Opinion: Daily Journal

Trust taxation debate highlights issue of unintended consequences

A recent U.S. Supreme Court decision could cost N.C. state government millions of dollars. At least one state senator hopes government’s reaction to that decision won’t cost millions more.

He raises concerns about unintended consequences from new government policies.

The issue cropped up during the latest meeting of the General Assembly’s Revenue Laws Study Committee. Members discussed the aftermath of last June’s Supreme Court ruling in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust.

A unanimous high court decided in Kaestner that North Carolina had no right to tax income from a trust simply because beneficiaries of that trust lived here. The trust office, trustee, and investments had no other connection to the Tar Heel State.

In this particular case, the trust had distributed no income to N.C. residents during the disputed time period. Nor did beneficiaries have the right to demand the trust’s income. No N.C.-based beneficiary was certain to receive any money.

Since the ruling last summer, roughly 500 taxpayers have relied on Kaestner to pursue refunds from the state Revenue Department. If granted, those refunds could total $10.5 million.

That’s not the whole story.

“North Carolina, in some ways, won the case,” argued legislative staffer Greg Roney. “Our statute … was not declared unconstitutional. All the court said was: As applied to this taxpayer … we couldn’t collect the tax.”

Based on the court ruling, then, the Revenue Department has changed no policies. It has asked those seeking refunds to answer a multiple-question survey. The answers should determine just how closely their tax disputes line up with the facts of the Kaestner case.

Looking ahead, the state has three policy options, Roney said. First, lawmakers and the department could do nothing.

Under this option, one would presume that the department would issue refunds to those trust beneficiaries whose cases line up with the Kaestner ruling. Revenue staffers would withhold refunds from others. The department would proceed under current law with the U.S. Supreme Court’s guidance in mind.

The second option involves expanding taxation of trusts. North Carolina collected $100 million in income tax from trusts in 2017, compared to $85 million in 2016. In some years, the number has been significantly higher, Roney said.

The Kaestner ruling suggests North Carolina could apply its income tax when a trustee or trust office is located in the state, Roney said. Current law does not call for that type of taxation. “We could go tax every trust and trustee that’s here — every trust that has its office here,” he said. “You are not actually taxing at the limits of your taxing authority.”

The third option focuses on placing new limits on taxation of trusts. Current law calls for the tax to kick in if the trust’s beneficiary lives in North Carolina. “It’s going to take the beneficiary plus something to make it constitutional,” Roney said. Perhaps the tax kicks in only when the beneficiary receives a distribution. Or it might apply if the beneficiary has more power over the trust or more interaction with the trustee.

Spelling out new conditions to trigger the tax would change taxpayers’ behavior. “If you specify them, then people would know exactly how to avoid the income tax,” Roney warned. “They would jump right into those holes that you specified.”

A state Revenue Department spokesman told lawmakers Kaestner has prompted internal discussions about the various policy options. Revenue might request legislative changes. One lawmaker urges the department to exercise caution.

“I want you to ask staff that if legislation is required to close what gaps you think are remaining in properly taxing trusts’ beneficiaries, that there be some good analysis about potential unintended consequences of that,” said Sen. Paul Newton, R-Cabarrus.

“Trusts are developed to avoid taxes,” Newton added. “That’s why they exist. So if we suddenly tax more heavily, what’s to prevent the trusts — the beneficiaries and the trusts — from just going to another jurisdiction that taxes with a lighter touch? I would want a lot of insight into that before we vote on something that will increase taxes on beneficiaries of trusts.”

Newton’s comment reminds this observer of the one-sentence distillation of Henry Hazlitt’s 1946 classic book, Economics in One Lesson. “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

In the case of changing North Carolina’s approach to taxing trusts, it’s important to look beyond state government’s short-term revenue impact. It’s also important to consider how a new policy would affect more than just current state residents who earn income from trusts. How might a policy change affect North Carolina’s attractiveness to other potential future taxpayers?

Unintended consequences can be significant. They can counteract or even defeat short-term goals tied to a new government policy. It’s nice to hear an elected official recognize the importance of identifying those consequences.

Addressing them now could help North Carolina avoid making a long-term mistake.

Mitch Kokai is senior political analyst for the John Locke Foundation.