Two States Find Their States' Statutes for Taxing Trusts Violate Due Process Clause

While most conversations since the Wayfair decision regarding state and local taxes have revolved around an expansion of a state’s ability to impose taxes, the high courts in two states have moved to reduce the state’s ability to impose taxes on income from trusts, finding that the state’s attempts to tax trust income are in violation of the U.S. Constitution.

The North Carolina Supreme Court in the case of Kimberley Rice Kaestner 1992 Family Trust v. Dep’t of Revenue, No. 307PA15-2 and the Minnesota Supreme Court in the case of Fielding v. Comm’r of Revenue, A17-1177 each ruled the respective states had inappropriately attempted to tax the income of the trusts in question.

In the North Carolina case, state law provided the state claimed the right to tax the income of a trust where the assets were held for the benefit of a North Carolina resident beneficiary, regardless of the residence of the trustee, where the trust was administered or whether any distributions were required to be or were made to the North Carolina beneficiaries.

As the opinion notes:

The relevant provision of section 105-160.2 has remained substantively unchanged since the tax years at issue and states that income tax on an estate or trust “is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State.” Id. § 105-160.2 (2017).

The trusts complained that the state was exceeding its authority under the United States Constitution by imposing its tax based solely on the existence of these beneficiaries.  As the Court opinion continues “[i]n its complaint and motion for summary judgment, plaintiff maintained that this section is both unconstitutional on its face and as applied to plaintiff.”

The North Carolina Supreme Court considered the issue of whether the imposition of this tax violated the due process clauses of both the U.S. and N.C. constitutions.  The Court noted the key question in this case when it cited the following due process test:

When applied to taxation, “[t]he Due Process Clause ‘requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’ ” Quill, 504 U.S. at 306, 112 S. Ct. at 1909 (quoting Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-45, 74 S. Ct. 535, 539 (1954)). … This “minimum connection,” which is more commonly referred to as “minimum contacts,” see id. at 307, 112 S. Ct. at 1910 (citing Int’l Shoe Co. v. Washington, 326 U.S. 310, 316, 66 S. Ct. 154, 158 (1945)), exists when the taxed entity “purposefully avails itself of the benefits of an economic market” in the taxing state “even if it has no physical presence in the State,” id. at 307, 112 S. Ct. at 1910 (citing Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476, 105 S. Ct. 2174, 2184 (1985)).

The North Carolina Supreme Court notes that the beneficiaries and the trust have a separate tax existence and finds that the state cannot use contacts of the beneficiaries to establish the minimum contact for the trust:

That plaintiff and its North Carolina beneficiaries have legally separate, taxable existences is critical to the outcome here because a taxed entity’s minimum contacts with the taxing state cannot be established by a third party’s minimum contacts with the taxing state. See Walden v. Fiore, ___ U.S. ___, ___, 134 S. Ct. 1115, 1122 (2014) (stating that “unilateral activity of another party or a third person is not an appropriate consideration when determining whether a defendant has sufficient contacts with a forum State” (quoting Helicopteros Nacionales de Colombia, S.A. v. Hall, 466 U.S. 408, 417, 104 S. Ct. 1868, 1873 (1984))); Hanson v. Denckla, 357 U.S. 235, 253, 78 S. Ct. 1228, 1239-40 (1958) (“The unilateral activity of those who claim some relationship with a nonresident [party] cannot satisfy the requirement of contact with the forum State.”). Here it was plaintiff’s beneficiaries, not plaintiff, who reaped the benefits and protections of North Carolina’s laws by residing here. Because plaintiff and plaintiff’s beneficiaries are separate legal entities, due process was not satisfied solely from the beneficiaries’ contacts with North Carolina.

