State Trust Taxes Ripe for Constitutional Challenges
Toni Ann Kruse and Melissa Price authored this bylined article on a recent case in the Minnesota Supreme Court that curtails the ability of states to impose their income taxes on nongrantor irrevocable trusts.
The article was originally published in Law360 on November 16, 2018.
Fielding v. Commissioner of Revenue is the most recent case in a series of cases that have used the U.S. Constitution to curtail the ability of states to impose their income taxes on nongrantor irrevocable trusts. The facts and holding of this case present a multitude of considerations for practitioners.
The Fielding case was decided by the Minnesota Supreme Court earlier this year and addresses the Minnesota income tax statute’s residency classification of trusts. The portion of the Minnesota trust residency test challenged in Fielding is based solely on the domicile of the grantor of a trust on the date the trust becomes irrevocable. If the grantor was a Minnesota domiciliary, the trust is a Minnesota resident. The court ruled that Minn. Stat. Sec. 290.01, Subd. 7b(a)(2) violates the due process clause of the federal and Minnesota state constitutions as applied to the MacDonald trusts, the trusts of which William Fielding was the trustee.
The Fielding claim was narrow in scope. The trustee argued that the statute was unconstitutional on its face because its single determinative residency factor — the grantor’s domicile when the trusts became irrevocable — was insufficient to win a due process challenge. The court broadened the inquiry and examined all relevant contacts between the trusts and the state, reasoning that if there were sufficient contacts, Minnesota would be able to impose its tax on the trusts despite the fact that the only statutory basis for taxation was the residency of the grantor. The court determined that to satisfy due process, a two-part test must be met: there must be a “minimum connection” between the state and the person, property or transaction subject to the tax; and the income subject to the tax must be “rationally related” to the benefits conferred on the taxpayer by the state.
Even under the broader scope of inquiry, the court found that taxing the MacDonald trusts as Minnesota residents (taxable in Minnesota on their worldwide income) violated due process. The court determined that the following factors were “irrelevant or too attenuated” to meet the constitutional test:
The domicile of the grantor when the trusts became irrevocable;
The creation of the trusts in Minnesota with the assistance of a Minnesota law firm;
The retention of the trust documents by a Minnesota law firm;
The designation of Minnesota law in the trusts’ choice of law provisions; and
The fact that a Minnesota resident was a primary beneficiary of one of the trusts.
The court determined that the designation of Minnesota law as the governing law, on its own, was insufficient to satisfy due process, but had the trusts invoked the jurisdiction of the Minnesota courts (e.g., as a testamentary trust would through the probate process), the court may have reached a different conclusion. The court also found that a beneficiary’s residency in Minnesota alone did not create a minimum connection with Minnesota but stated that had this factor been part of the statute or had the time frame between “trust creation, funding and tax liability” been shorter, it may have reached a different conclusion.
The analysis in Fielding follows the reasoning set forth in a number of earlier cases, including Quill Corp. v. North Dakota. Quill set forth a due process analysis applied by the courts in subsequent cases in Pennsylvania, Illinois and North Carolina (e.g., McNeil v. Commonwealth of Pennsylvania, Linn v. Department of Revenue and Kimberly Rice Kaestner 1992 Family Trust v. North Carolina) to strike down the application of their state income tax statute to trusts with tenuous connections to the state.
Practitioners should be careful to review the relevant state taxation statutes before advising clients on the selection of terms, governing law and trustees of a trust. Clients have good reason to care about state taxation, particularly when the state tax rate can be as high as 13.3 percent and even more so today because of the recent changes to the federal tax laws capping the state and local tax deduction.
State statutes that use a single factor to define a resident trust seem ripe for a constitutional contest. States that treat a trust as a resident trust based solely on the residence or domicile of a grantor when the grantor funds the trust or the trust becomes irrevocable include: Illinois, Maine, Maryland, Michigan, Minnesota, Nebraska, Oklahoma, Vermont, Washington D.C. and West Virginia. States that rely on another single factor as a basis for trust taxation include: California, Indiana, Kansas, Kentucky, Mississippi, Montana, North Carolina, South Carolina and Tennessee. Relying on the decision in Quill, courts have held that the residence of the grantor or trust beneficiaries, without more, is insufficient to satisfy either the “minimum connection” test or “rational relationship” test of the due process clause.
When working with clients to create new trusts or to advise them in connection with the administration of existing trusts, practitioners should take steps to minimize contacts between states which impose income tax on trusts and trusts that are potentially vulnerable to those taxes. The ideal planning should be specific to the states with which the grantor and beneficiaries have a nexus and the residency requirements in those states.