When There Really Isn’t Any There There:  The Supreme Court in  North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust

By Morgan Maxwell

When the Supreme Court speaks we expect some broad pronouncement, a grand statement settling an intractable problem going to the very essence of the function and application of law in an ordered society.  Particularly so in matters of taxation, not only because I am a tax lawyer, but because taxation is where Government and the citizenry interact most frequently, most universally, sometimes most grindingly, and with the most variety.  As much as we (or some of us) might want a select group of Solons to resolve every question and achieve perfect balance, sometimes the courts, even the Supreme Court, is constrained to simply decide the case in front of it, and thus there may be no greater meaning to be imparted except the resolution of the immediate dispute.  This was the case in Kaestner Family Trust, decided by the Court on June 21, 2019.¹

This case starkly demonstrates the dichotomy between a common sense view of how the law should be interpreted and applied, and a hyper-technical legalistic approach.  This was a fairly easy case, from a common sense point of view.²  North Carolina was seeking to tax income of a trust that had almost nothing to do with North Carolina, except for the accident of a beneficiary of the trust moving to North Carolina years after the trust was created.  On the other hand, the Department of Revenue had a fairly straight-forward argument: the North Carolina courts had held that this tax could be imposed if a trust merely had a North Carolina resident as a beneficiary.

The problem with trusts (or is it their glory?) is that one can create one’s own legal universe; the idiosyncratic provisions one might choose are limited only by the settlor’s imagination.³ In Kaestner Family Trust, an idiosyncratic trust met a fairly idiosyncratic law⁴ and produced a result of extremely narrow application.

The original trust was formed nearly 30 years ago by a New York resident for the benefit of his three children, and its trust instrument provided that it was to be governed by New York law.  The initial trustee was a New York resident, succeeded along the way by a Connecticut

                                               

¹  South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018)., discussed herein, another tax case, was decided on this same date in 2018.  I cannot wait to see what happens on June 21, 2020.

² I’ve warned you in prior blogs not to be beguiled by common sense when it comes to taxation.

³  Occasionally, a trust provision will be held to violate some greater interest, such as “public policy” or even the Constitution: see The Girard Trust case, Pennsylvania v. Board of Trusts, 353 U.S. 230 (1957).

⁴  Several times in its opinion the Court was at pains to explain that very few if any other states had a taxing scheme anything like North Carolina’s resident.  The trust’s documents and records were maintained in New York, and the custodians of the trust’s property were located in Massachusetts.  The trust instrument granted the trustee “absolute discretion” to distribute the trust’s assets to the beneficiaries “in such amounts and proportions” as the trustee might “from time to time” decide (as quoted by the Court).  In other words, the beneficiaries had no right to receive income or principal, no power to demand any distributions, and no expectation whatsoever as to whether or when any distributions of income or principal would be made by the trustee.⁵

One of the beneficiaries, Kimberley Rice Kaestner, moved to North Carolina with her minor children in 1997, and a few years later, the trustee divided the original trust into three separate trusts, one for each of the original settlor’s children.  One of these trusts was the taxpayer in this case.  Each of the separate trusts had the identical terms of the original trust, most importantly the absolute discretion on the part of the trustee as to amounts and timing of distributions; and the same controlling arrangements, residence of trustee, location of trust papers, location of trust property custodians, and so on.

The relevant North Carolina statute taxes trust income that “is for the benefit of” a North Carolina resident, which the North Carolina courts had interpreted to authorize a tax on a trust on the sole basis that a trust beneficiary resides in the State.  Accordingly, the North Carolina Department of Revenue assessed a tax on the full amount of the Trust’s income for the tax years 2005 through 2008.  The trustee paid the tax under protest and sued for a refund in state court arguing that the tax as applied to the Trust violated the Due Process clause of the 14th Amendment to the U.S. Constitution.