For taxation of a foreign trust to satisfy the due process guarantee of the Fourteenth Amendment and the similar pledge in Article I, Section 19 of our state constitution, the trust must have some minimum contacts with the State of North Carolina such that the trust enjoys the benefits and protections of the State. When, as here, the income of a foreign trust is subject to taxation solely based on its beneficiaries’ availing themselves of the benefits of our economy and the protections afforded by our laws, those guarantees are violated. Therefore, we hold that N.C.G.S. § 105-160.2 is unconstitutional as applied to collect income taxes from plaintiff for tax years 2005 through 2008. Accordingly, we affirm the decision of the Court of Appeals that affirmed the Business Court’s order granting summary judgment for plaintiff and directed that defendant refund to plaintiff any taxes paid by plaintiff pursuant to section 105-160.2 for tax years 2005 through 2008.

The North Carolina opinion also cites the following rulings from other states that it argues reaches the same conclusion on similar bases:

…[S]everal other jurisdictions have applied reasoning similar to our analysis here in the context of deciding whether taxation of a given trust violated due process. See Linn v. Dep’t of Revenue, 2013 IL App (4th) 121055, ¶ 33, 2 N.E.3d 1203, 1211 (2013) (applying Quill and holding that there was insufficient contact between Illinois and the taxed trust to satisfy due process when the trust, inter alia, “had nothing in and sought nothing from Illinois” and conducted all of its business in Texas), appeal dismissed, 387 Ill. Dec. 512, 22 N.E.3d 1165 (2014); Fielding v. Comm’r of Revenue, File Nos. 8911–R, 8912–R, 8913–R, 8914–R, 2017 WL 2484593, at *19-20 (Minn. T.C. May 31, 2017) (deciding that taxation of an inter vivos trust based solely on the in-state domicile of the grantor at the time the trust became irrevocable violated due process); Residuary Tr. A v. Director, Div. of Taxation, 27 N.J. Tax 68, 72-73, 78 (2013) (holding that neither the New Jersey domicile of a deceased testator nor the New Jersey business interests of several corporations in which the testamentary trust held stock justified New Jersey’s taxation of “undistributed income from sources outside New Jersey” pursuant to the due process minimum contacts standard), aff’d per curiam, 28 N.J. Tax 541 (2015); T. Ryan Legg Irrevocable Tr. v. Testa, 149 Ohio St. 3d 376, 2016-Ohio-8418, 75 N.E.3d 184, at ¶ 68 (2016) (applying Quill and holding that a tax assessment by Ohio against a Delaware trust did not violate due process when the trust was created by an Ohio resident to dispose of his interest in a corporation that “conducted business in significant part in Ohio” and the settlor’s “Ohio contacts [were] still material for constitutional purposes”), cert. denied, ___ U.S. ___, 138 S. Ct. 222 (2017).

The Minnesota law attempted to impose tax on the trust via different statutory mechanism.  Minnesota in 1996 modified its law to define a trust as a resident trust if the trustee was a resident of Minnesota on the date the trust became irrevocable. 

The effect of such a residency test, which exists in several states’ statutes, is to make the trust perpetually a resident trust regardless of whether there is any connection to the state in later years.  Even if the trustee resides out of state, manages the trust assets from outside the state, the trust has no assets in the state and no beneficiaries are resident of the state, the trust will still owe state income tax on all its undistributed income to the state where the grantor resided when the trust became irrevocable.

In this case the grantor initially retained the right to substitute assets of equivalent fair value for trust assets. So, at the beginning, the trusts were taxed as grantor trusts, with income taxable to the grantor.[1] On December 31, 2011 the grantor relinquished his right to substitute assets, so the trusts were no longer grantor trusts and became taxable entities in their own right.

This was the triggering event for Minnesota’s statute defining a resident trust:

The Trusts therefore ceased to be “grantor type trusts” and became irrevocable on December 31, 2011. See Minn. Stat § 290.01, subd. 7b(a) (“[A] trust is considered irrevocable to the extent the grantor is not treated as the owner [of a trust].”). At the time the trusts became irrevocable, Reid MacDonald was domiciled in Minnesota. Based on Reid MacDonald’s domicile in Minnesota when the Trusts became irrevocable, the Trusts were then classified as “resident trusts” under Minn. Stat. § 290.01, subd. 7b(a)(2).1 Katherine Boone, a domiciliary of Colorado, became the sole Trustee for each of the Trusts on January 1, 2012.

