Kaestner and the Multistate Quest

Diann L. Smith: There has been another U.S. Supreme Court oral argument in a state tax case looking at what is the jurisdiction of that state to tax.¹ This case has to do with trust income and whether the state where the beneficiary of the trust is a resident can tax the trust. What is important about this case is that the state is not trying to tax the beneficiary, because it’s clear that if the trust had distributed any income to the beneficiary, then the state of residence could tax the beneficiary. That’s not what is happening here. The state is trying to tax the trust itself based on where the beneficiary is located.

The Supreme Court in the oral argument that happened recently was a very active Court. When you look through the transcript, the justices actually spoke much more frequently than the attorneys did, and the justices frequently spoke over each other. One of the things that I think the Court really struggled with was trying to determine: What is this animal that’s a trust? Before I really became familiar with this case I had not spent any time on trusts at all. Now I find them fascinating. What complicates this case is that unlike other entity forms that are subject to tax, like a C corporation or an individual that’s getting income from an LLC — any of the things that I’ve dealt with in my career — the trust is a different entity. It doesn’t really exist; it just is essentially a concept in which other things happen. So the idea of taxing a trust is somewhat slippery because it’s really physically nebulous . . . there’s the idea of where is the trust administered, where was the trust set up, where is the trustee, and of course, where is the beneficiary or beneficiaries?

Kendall L. Houghton: I think your point is really an important one, and it sort of tickles the due process analysis, doesn’t it?

Smith: Exactly.

Houghton: If a trust is meaningless, then how do you determine whether the trust itself has intentionally exploited a local market, has engaged in activity there, has established minimum contacts, and so forth? If a trust is, in a sense, more passive than the other types of business entities you alluded to, Diann, what does that tell us about the trust beneficiary? Are they two steps removed and twice as passive?

Smith: Exactly, Kendall, and that’s one of the things in which the Court got somewhat hostile with the state’s arguments. The attorney for the state kept arguing, “Listen, the state has provided services to this beneficiary, so we should be able to tax the income.” But realistically, the beneficiary may actually never receive that income. The trust currently has the income, and the beneficiary could die tomorrow. Or depending on the type of trust, the trustee could decide, “No, we’re not going to ever give it to this beneficiary; we’re going to give it to this other beneficiary.” There are so many contingencies in this trust concept as to whether or not a certain beneficiary is going to get the income. Thus it makes it difficult to say that a state has sufficient connection merely because there’s that beneficiary there.

Stephen P. Kranz: At the same time, the Court also investigated the situation in which the beneficiary was guaranteed to get the money sometime; there was no contingency, just a timing issue. Then the Court answered its own question by noting that the beneficiary might be living in another state when the money is distributed.

Smith: Another thing that the Court seemed concerned about was that the state was somewhat of an outlier. Most states don’t tax trusts this way; there are only a couple others that do, and even those could be distinguished. So while I think historically the Court has given states a lot of leeway to decide their own tax systems, in this circumstance the Court was very concerned about, “Well, other states aren’t doing it the same way. How do we prevent double taxation?” The attorney kept saying, “oh, we have these credits,” but he could not really articulate exactly how those credits were working when other states were not doing the same thing.

It will be interesting to see how this case comes out. I don’t know to what extent it will affect general taxation, but I do think it will have some interesting things to say about the due process concept.

Kranz: The Court really struggled to find a relevant comparison here. The justices tried looking at owning appreciating land in another state or a stock portfolio. But these situations do not fit because the taxpayer would have control over the assets, which does not necessarily occur in a trust. I think this demonstrates how the Court was looking to see whether it should decide the issue purely on the facts of this trust, which would give some instruction to the states but might not really answer the question of where trusts can be taxed because of the variability of trusts themselves.

Houghton: So one more question for you then, Diann: Do you view that exchange between the state’s attorney and the justices — on the notion of credits and how they may or may not apply — as illustrating the dormant commerce clause internal or external arguments, or maybe both?