The trial court held in favor of the Trust, concluding that “the Kaestners’ residence in North Carolina was too tenuous a link between the State and the Trust to support the tax…,” under the standards of the Due Process clause.⁶ Both the North Carolina Court of Appeals and the North Carolina Supreme Court affirmed, and the Department of Revenue appealed to the

                                                                       

⁵  This might be regarded as an unusual or even an extraordinary provision until one considers that all of the beneficiary’s share of the trust’s property was to be distributed to the beneficiary when he or she turned 40.  This event was to take place after the tax years at issue, 2005 through 2008. In addition, after the tax years at issue, and before Kaestner turned 40, in accordance with Kaestner’s wishes, the trustee rolled the trust assets over into another trust rather than distribute them to Kaestner.

⁶  The trial court also held that the tax as applied violated the dormant Commerce Clause of the Constitution.  Neither of the North Carolina appellate courts nor the U.S. Supreme Court addressed this issue, but it is a fascinating one, and was central to the recent U.S. Supreme Court case South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018).  For those interested in the topic, see my blog The Supreme Court Tackles the Internet – Remote Sellers and the Sales Tax at my website, www.attorneysfortaxpayers.com.

U.S. Supreme Court.⁷

The North Carolina Supreme Court decided in favor of the Trust on the principal grounds that the Trust and its beneficiaries had separate legal existences for tax purposes, and the connection between the beneficiaries and North Carolina could not by itself establish a sufficient taxable connection between the Trust and North Carolina.  The U.S. Supreme Court’s take was slightly different.  It saw the question as “whether the Due Process Clause prohibits States from taxing trusts based only on the in-state residency of trust beneficiaries.”

Due process can be a relatively slippery concept, but its provenance is deadly serious: the Fourteenth Amendment to the Constitution provides that “[n]o State shall … deprive any person of life, liberty, or property, without due process of law.”  In the area of taxation, the Court, in a unanimous decision authored by Justice Sotomayor (with a concurring opinion by Justice Alito joined by Chief Justice Roberts and Justice Gorsuch), pointed out that the touchstones of due process are whether there is “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax…,” and whether “the income attributed to the State for tax purposes … [is] rationally related to ‘values connected with the taxing State.’”  Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992).⁸  In other words in other words, in order for a tax to be sustained, the State must have given something for which it can ask return, Wisconsin v. J. C. Penney Co., 311 U.S. 435, 444 (1940); and the imposition of the tax must comport with “fundamental fairness.” Quill at 312.

As suggested above, there are a lot of ways in which basically the same idea can be expressed, and in the ensuing pages of the Opinion, the Court employed many of them.  At the end of the day, the Court held in favor of the Trust.  Two extensive quotes from Justice Sotomayor’s opinion clearly explain the Court’s rationale:

“We hold that the presence of in-state beneficiaries alone does not  empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that  income and are uncertain ever to receive it.  In limiting our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.”

                                                                          

⁷  One might wonder why, after being repeatedly rebuffed by the North Carolina courts, the Department of Revenue continued to pursue the matter.  Surely a matter of principle?  Well, the tax involved for the four taxable years amounted to $1.3 million, which at the then-prevailing tax rate means that the Trust was earning nearly $4 million a year.  Certainly dollars worth trying a Hail Mary for.

 ⁸  As noted by the Court, Quill was overruled by Wayfair, the case cited in note 4, but on different grounds.  The Court here noted the second thing it was not addressing: since the North Carolina tax did not meet the “minimum connection” test the tax would fail, and thus the Court saw no need to address the “rational relationship” test.

“When a tax is premised on the in-state residence of a beneficiary, the  Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset.  Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83, 91-92 (1929).  Otherwise, the State’s relationship to the object of the tax is too attenuated to create the ‘minimum connection’ that the Constitution requires.  See Quill, 504 U.S.,  at 306.”