The opinion goes on to describe the events of the following years:

After they ceased to be grantor-type trusts, the Trusts filed Minnesota income tax returns as resident trusts, without protest, in 2012 and 2013. On July 24, 2014, William Fielding, a domiciliary of Texas, became Trustee for the Trusts. Shortly thereafter, all shareholders of FFI stock, including the Trusts, sold their shares. Because the Trusts were defined to be Minnesota residents (as a result of grantor MacDonald’s Minnesota domicile in 2011), they were subject to tax on the full amount of the gain from the 2014 sale of the FFI stock, as well on the full amount of income from other investments.2 See Minn. Stat. § 290.17, subd. 2(c) (2016) (providing that Minnesota taxes “resident trusts” on all “income or gains from intangible personal property,” including investment income, “not employed in the business of the recipient of the income”). Had the Trusts not been deemed residents of Minnesota, those items of income would have been assigned to the Trusts’ domicile and would not have been subject to Minnesota income taxation. See Minn. Stat. § 290.17, subd. 2(e) (2016).

The trust argued, first, that the residence of the grantor is an insufficient basis for Minnesota to impose tax on worldwide income of the trust and, second, since the statute only uses that as the basis for imposing the worldwide tax, the state should not be allowed to impose the tax by looking to other contacts the trust had with the state.

The Court, while agreeing with the first point, did not agree with the second.  Rather the court stated that, effectively, to be able to tax the trust on worldwide income the trust had to have had a resident grantor and there must be sufficient contacts to allow the taxation.

But the Court still found that, in this case, there not sufficient contacts with the state to allow the tax to be imposed.  As with North Carolina, the Minnesota court looked to the due process clause of the Constitution. 

The trust argued that there not sufficient contacts with Minnesota:

The Trusts…note that no Trustee has been a Minnesota resident, the Trusts have not been administered in Minnesota, the records of the Trusts’ assets and income have been maintained outside of Minnesota, some of the Trusts’ income is derived from investments with no direct connection to Minnesota, and three of the four trust beneficiaries reside outside of Minnesota.

The state countered with other factors that, the state argued, should count as sufficient contacts:

The Commissioner contends that she can constitutionally tax the Trusts’ worldwide income based on several contacts between Minnesota and the Trusts, asserting that the Trusts “ow[e] their very existence” to Minnesota. Specifically, the grantor, Reid MacDonald, was a Minnesota resident when the Trusts were created, was domiciled in Minnesota when the Trusts became irrevocable, and was still domiciled in Minnesota in 2014. The Trusts were created in Minnesota, with the assistance of a Minnesota law firm, which drafted, and until 2014 retained, the trust documents. The Trusts held stock in FFI, a Minnesota S corporation. The Trust documents provide that questions of law arising under the Trust documents are determined in accordance with Minnesota law. Finally, one beneficiary, Vandever MacDonald, has been a Minnesota resident at least through the tax year at issue.

The majority of the Supreme Court found that the state’s cited connections were not sufficient to allow it to impose the tax for three reasons.  The Court first eliminated the state’s attempt to rely on the ties of the grantor, the very issue that the statute attempts to rely on.  The Court outlined its refusal to treat this as an adequate contact in the following paragraphs:

First, the grantor’s connections to Minnesota — the Minnesota residency of Reid MacDonald in 2009, when the Trusts were established; in 2011, when the Trusts were made irrevocable; and in 2014, when the Trusts sold the FFI stock — are not relevant to the relationship between the Trusts’ income that Minnesota seeks to tax and the protection and benefits Minnesota provided to the Trusts’ activities that generated that income. The relevant connections are Minnesota’s connection to the trustee, not the connection to the grantor who established the trust years earlier.

