Death & Taxes: Are Trust Nexus Challenges Next in Line?

After last month’s U.S. Supreme Court decision in South Dakota v. Wayfair, taxpayers and experts alike have been wondering how this constitutional shift away from physical presence nexus will affect the states’ imposition of sales and use taxes and corporate income taxes. However, they should not forget that constitutional challenges abound in yet another field of tax: trust income tax.

The most recent example of such a challenge comes from Fielding v. Minnesota Commissioner of Revenue. In Fielding, the Minnesota Supreme Court found that the trusts lacked sufficient contacts with the state in order to be taxed on all sources of their income as resident trusts during the 2014 tax year at issue, despite meeting the state’s statutory definition of a trust.

Under Minn. Stat. § 290.01(7b)(a)(2), an irrevocable trust is a resident trust if the grantor was domiciled in Minnesota when the trust became irrevocable. The trusts in Fielding became resident trusts at the end of 2011 when the grantor, a Minnesota domiciliary, gave up his right to substitute trust assets, causing the trusts to become irrevocable.

In 2014, the trusts sold their shares of stock in a Minnesota S corporation and, as resident trusts, were subject to tax on the full amount of the gain from the sale, as well as all other investment income.  After filing their 2014 fiduciary income tax returns as residents under protest, claiming Minnesota’s residency definition was unconstitutional, the trusts filed amended returns as nonresident trusts requesting refunds of over $250,000 for each trust, which the Commissioner of Revenue denied.

The trusts then appealed to the Minnesota Tax Court, which concluded that the state’s definition of a resident trust violated the due process clause because the grantor’s domicile when the trust becomes irrevocable was not “‘a connection of sufficient substance.’”

On appeal, the Minnesota Supreme Court affirmed the Tax Court’s decision, concluding that the contacts on which the Commissioner relied (the grantor’s Minnesota domicile, the trusts’ creation in Minnesota with the assistance of a Minnesota law firm, the use of Minnesota’s law as the governing law of the trust, and a single resident beneficiary) were “either irrelevant or too attenuated to establish that Minnesota’s tax on the [t]rusts’ income from all sources complies with due process requirements.”

The Court also found that the trusts’ remaining contacts with Minnesota during the tax year at issue were “extremely tenuous.” It noted that the trustees had almost no contact with Minnesota, and all trust administration activities took place out of state, before stating that “[t]he [s]tate cannot fairly ask the [t]rusts to pay taxes as residents in return for the existence of Minnesota law and the physical storage of trust documents in Minnesota.”

Although we will need to wait and see whether Minnesota will change its trust residency statute in light of the Court’s ruling, one thing is certain: states where trust residency depends solely on the grantor’s domicile when the trust is created or becomes irrevocable must be prepared to prove such factors pass constitutional muster. Minnesota’s not the first state whose definition was deemed unconstitutional, but it’s unlikely to be the last.  

Continue the discussion on Bloomberg Tax's State Tax Group on LinkedIn: Do you think the number of constitutional challenges to trust residency statutes will continue to grow now that the spotlight is on state nexus policies in other areas of tax?

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