To say that the Court intends this to be a narrowly-construed, fact-specific decision would be putting it mildly indeed.  The Court’s litany of those matters, issues or questions that it was specifically not passing on is almost comical: while the Kaestner beneficiaries did not have the requisite relationship with the Trust property to justify the tax, “[w]e do not decide what degree of possession, control, or enjoyment would be sufficient” to support taxation; after pointing out that the Kaestner beneficiaries had no right to assign their interest in the Trust, the Court declined to address whether the right to assign would afford the beneficiary the requisite control, possession or enjoyment to justify taxation; after pointing out, repeatedly, that the Kaestner beneficiaries received no income, could demand no distributions, and were uncertain of ever receiving any distributions, the Court demurred: ”We have no occasion to address, and thus reserve for another day, whether a different result would follow if the beneficiaries were certain to receive funds in the future;” after noting the Trust’s broader argument that only the trustee’s contacts with the taxing State should determine the State’s power over a trust, including its power to tax the trust’s property or income, the Court said: “Because the reasoning above resolves the case in the Trust’s favor, it is unnecessary to reach the Trust’s broader argumemt….”⁹

It seems that, having been hoisted on the petard of stare decisis in Wayfair¹º, the Court was going to be sure that there would be no reason to accord any stare decisis effect to Kaestner Family Trust.  There will be absolutely no reason to cite the case in any future decision for any substantive point of law except as a reminder of what the Kaestner Family Trust Court told us it was not deciding.  Also, I think, as a reaction to the mess the Court made of stare decisis in Wayfair, Justice Alito in his concurring opinion (joined in by Justice Gorsuch and Chief Justice Roberts), hoped to squelch any supposition that there would be a reason to question the continued vitality of any case relied on:

“I write separately to make clear that the opinion of the Court merely applies our existing precedent and that its decision not to answer questions not presented by the facts of this  case¹¹  does not open for reconsideration any points resolved by our prior decisions.”

                                                           

⁹  There are at least two additional questions that the Court surely would not have addressed.  First, is affirmatively abjuring a future right to possess, control or enjoy property, as was done when the Trust property was rolled over to another trust, tantamount to possessing, controlling or enjoyment for purposes of taxation and the Due Process clause?  Second, does the kind of enjoyment no doubt experienced by the Kaestner beneficiaries and the trustee at keeping the Trust property out of the clutches of the North Carolina Department of Revenue sufficient to satisfy the Due Process clause?

¹º  See my blog cited in note 6.

It is said that hard cases make bad law, and Kaestner Family Trust seems to prove that an idiosyncratic set of facts piled upon an idiosyncratic trust instrument to which an idiosyncratic taxing scheme is applied, makes … no law.  So why did the Supreme Court feel it had to issue a decision in this case?  It was a unanimous decision, a mere affirmance of the North Carolina Supreme Court would have reached the correct result, take the afternoon off.  The Court must have been sufficiently uncomfortable with the North Carolina Supreme Court’s stated grounds – that “the Trust and its beneficiaries had separate legal existences for tax purposes, and the connection between the beneficiaries and North Carolina could not by itself establish a sufficient taxable connection between the Trust and North Carolina.” (quoting from above)  To the extent that “substance” should be preferred to mere “form” in matters of taxation,¹² the North Carolina Supreme Court’s approach might have felt a little too “form-y” when compared to the more “substance-y” failure to achieve minimum contacts and “rational relation” of the Due Process clause jurisprudence.  Or maybe they just wanted to prove, in these contentious times, that they could reach unanimity on something.

                                                           

¹¹ There are those who consider that this is what the Supreme Court is always supposed to do.

¹²  A high-sounding doctrine that is often, alas, honored in the breach.  Take as only one example from what may be hundreds, a decision upholding a tax the subject of which was the privilege of doing business in the state and the measure of which was net income, on the basis that the tax was not, after all, a tax on net income.  Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).  The English language can be a dangerous thing in the wrong hands, like a draftsman of a taxing statute or a Department of Revenue.