Smith: I think this really was a pure due process analysis. To me, it was much more of a practical discussion of, “OK, what is our decision in this case going to mean?” And while many of us think of the U.S. Supreme Court justices as these academics trying to interpret the law, I think this is a good example of them also being concerned: “OK, what is the result of what we do here?”

Kranz: Does it have any impact on taxation of joint ventures or business arrangements that are not conducted in an entity per se?

Smith: To the extent there is an entity-level tax, I think it could have implications if the joint venture has no connection with the state of an individual participant’s residence. Trusts are different from joint ventures, but there is still a question as to whether there is an appropriate connection between the individual resident’s state and the income of the joint venture. The individual can be taxed on that income, but can the joint venture?

Houghton: Appropriate as a matter of tax policy or as a constitutional matter?

Smith: I think both. The state trying to impose an entity-level tax has not provided anything to the joint venture that it is not already providing to the individual.

Joe Crosby: And Diann, your comment regarding the justices being interested in the results is really important here as well, because there’ve been a number of cases — it’s been a fairly active period for the Supreme Court regarding state taxation — and of course, in the Wayfair case last year and in the Murphy case, which was not a tax case directly, but many folks thought there were implications, the Court clearly granted new authorities to the states, or clarified the robustness of some theories of state authority. And if the justices were to find in favor of North Carolina here, I can only begin to imagine the potential legislative mischief going forward — because states would have the opportunity to really reevaluate how broad their authority was to reach out-of-state parties whose connections with the states were minimal, if at all.

Smith: Exactly. This practical-versus-legal analysis came through very heavily in the oral argument. Apparently, the reason that this problem arises — we’ve been talking a lot about the most recent federal tax reform — is from an older piece of reform when the federal government changed the way it taxed trust income but states had difficulty conforming. So North Carolina kept its old system of taxing the beneficiary, because it felt the change in the way trust income was being taxed meant the trust could be located in states that did not tax the trust income, and that that created a loophole. This was another thread throughout the argument — that if the state does not win, there are these states that are tax havens for trusts, and that no state will be able to tax that income.

Houghton, Smith: [laughs].

Smith: Joe, switching gears entirely, I understand you’ve been thinking a lot about the post-Wayfair continued collection issues.²

Crosby: Yes, thanks Diann. As we’ve talked about many times before, when we predicted in some ways that the next iteration of legislation in the wake of Wayfair was not really economic nexus, but marketplace facilitators, because the reality is many states had acted even before the decision regarding economic nexus. What’s interesting and what we’ve been thinking about is now that retailers have been successful in working with states to make the playing field more level — so to speak — regarding collection, what comes next? And to me, I think retailers will turn to their intrinsic interest in simplification.

What the streamlined states began 20 years ago now . . . there’s still abiding interest in that for anyone who’s required to collect tax — and now there’s more of them in terms of entities required to collect. But there may be some interest in the states, which isn’t obvious in that the challenge in expanding streamlined to additional states was that there did not seem to be any political or substantive interest on the part of those states. You would think in the wake of Wayfair, there would be even less interest, because there’s really no convincing legal argument that you need to join streamlined to be able to require remote sellers to collect tax.

Nevertheless, there may be some benefit for new states to join streamlined in that there is a significant amount of remote commerce that is below any threshold any state is enacting, and potentially — to get back to the case we were just discussing — below the threshold at which the due process clause would find it offensive for a state to require a remote seller to collect tax. But are there other ways that states can simplify and make it easier for smaller sellers to collect tax and in some ways, induce them to collect tax? And I think there are, and joining or complying with streamlined is one of them, but even in states where that can’t happen politically, providing software certification and making that software available to smaller sellers at no direct charge to them could be a way for states to continue their efforts to level the playing field, simplify sales tax for retailers, and generate additional revenue at the same time.

Smith: Joe, do you know if there have been discussions started with any states about that option?

Crosby: So there have been. In fact, Missouri is right now in its legislature considering how it can join streamlined. I think at this point the decision has been made that fully complying with the Streamlined Sales and Use Tax Agreement is a bridge too far for the immediate future, but it can implement certified service provider [CSP] language to allow it to move forward on that basis. Connecticut is considering something similar right now, and I know that there are some other states like New Mexico that have provided for certification. Finally, the streamlined folks themselves are talking with states about coming into compliance.