A trust is its own legal entity, with a legal existence that is separate from the grantor or the beneficiary. See Greenough v. Tax Assessors of Newport, 331 U.S. 486, 495–96 (1947) (“The citizenship of the trustee and not the seat of the trust or the residence of the beneficiary is the controlling factor.”); Anderson v. Wilson, 289 U.S. 20, 27 (1933) (noting that “the law has seen fit” to consider a trust “for income tax purposes as a separate existence”). Here, grantor Reid MacDonald is not the taxpayer, the Trusts are. Moreover, regardless of the grantor’s personal connections with Minnesota, after 2011 he no longer had control over the Trusts’ assets. See, e.g., Safe Deposit & Tr. Co. of Baltimore v. Virginia, 280 U.S. 83, 91–93 (1929) (concluding that Virginia, where the grantor resided but had no “control or possession” over the intangible assets of the trust, which was domiciled in Maryland, could not impose a tax on those assets); Taylor v. State Tax Comm’n, 445 N.Y.S.2d 648, 649 (N.Y. App. Div. 1981) (holding that New York could not impose an income tax on trust property because “possession and control” of those assets was held by trustees who were not residents of or domiciled in New York). For similar reasons, the Minnesota residency of beneficiary Vandever MacDonald does not establish the necessary minimum connection to justify taxing the Trusts’ income.6 See Greenough, 331 U.S. at 495–96.

Nor do we find the grantor’s decision to use a Minnesota law firm to draft the trust documents to be relevant. The parties stipulated that the law firm represented the grantor. Other than retaining the original signed trust documents, nothing in the record establishes that the law firm represented the Trusts or the Trustees in connection with the activities that led to the income that the State seeks to tax, let alone during the tax year at issue. We are unwilling to attribute legal significance to the storage of the original signed trust documents in Minnesota, when this act may have been nothing more than a service or convenience extended to the firm’s client — the grantor.

The Court also noted the lack of any Minnesota property held by the trust:

Second, the Trusts did not own any physical property in Minnesota that might serve as a basis for taxation as residents. See, e.g., Westfall v. Dir. of Revenue, 812 S.W.2d 513, 514 (Mo. 1991) (upholding Missouri’s tax on a trust, in part because the trust owned real property in the state). The Commissioner urges us to hold that the Trusts may be taxed as residents due to their connections to FFI, a Minnesota S corporation, and it is undisputed that the Trusts held interests in intangible property, FFI stock. Although FFI was incorporated in Minnesota and held physical property within the state, the intangible property that generated the Trusts’ income was stock in FFI and funds held in investment accounts. These intangible assets were held outside of Minnesota, and thus do not serve as a relevant or legally significant connection with the State. See, e.g., Safe Deposit & Tr. Co., 280 U.S. at 92 (stating that intangible assets held by a trustee located in Maryland “did not and could not follow” the grantor and beneficiaries who were domiciled in Virginia); In re Swift, 727 S.W.2d 880, 881–82 (Mo. 1987) (concluding that the “creation and funding” of the trusts in Missouri with intangible assets that the trustee “held, managed and administered in Illinois” did not allow Missouri to tax the trust’s income); Mercantile-Safe Deposit & Tr. Co. v. Murphy, 242 N.Y.S.2d 26, 28 (N.Y. App. Div. 1963) (concluding that New York, which was the grantor’s domicile, could not tax the trust’s income from intangible assets held in Maryland).