 

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A Philadelphia Court of Common Pleas jury has granted a unanimous defense verdict in favor of an Elkins Park, Pa. senior care facility in a claim by the family of a deceased female resident over her care and treatment.

Spector Gadon Rosen Vinci P.C. (SGRV) attorneys Brooke C. Madonna and Stephanie V. Shreibman won the unanimous defense verdict on behalf of defendant Oak Health & Rehabilitation Center, Inc. and Oak HRC Elkins Crest, LLC d/b/a Elkins Crest Health & Rehabilitation Center.  The case was tried before the Honorable Ann M. Butchart of the Court of Common Pleas of Philadelphia County.

The case involved an elderly woman with medical issues including dementia who was a resident at Elkins Crest for a year and three months.  The plaintiff alleged, inter alia, that the nursing home failed to follow a doctor’s order requiring that the resident be fed all meals by the nursing staff, causing her to drastically lose a large amount of weight and putting her at risk to develop pressure ulcers.

The resident developed a Stage IV pressure wound on her sacrum while at the hospital, also a defendant, that never healed and allegedly contributed to her eventual death.  Madonna and Shreibman successfully argued a motion in limine to prevent the plaintiff from alleging death related to the care and treatment at Elkins Crest, so only the survival claim went to the jury.  The Court also allowed a charge of punitive damages to go to the jury against Elkins Crest.  Madonna and Shreibman were able to secure a unanimous defense verdict.

Spector Gadon Rosen Vinci P.C. has represented clients nationally and internationally for 45 years and provides counsel and expertise across the entire spectrum of legal practice, from complex litigation to sophisticated transactional and corporate matters.  The firm has offices in Philadelphia, New Jersey, Florida, New York and Atlanta.

The firm represents businesses, corporate boards, and highly placed individuals.  Its clients are engaged in a variety of industries including finance and banking, manufacturing, hospitality, gaming and entertainment, real estate and commercial development, insurance and venture capital, energy, financial services, health care, security and telecommunications.

The firm’s practice areas include high stakes litigation, business disputes, commercial litigation, professional liability, products liability, securities, trust and estates, fiduciary litigation, bankruptcy and creditors rights, civil RICO, trade secrets, trademark and restrictive covenants, intellectual property, antitrust, white-collar criminal defense, banking and financial services, corporate formation and governance, cyber risk and security, employment, entertainment and amusements, environment and energy, wealth management, healthcare, hospitality, insurance coverage and insured casualty litigation, mergers, acquisitions and divestitures, real estate, sports and tax law.

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Michael J. McGirney, a Member of Spector Gadon Rosen Vinci P.C.’s Litigation Practice Group, will discuss “Introduction to Insurance Agent of Broker Claims” for The CLM at Kemper Insurance on June 6th in Plantation, FL.

The CLM, a member of The Institutes, is dedicated to meeting the professional development needs of the claims and litigation management industries. They organize many networking events, continuing education programs, and a wide variety of industry resources including the Annual Conference, Claims College, and Litigation Management Institute.

McGirney concentrates his practice in complex litigation with an emphasis on the defense professionals. He has been certified by the state of Florida on mediator ethics and he has served as an instructor on mediator ethics and liability throughout the state of Florida. He has served as a mediator, arbitrator and as a consulting and testifying expert witness in insurance claim matters, bad faith matters, legal malpractice litigation and ethics issues.

Spector Gadon Rosen Vinci P.C. represents business and commercial law clients nationally and internationally, serving entities, corporate boards and highly placed individuals engaged in multifaceted industries (including finance and banking, manufacturing, hospitality, gaming and entertainment, real estate and commercial development, insurance and venture capital) through a cadre of dedicated and highly skilled lawyers with a reputation for using unique strategies, and a proven success record with tough cases.  The firm’s practice groups include banking and financial services, bankruptcy and creditor rights, commercial litigation, corporate formation and governance, cyber risk and security, employment, entertainment and amusements, environment and energy, estates, trust and wealth management, healthcare, hospitality, insurance coverage and insured casualty litigation, mergers, acquisitions and divestitures, professional liability, real estate, securities and sports, and tax law.

