With the Wayfair decision clarifying nexus under the commerce clause, federal due process clause questions look to be the next front of the nexus fight — and a trust case could be the first vehicle for Supreme Court commentary on the issue.
The Court on January 11 agreed to review the North Carolina Supreme Court’s decision in Kimberley Rice Kaestner 1992 Family Trust v. Department of Revenue, a case involving whether an in-state beneficiary alone is sufficient contact to allow the state to tax a trust under the due process clause.
The case is one of two trust taxation cases involving the due process clause before the Court. The Minnesota Department of Revenue is asking the Court to review the state supreme court’s decision in Fielding v. Commissioner of Revenue, which held that four resident trusts administered by an out-of-state trustee do not have sufficient minimum contacts for Minnesota to impose tax.
Weeks before the Court granted cert in Kimberley Rice Kaestner, Multistate Tax Commission Counsel Bruce Fort and Jeffrey Friedman of Eversheds Sutherland (US) LLP agreed that the South Dakota v. Wayfair Inc. decision “is going to put more pressure on the due process clause.”
"I think we’re already seeing that in some of these trust cases,” Fort said December 17 at the New York University School of Professional Studies Institute on State and Local Taxation.
“It’s interesting to find cases where courts have said there is overreaching for nexus purposes,” Friedman said of the trust cases. He added that state courts seem to believe “it is a bridge too far” for a single in-state beneficiary to be enough to confer nexus over the trust.
Trust income just needs to be apportioned, Fort said. “I think that when it’s an all-or-nothing kind of tax, courts are much more likely to say, 'well, why should it be our state that gets all of it?'” Fort said. He agreed with Friedman that the Kimberley Rice Kaestner case “might be a situation of a bridge too far,” and added that the North Carolina courts seemed “bothered by the idea that nexus was created by one beneficiary in the state that didn’t even take her distributions.”
Friedman said states' attempts to tax the entire unapportioned gain or income of a trust add to the possibility of overreach and could make such cases more appealing for review by the courts.
During a later panel at the NYU forum, Steve Wlodychak of EY said the counsel for the Kaestner Trust waived the trust’s right to respond to North Carolina’s cert petition, but that after the justices went to conference, the Court ordered the trust to file a response.
Bruce Ely of Bradley Arant Boult Cummings LLP said such an order is rare, while Wlodychak added that he doesn’t know what it means.
“The fact that the Supreme Court asked the taxpayer to file a response, that’s kind of ominous,” Wlodychak said.
Both the North Carolina and Minnesota high courts seemed to be on solid ground in their decisions, Wlodychak said, adding that neither state revenue department had been able to prove minimum due process contacts with the irrevocable trusts at issue at any point during the proceedings at the state level.
‘Wynne-Like’ Decision?
Michael Giovannini of Alston & Bird LLP told Tax Notes that the Court likely took Kimberley Rice Kaestner to resolve a split in authority regarding the narrow issue of taxing trust income based on the trust’s in-state beneficiaries, but that the Court’s decision could have greater impact.
The decision “could be highly impactful to the extent the Court modifies its due process analysis as applied to state tax nexus disputes,” Giovannini said, noting that there have been several recent due process clause cases — some involving other contexts — that have application to state tax.
Matt Hedstrom, also of Alston & Bird, agreed, adding that "this is particularly true in this post-Wayfair world where taxpayers are trying to find the daylight between commerce clause substantial nexus now, which is essentially satisfied by economic nexus, and due process clause nexus considerations.”
Hedstrom continued by saying that the due process clause has now “become more important to out-of-state taxpayers in shielding them from states’ broad attempts to tax their income.”
Michael Lurie of Reed Smith LLP told Tax Notes that the Court’s analysis in this case might shed some light on what types of contacts are sufficient and how purposeful those contacts need to be in other cases in which there is a relationship between two parties and a state is trying to tax one party based on the contacts the second party has with the state.
Lurie said the decision could have implications beyond trust taxation and provide guidance in the corporate tax nexus arena. As an example, he cited a manufacturer that has a wholesaler selling its products into a state with an economic nexus threshold for income tax purposes and destination-based sourcing. The Court’s reasoning in Kimberley Rice Kaestner could address whether the state would have the power to tax the manufacturer using its economic nexus rule when it’s actually the wholesaler that has the connection to the state, Lurie said.
The Court could also address what contacts are sufficient to create nexus if a company that is fulfilling sales on behalf of another party also stores inventory in the state or makes sales in the state that the other party has no say in, Lurie said.