I think it will take a little bit of time for the dust to settle, but I won’t be surprised if large retailers return to this original concept of streamlined as something that is a benefit in and of itself. All of us have been involved in that and were around near the beginning of that effort and can remember some pretty impassioned presentations by representatives of larger retailers about the complexities associated with sales tax compliance. And certainly, in the intervening two decades, the software and services associated with those has made it much simpler to comply or have reduced the costs of compliance. But I still think that simplification is an end in and of itself that the retail community itself will express interest in, and I think there’s some interest that non-streamlined states may not have fully appreciated before Wayfair for partnering with retailers in that effort.

Houghton: And Joe, just to remind our audience, the use of a certified software provider carries with it some assurance that utilizing the software prevents you from being the subject of interest or penalty assessments, correct?

Crosby: That’s correct, Kendall. That’s a critical part of what’s in the Streamlined Agreement, and what you would think that other states would do is that if the state certifies the software, it’s essentially relieving a retailer who uses that CSP of liability absent some sort of fraud or bad faith. Steve, I know you were engaged in this right from the get-go. Anything you would add in terms of this maybe being a potential renaissance for streamlined?

Kranz: The optimist in me would like to believe that, Joe. The pessimist in me concludes that it’s unlikely there will be a sufficient prioritization of simplification by retailers large or small and a dedication of the resources that would be needed, not just to breathe life into the Streamlined Sales Tax Governing Board, but to move the political needle in states and get them to adopt the kind of changes that the Streamlined Agreement requires. I could see a path in which some of the rules of the Streamlined Agreement are adopted in states, but wholesale adoption of the agreement and all of its provisions . . . we spent 20 years trying to get more states to do that, and got to 24, but there were real impediments to changing laws in Massachusetts and Texas and other states that did not follow the sourcing regime or the rounding rule that I think will continue to prevent states from adopting streamlined as a whole. The best case, I would predict, is that we see some states adopt pieces of it.

Crosby: I think you may be right, Steve, just from a practical perspective, and I know streamlined itself is talking about what are core components that other states might want to adopt or use — like the registration system — without adopting the entire agreement. In quantifying the revenue implications, part of our intent was to remind states that there are due and payable taxes that are not going to be collected or remitted unless they do something. It will be interesting to me if some of the larger retailers also go back and take a look at their own costs, because nothing really moves the needle so much as realizing that you’re either forgoing revenue or spending resources that you may not need to if you were able to really demonstrate there would be an ROI [return on investment] for expanding streamlined to additional states. That might encourage some retailers to put resources behind making that happen. But absent that, I think you’re right; it’s unlikely to be expanded, although bits and pieces of it — like the CSP part — may be adopted.

Kranz: There’s litigation now in Massachusetts — which has not adopted streamlined — challenging the state’s cookie nexus.³ One thing that could change the dynamic politically is if the argument could be made that it doesn’t qualify, that the state doesn’t qualify under Wayfair for remote sales tax collection. If litigation in a non-streamlined state successfully pushes back on the state’s assertion of Wayfair authority, then suddenly I think you would see the states themselves clamoring for simplification, and wanting to do what South Dakota did — in large part, joined streamlined and adopted its regime.

Doug Sheppard: Joe, am I to also infer that MultiState Associates would not have done that report if it did not think that it would at least have some effect on the debate and the outcome in terms of getting more participation?

Crosby: Doug, absolutely. When we look at issues, we’re looking to influence the discussion. I’m hopeful that focusing on the revenue — the change that’s still in the couch — will encourage people to do some spring cleaning and figure out ways to make it easier for small sellers to collect. Not to target small sellers, I don’t think this is an area where states should be thinking about ways to lower their thresholds or otherwise force smaller sellers to collect, but really to facilitate collection, because there are thousands of smaller sellers out there that would just as soon comply if there were an easy way to do so.