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Michael J. McGirney, a Member of Spector Gadon & Rosen, P.C.’s Litigation Practice Group, will discuss “Ethics for Construction Attorneys” at the NBI Construction Law Seminar on March 26th in Ft. Lauderdale, FL.

The Seminar features presentations by the most prominent and experienced construction lawyers in the country and provides in-depth understanding of critical construction project legal matters that have the potential to cause immense issues for your clients.

McGirney will explore the ethics in construction, diving into topics such as client authority, contractions claims for attorneys’ fee/expenses, dealing with unpresented persons and ethical concerns as attorney for the project.

McGirney concentrates his practice in complex litigation with an emphasis on the defense professionals. He has been certified by the state of Florida on mediator ethics and he has served as an instructor on mediator ethics and liability throughout the state of Florida. He has served as a mediator, arbitrator and as a consulting and testifying expert witness in insurance claim matters, bad faith matters, legal malpractice litigation and ethics issues.

Spector Gadon & Rosen, P.C. represents business and commercial law clients nationally and internationally, serving entities, corporate boards and highly placed individuals engaged in multifaceted industries (including finance and banking, manufacturing, hospitality, gaming and entertainment, real estate and commercial development, insurance and venture capital) through a cadre of dedicated and highly skilled lawyers with a reputation for using unique strategies, and a proven success record with tough cases.  The firm’s practice groups include banking and financial services, bankruptcy and creditor rights, commercial litigation, corporate formation and governance, cyber risk and security, employment, entertainment and amusements, environment and energy, estates, trust and wealth management, healthcare, hospitality, insurance coverage and insured casualty litigation, mergers, acquisitions and divestitures, professional liability, real estate, securities and sports, and tax law.

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President Obama signed into law the Defend Trade Secrets Act of 2016 (“DTSA”) last week which provides a federal cause of action for misappropriation of trade secrets. Prior to its enactment, trade secret misappropriation claims were generally governed by state laws. Companies who are victims of misappropriation will now have the opportunity to litigate trade secret misappropriation claims in federal court. Notably, the DTSA does not preempt the state laws governing misappropriation so trade secret litigation can still be pursued in state court.

The substantive rights under the DTSA are largely the same as those rights provided under the Uniform Trade Secrets Act (“UTSA”) which has been adopted by most states. However, unlike the UTSA, the DTSA permits ex parte seizure of the misappropriated material under extraordinary circumstances. The DTSA also forecloses the possibility of obtaining injunctions based upon the “inevitable disclosure doctrine”. In other words, there must be evidence of a threatened misappropriation to obtain injunctive relief and injunctions cannot be based on simply on the fact that the information is known to the former employee.

Most significantly, the DTSA permits whistleblowers and individuals bringing retaliation claims to disclose trade secrets to their counsel and law enforcement officials for purposes of reporting violations of law without civil or criminal liability. The DTSA also permits the disclosure of trade secret information in court documents filed by a whistleblower or retaliation claimant as long as the documents are filed under seal. Employers are required to provide written notice of this available immunity under the DTSA in any non-disclosure agreements, confidentiality agreements and/or any other policies or manuals that govern disclosure of trade secret information. Employers who do not provide this notice will be foreclosed from recovering exemplary damages and attorney’s fees available under the DTSA. Accordingly, employers seeking to take advantage of recovering exemplary damages and fees should update their agreements and policies used with employees and contractors.

If you require assistance updating policies and agreements regarding confidentiality and non-disclosure of trade secrets or have any questions regarding the DTSA, please contact Jennifer Myers Chalal at jchalal@lawsgr.com or (215) 241-8817.

