the plate. It argues that the trust exists solely for the benefit of North Carolina residents, who enjoy its protections and use its public services. It allows the trust to claim a credit for taxes paid to other states, but if the trust doesn’t pay state tax anywhere else, North Carolina argues that at least the trust should pay tax in the Tar Heel State.

Seems like a pretty good argument. Alas, the Supreme Court on Friday rejected the argument in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, the facts of which are almost as described above. (The private equity investor first chose an attorney who moved to Florida before settling on the Connecticut attorney as a replacement. The daughter didn’t move to North Carolina until after the trust’s formation, and her kids came later. None of this much matters to the case.) On a day when several other decisions were fractured ideologically, this one was unanimous — with Justice Sonia Sotomayor writing for the court. Liberals and conservatives alike agree that the trust shouldn’t have to pay state income tax in North Carolina — or, it appears, anywhere else.

On what grounds, you might ask? Why, it’s the Due Process Clause of the Fourteenth Amendment! No state “shall … deprive any person of life, liberty, or property, without due process of law.” (Who exactly is suffering the due process violation here? The court doesn’t bother to say.)

Justice Sotomayor seeks to emphasize the narrowness of the court’s holding. It all turns, she says, on the fact that the Connecticut attorney has discretion over distributions. It’s a pity that Supreme Court opinions don’t come with emojis, because this just calls out for the winking face. Of course we all know that the Connecticut attorney will make distributions as directed by the private equity investor and the trust beneficiaries — and the only people eligible to receive trust distributions are the beneficiaries who live in North Carolina. But the trust documents say that the attorney has discretion, and that’s enough for the court.

Now, those documents also instruct the trustee to consider the trust “as a family asset” and to be “liberal” in exercising his discretion over distributions. Those documents go on to instruct the trustee to use trust assets to pay for the beneficiaries’ education, purchase homes for them, help them start a business, and assist them in other ways too. The court nonetheless buys into the legal fiction of the trustee’s discretion. As far as fiction goes, this is pulp.

Justice Sotomayor also emphasizes that the court is only striking down North Carolina’s tax regime, not any other state’s. Technically, that’s true. I don’t think anyone really believes it though. Does New York have a viable claim based on the fact that the private equity investor lived in the Empire State at the time of the trust’s creation? If that’s enough, then fine, but it’s hard to imagine that the grantor’s state of residence at the time of the trust’s creation more than a quarter century ago will have a stronger claim to tax trust income than the state where all the beneficiaries now reside.

Worse yet, the court’s opinion reaffirms Safe Deposit & Trust Co. — an indefensible precedent from the late Lochner era. (To tag Safe Deposit & Trust Co. with the “Lochner” label is, frankly, unfair to Lochner: while both decisions elicited stinging dissents from Justice Oliver Wendell Holmes, Lochner at least had a coherent — though incorrect — economic theory to back it up. Safe Deposit & Trust Co. was judicial balderdash.) Safe Deposit & Trust Co. stands for the proposition that neither the grantor’s home state nor the beneficiary’s home state can tax the income of a trust administered elsewhere. Now, to be fair, Justice Sotomayor is less strident in her reaffirmation of Safe Deposit & Trust Co. than is Justice Alito in his concurrence. Justice Sotomayor’s opinion reaffirms “[t]he aspects of the case noted here,” whereas Justice Alito — joined by the Chief Justice and Justice Gorsuch — would “not open for reconsideration any points resolved by” Safe Deposit and its ilk. But there is not much daylight between two positions. Justice Sotomayor, by emphasizing the ostensible consistency between Safe Deposit and modern due process jurisprudence — is certainly not setting the table for Safe Deposit’s eventual overruling. Quite the opposite.

So what next? If you’re a rich person in a high-tax state, the path forward is quite clear. Transfer income-generating assets to an irrevocable trust in a state that does not tax trust income on the basis of trustee residence or place of administration. Thanks to Safe Deposit, income generated by the trust now lies beyond the reach of tax authorities in your home state. Choose a reputable trustee and give her nominal discretion over the timing of distributions. Thanks to Safe Deposit and now also to Justice Sotomayor’s opinion in Kaestner, the income generated by the trust lies beyond the reach of tax authorities in your beneficiary’s home state too. Be careful about the timing of distributions, because the beneficiary’s home state can tax those. Your best bet is to instruct your trustee to make distributions in years in which the beneficiary lives in a low-tax — or, better yet, no-tax — state. (Ever want to spend a gap year in Miami? Or Austin? Or Seattle?)

If you’re a state with an income tax, the path forward is murkier. One option is to adopt a “throwback” tax — a tax that applies at the time of distribution to the trust’s previously accumulated income. It’s not a perfect solution, though, because beneficiaries still can avoid throwback taxation by moving in the year of distribution.

States might experiment with other strategies as well. New York is trying to tax New York-resident grantors on income generated by certain Nevada trusts that are especially egregious tax-avoidance tools. (We’ll see if that passes constitutional muster.) Connecticut maintains a gift tax, which potentially applies at the time that assets are transferred to the trust. That might help too — though private equity and venture capital investors will get around it by transferring interests in their funds at the time of formation and arguing that those interests aren’t worth anything (yet).

Why, you might ask, did the full court acquiesce in this result? Beats me. A sympathetic explanation for the liberal justices’ votes is that they have decided to hold the line on stare decisis come heck or high water. If Safe Deposit & Trust goes, then Roe v. Wade could go next. But note that Justice Sotomayor’s opinion does not double-down on stare decisis. It seems to suggest, instead, that Safe Deposit & Trust was rightly decided in the first instance. (That rumble you feel below you is Holmes turning over in his grave.)

I guess it’s also possible the justices really believe that the Connecticut attorney’s nominal discretion over trust distributions is a fact of great constitutional significance, so much so that it would violate the due process rights (of the attorney?; of the beneficiaries?) for North Carolina to try to tax trust income. Maybe. But while Justice Sotomayor repeatedly says that her approach is “pragmatic,” this would be formalism at its acme.

In sum, Kaestner is a disappointing decision that will cost North Carolina many millions of dollars and — when all is said and done — will likely cost other states billions more. Will it go down as part of the anti-canon of worst Supreme Court decisions ever? Of course not. But when the history of our second Gilded Age is written, Kaestner will warrant a plaintive footnote — an illustration that in era of already-too-wide wealth inequality, concerns about high-end tax avoidance elicited from the justices little more than a shrug.

Whatever Source Derived

Thoughts on tax and the law

Daniel Hemel

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Assistant Professor; UChicago Law; teaching tax, administrative law, and torts

Whatever Source Derived

Thoughts on tax and the law