Finally, the majority declined to look to contacts in previous years to establish a right for Minnesota to impose its tax in the year before the Court:

Third, we do not find the contacts with Minnesota that pre-date 2014, the tax year at issue, by the grantor, the Trusts, or the beneficiaries, to be relevant. We have evaluated a taxpayer’s contacts with Minnesota, for due process purposes, in the tax year at issue. See Luther, 588 N.W.2d at 509 (explaining that the taxpayer had the “opportunity to enjoy the many services, benefits, and protections” provided by the State for at least “the majority of” the tax year at issue). Other courts have also held that the relevant facts for evaluating the sufficiency of a taxpayer’s contacts are drawn from the tax year at issue. See, e.g., Linn v. Dep’t of Revenue, 2 N.E.3d 1203, 1210 (Ill. App. Ct. 2013) (“[W]hat happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.”); Potter v. Taxation Div., 5 N.J. Tax 399, 404–05 (N.J. Tax Ct. 1983) (declining to rely on the trust’s receipt of the grantor’s assets, which “occurred prior to the tax year in question,” to allow the state to tax).

There is good reason to focus on the taxpayer’s contacts in the tax year at issue. The direct link between the activities that generated the income in the year at issue and the protections provided by the State in that same year establishes the necessary rational relationship that justifies the tax. In contrast, allowing the State to look to historical contacts unrelated to the tax year at issue risks leaving taxpayers unaware of whether or when their contacts with Minnesota may justify the imposition of a tax. See Luther, 588 N.W.2d at 508 (“Due process deals with the fairness of the tax at issue and ensures that the taxpayer has adequate notice that she may be subject to the tax.”).

In addition, allowing the State to pick and choose among historical facts unrelated to the tax year at issue is unworkable. This ad hoc approach could force taxpayers to challenge tax liability annually until a court determines that the past contacts have sufficiently decayed such that they are no longer sufficient to support taxation as a resident. Nor can we see any reasonable means of determining when the decay will be sufficient. Accord Blue v. Dep’t of Treasury, 462 N.W.2d 762, 764–65 (Mich. Ct. App. 1990) (“We analogize the present case to a hypothetical statute authorizing that any person born in Michigan to resident parents is deemed a resident and taxable as such, no matter where they reside or earn their income. We believe this would be clearly outside of the state’s power to impose taxes.”).

Thus, we are left to consider the extremely tenuous contacts between the Trusts (or their Trustees) and Minnesota during tax year 2014. The Trustees had almost no contact with Minnesota during the applicable tax year. All trust administration activities by the Trustees occurred in states other than Minnesota. Boone never traveled to Minnesota during her time as a Trustee. Fielding traveled to Minnesota for a weekend in the fall of 2014 to attend a wedding, but he never traveled to Minnesota for any purposes related to the Trusts. This level of contact is clearly not enough to establish residency for taxation purposes.

The Court also does not find significant the fact that the trust document provides it is to be governed by Minnesota law, although the Court suggests that the case could be different for a testamentary trust rather than one established by the grantor during his life:

We acknowledge that “questions of law” that may arise under the trust agreements are determined by the laws of Minnesota. Standing alone, however, this choice-of-law provision is not enough to permissibly tax the Trusts as residents. Our laws protect residents and non-residents alike. We will not demand that every party who chooses to look to Minnesota law — not necessarily to invoke the jurisdiction of Minnesota’s courts — must pay resident income tax for the privilege. Of note here, unlike cases in other states that considered testamentary trusts, the inter vivos trusts at issue here have not been probated in Minnesota’s courts and have no existing relationship to the courts distinct from that of the trustee and trust assets. See District of Columbia v. Chase Manhattan Bank, 689 A.2d 539, 544 (D.C. 1997); In re Swift, 727 S.W.2d at 882.

The way that states determine how much of a trust’s income the state can tax and under what conditions that happens varies widely from state to state.  And since these cases still come to a “facts and circumstances” test for contacts, they don’t make determining which state(s) a trust needs to file a tax return in easier.

As a practical matter, even trusts with exposure to these two states are not likely to find that either state’s revenue department will agree that the trust you are representing has facts identical to those of the trusts in these cases, rather point to some other “contact” with the state that will argue differentiates the new case. 

But the cases do mean the states in question can’t rely on their broad, bright line tests as the sole criteria for imposing the tax on a particular trust.

[1] IRC §675(4)