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The new rules proposed by the U.S. Department of Labor that will greatly increase the minimum salary requirement for employees to be considered exempt from overtime under the executive, administrative or professional exemptions have been adopted and will go into effect on December 1, 2016. The new rules key the minimum salary requirement to what the DOL determines is the 40th percentile of the salaries for all full-time salaried employees, currently $913 per week or $47,476 annually. Nondiscretionary bonuses and incentive payments (including commissions) may be used to satisfy up to 10 percent of the required minimum salary.

While this increase is less than what was originally proposed ($921 per week), it is still more than double the current $455 weekly salary threshold. Under the final rules, the minimum annual salary will not increase each year, but will be reviewed and could be increased every three (3) years as the annual salaries of full-time salaried employees increase. The threshold annual salary for the “highly compensated” exemption will be raised to $134,004.

In the interim, the House and Senate bills that would block the new overtime rules, Senate Bill 2707 and House Bill 4773 are still in committee.

All employers need to review their compensation structure and determine whether or not the employees they are treating as exempt under the administrative, executive or professional exemptions will meet the new minimum salary threshold, and either adjust employee salaries or prepare to treat employees whose salaries fall under the new threshold as non-exempt for overtime purposes.

If you have any questions or would like additional information, please contact Nancy Abrams at nabrams@lawsgr.com or 215-241-8894

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Family Limited Partnerships (“FLP”) have been a great estate planning tool for many years. FLP’s can enable a family to shift significant assets and income to children or grandchildren at a very high discount. The discount can range from 25% to 50% depending upon the type of assets in the partnership. Therefore, it should come as no surprise that the IRS dislikes FLPs and sometimes examines very carefully the valuations used for gifts and in estates.

When the IRS finds an FLP that looks abusive, it will do its best to attack the tax planning used by the family. The IRS found such a partnership in Holliday V. Comm’r, a 2016 tax court case. In the Holliday case, the IRS was successful in bringing the entire partnership back into a parent’s taxable estate as if the FLP did not exist. In Holliday, this meant that the decedent’s 89.9% interest in the FLP was ignored and she was treated as owning 100% of the FLP at her death. Also, the 40% discount the estate took on the value of the FLP on her estate tax return was eliminated. Instead 100% of the value of the FLP’s assets were subject to federal estate tax.

Some of the mistakes this family made were (i) the formation of the FLP, funding of the FLP, the transfer of the general partner interests to the decedent’s children and the gifts of limited partnership interests were all made on the same day, (ii) the partners never held partners’ meetings, (iii) the general partner was not paid for managing the FLP, (iv) the FLP made only one distribution instead of regular annual distributions, (v) the court could find no “non -tax reason” for the FLP, (vi) the court was convinced there was a deal to hold the money in the FLP for the parent just in case she needed it during her lifetime and (vii) the FLP was formed by the son using a power of attorney after his mother (the decedent) went into a nursing home. This combination of bad facts resulted in a FLP being disregarded and brought back in the parent’s estate when she died.

What to do if you have a FLP and want to preserve the value for your family? The following is a partial list: (i) have annual meetings of the partners, (ii) pay some modest compensation to the general partner, (iii) make annual distributions to all of the partners, (iv) wait at least 6 months after formation of the FLP to transfer any portion of the parent’s interest to children or trusts and (v) don’t wait until the parent is in a nursing home. And just because you made gifts of FLP interests and filed a gift tax return, you still need to follow these guidelines. Otherwise there is a risk of the FLP being brought back into one’s taxable estate and the loss of substantial discounts on the assets. It is an excellent idea to have an annual checkup of your FLP to see how it complies with the tests that the IRS now is using to evaluate FLPs. Please give us a call to review your FLP or to help you take advantage of a fine estate planning tool when used right.

Please feel free to contact Alan Mittelman 215-241-8912 or amitt@lawsgr.com if you have any questions.

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