The Court’s decision could be “Wynne-like” and provide “some kind of universal logic that can be applied beyond just the narrow facts of this case,” Lurie added.
Kimberley Rice Kaestner could also be important outside state taxation and potentially affect personal jurisdiction jurisprudence, according to Lurie. A decision by the Court that the due process clause doesn’t prevent taxation if a beneficiary lives in the state would raise the question of whether trusts can be sued in states where beneficiaries live, he said.
The Court has had difficulty in the last 20 or 30 years in reaching consensus on what personal jurisdiction means and what is needed for personal jurisdiction, Lurie said. He added that the Court would likely be cautious about whether its ruling would “upset the apple cart.”
“We like to think that state tax is everything, but personal jurisdiction literally extends to every litigation area of the law,” Lurie said.
The briefing before the Court as the Kimberley Rice Kaestner case moves forward should give more insight into the potential impact of the Court’s decision, Lurie said. He added that it will be interesting to see if other states become involved in the briefing and, if so, what their views of the case and its impact are.
At NYU, Fort had a slightly different take, saying that “states have not jumped in as vigorously as I would hope” at the cert petition stage.
At issue in the North Carolina case is an irrevocable trust created for Kimberly Rice Kaestner and her children; the trust was created in New York, its trustee lived in Connecticut, and the Kaestners in North Carolina. The DOR assessed tax on undistributed income that had accumulated in the trust; the trust paid $1.28 million in tax under protest, and filed a challenge claiming that the statute at issue was unconstitutional on its face and as applied.
In a 6-1 decision, the North Carolina Supreme Court held that 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,” and that the Kaestner Trust had not purposefully availed itself of the state’s economic market. The court held that the beneficiaries and the trust have a separate tax existence.
Wlodychak and Ely pointed out that the court addressed only the constitutional issue under an “as applied” to the taxpayer standard. It did not strike down the statute as to all taxpayers.
“Both of these cases are significant,” Fort said. “But I think the really interesting case here is Fielding.”
Minnesota is one of 22 states that classify a trust as a resident trust if the grantor was an in-state resident on the date the trust became irrevocable. William Fielding, the grantor of the four trusts at issue in the case, was a resident of Minnesota when the trusts became irrevocable.
But the Fielding case further differs from Kimberly Rice Kaestner in that some of the income from the four trusts was derived from sources in Minnesota.
The Minnesota DOR enumerated these additional connections in its cert petition: The trusts “were funded by stock in a closely held family business headquartered in Minnesota; the capital gains being taxed resulted from the sale of stock in that Minnesota business; the trust documents were drafted and signed in Minnesota; the trust agreements incorporate Minnesota law; and one of the beneficiaries resides in Minnesota.”
The Minnesota Supreme Court held that the trusts did not have sufficient minimum contacts with the state even though the grantor originally resided in state. The court further held that the additional connections were insufficient relevant contacts with the state for Minnesota to tax the trusts as resident trusts under the due process clause.
“They’re saying that it’s an intangible in Minnesota,” Fort said. “Well, the intangible is a fairly closely held business, it’s the stock in that business. It is a Minnesota business — it was established in Minnesota — and yet, still, the Minnesota Supreme Court said it was insufficient.”
‘Judicially Created Shelter’
Several common themes appear in the cert petitions filed by the North Carolina and Minnesota revenue departments, including a split in the states on due process minimum contacts regarding trust taxation, the financial implications for the states, and Wayfair as precedent for Supreme Court action.
“Wayfair is a model for modernizing this Court’s trust-taxation jurisprudence,” North Carolina argued in its cert petition. The notion that a trust's beneficiaries’ contacts with a taxing state are not contacts of the trust itself “is an outdated notion, reminiscent of the physical-presence rule that was retired in Wayfair.”
“Second, like Wayfair, this case presents an opportunity for the Court to eliminate a ‘judicially created tax shelter,’” the North Carolina DOR said.
Nine states have decided whether the due process clause forbids states from taxing trusts based on an in-state beneficiary, according to the cert petition; five, including North Carolina, have concluded that it does. According to the DOR, the decisions rejecting jurisdiction “have enabled beneficiaries to avoid paying state taxes altogether" (emphasis in original).
The DOR told the Court that absent a law like North Carolina’s, which allows the state to tax a trust’s undistributed income, “a beneficiary could enjoy the protection of a state for most of her life, then avoid taxation by relocating to a non-taxing state before taking a distribution.”
Further complicating matters is the fact that “neither side of the split involves uniform reasoning,” the cert petition said. Some state courts have followed the U.S. Supreme Court’s trust taxation precedents, while others “have looked to this Court’s modern due-process decisions — for example, cases involving jurisdictional challenges by tort defendants — but have struggled to apply those precedents in the unique context of trust taxation.”
The Minnesota DOR also cited Wayfair in its cert petition seeking review of Fielding. The due process clause “should not mean different things in different states,” the Minnesota DOR said, adding that the Kimberley Rice Kaestner and Fielding decisions enable individuals to avoid taxation altogether on significant accumulations of wealth. “Whether such tax loopholes should exist might be an interesting policy question. But they are not compelled by the Constitution,” the DOR said.
"Just last Term, this Court rejected a ‘judicially created tax shelter’ that constituted ‘an extraordinary imposition by the Judiciary on States’ authority to collect taxes and perform critical public functions,’” the Minnesota DOR said. “The Minnesota Supreme Court and many other state courts have created another tax shelter not mandated by the Constitution. This Court’s intervention is again needed.”
The states have also cited refund claims in their discussions of the revenue impact of adverse decisions. The North Carolina DOR said rulings in favor of the trusts leave states “exposed to hundreds of millions of dollars of potential claims for refunds,” and that it “has already received more than 450 contingent income-tax returns from trusts that are awaiting the outcome of this petition.”
In its reply in opposition to the Court taking the case, the Kaestner Trust said the North Carolina cert petition is the first place that the DOR's 450 refund claims figure had appeared, and that the DOR has provided no evidence for it.
Meanwhile, in earlier comments to Tax Notes, Lurie pointed out that a Supreme Court decision in favor of the Kaestner Trust could open up states like California, Missouri, and Connecticut to refund claims, because courts in those states have held that it's constitutional to impose tax on a trust based on an in-state beneficiary.
The Kaestner Trust also argued that the case is “a poor vehicle for addressing constitutional implications of state taxation of out-of-state trusts and would have limited precedential value.” Only four other states have similar statutes, the trust argued, adding, “No court has held that a beneficiary’s presence is sufficient to tax the undistributed income of a foreign trust.”
The trust also argued that even if an in-state beneficiary constitutes a minimum connection, the income attributed to North Carolina is not rationally related for due process purposes — all of the trust's assets are held and generated outside the state. “The Department taxed 100 percent of the trust’s income while providing no opportunity to the Kaestner Trust to create that income,” according to the trust.
With the Supreme Court granting cert in Kimberley Rice Kaestner, the trustee in Fielding tried to distinguish its case in its January 22 brief opposing review of the Minnesota Supreme Court's decision. Fielding argued that while both North Carolina and Minnesota “rely on the connections of a third party rather than the connections of the trust itself,” Minnesota’s grantor-domicile rule presents “much more serious due process infirmities.”
Fielding claimed that the Minnesota Supreme Court would have also invalidated the tax under the commerce clause had it addressed the issue, arguing that the trusts’ contacts with the state would not have met the commerce clause’s substantial nexus requirement.
Fielding also argued that the tax was not fairly apportioned and failed the internal consistency test.
Apportionment
Megan Miller, also of Reed Smith, said apportionment would not be an issue for the Kimberley Rice Kaestner decision, though it might be a related question.
Lurie said that if a taxpayer doesn’t have minimum contacts in the state, apportionment wouldn’t come into play under the due process clause. He continued that this was distinct from a commerce clause analysis, which has both apportionment and nexus prongs.
Miller agreed, adding that a taxpayer would still need minimum contacts with the state to even get to the apportionment prong under the commerce clause.
Though the North Carolina Business Court ruled in Kimberley Rice Kaestner that the taxation of the trust violated both the due process clause and the commerce clause, the state appellate court and supreme court both declined to address the commerce clause argument.
In urging the U.S. Supreme Court not to grant review, the trust said the unaddressed commerce clause issue meant that a decision from the Court may not resolve the case. The DOR countered that the case was unlikely to return to the Court on commerce clause grounds in light of the Wayfair decision, and that any remaining commerce clause issue could be addressed through “a straightforward application of this Court’s precedents.”
But Giovannini said that “a significant expansion of states’ rights to tax under the due process clause in this context would certainly raise the importance of other constitutional limitations, including that any tax be fairly apportioned.”
“If a number of states assert jurisdiction over a given trust’s income, some thought will have to be given on how to ‘divide’ up the income,” Giovannini said. “However, the nature of the trust assets, the lack of uniformity, and lack of clarity may make this difficult.”