Two recent cases have examined how much “presence” in a state will permit that state to tax a trust’s undistributed income. Generally, the trust’s principal place of administration is the place that subjects the trust to state income tax. Delaware, for example, does not tax trust income or capital gains, so it is a popular place for national corporate trustees to locate. If, however, income is distributed from the trust to a beneficiary and that beneficiary resides in a state with a state income tax, then that income is taxed to the beneficiary at his/her rates. Income and capital gains not distributed, however, will be taxed (or not taxed) based on the trust’s tax situs.
The Maryland Trust Act
The Maryland Trust Act (“MTA”) presumes that the place named in the trust document is valid as its principal place of administration as long as there is an actual and reasonable nexus with that location.
Many trust agreements permit a change of situs as a way to move the trust over time to a more beneficial “location” for tax purposes. This does not mean, however, that the governing law with respect to the validity of the trust and/or the construction of its dispositive provisions change. The governing law for those aspects of a trust are locked in usually at the place of formation. This permits having Maryland law apply with its good asset protection provisions for third-party trusts but still may allow forum shopping to try to improve tax situs as long as the client is willing to use a corporate trustee and shift the administrative functions to a corporate trustee located in a no-tax state.
A Brief Look at Two Recent Cases
Two recent cases explore the flexibility of the tax situs rules for trusts. In Kimberly Rice Kaestner1992 Family Trust v. N.C. Dept. of Revenue, 814 S.E.2d 43 (N.C. 2018), the North Carolina appellate court upheld a decision finding a state statute unconstitutional under the due process clause of the U.S. Constitution. The state’s statute in North Carolina attempted to tax all trust income, distributed or not, if a trust beneficiary was located within the state. In the Kaestner case, the beneficiary was a North Carolina resident. The trust stated that New York substantive law would apply to the trust and, additionally, most of the financial and legal records were held in New York and the tax returns of the trust accountings were prepared in New York. The Kaestner court held that a trust is a legal entity separate from the beneficiary and that the beneficiary’s residence in the State of North Carolina was irrelevant under the “minimum contacts” rule to permit state taxation.
Another case, Fielding v. Comm. of Revenue, 916 N.W.2d 323 (2018) likewise held that a tax residency statute violated the due process clause. In that case, the State of Minnesota sought to tax a trust despite the fact that all trust functions were out of state. In Fielding, the connection with the taxing state was more pronounced, thus a stronger case could be made to connect the trust to Minnesota. The settlor was a resident of the state when the trust was created and became irrevocable, the trusts were holding stock in a state chartered and operating S Corporation, the trust documents provided questions of law should be provided with Minnesota law, and one beneficiary had been a Minnesota resident throughout the tax years in question. In that case, no trustee had been a Minnesota resident and the trusts were not administered in Minnesota. The court held that the trusts held no physical property in Minnesota given that the Minnesota corporation was intangible and therefore had a tax situs outside of the state. Minnesota has filed a cert petition to the U.S. Supreme Court in Fielding.
Have Questions or Concerns About How This May Impact Your Situation? Contact a Maryland Trust Lawyer
The rules underlining where a trust income may be taxed will be before the U.S. Supreme Court if the petition for cert is granted in Fielding. In mid-2018, the U.S. Supreme Court in an internet sales tax case walked back the traditional “physical presence rule” of the retailer when imposing a state sales tax. South Dakota v. Wayfair, Inc., 138 S.Ct. 2080 in reversing Quill Corp. v. North Dakota, 504 U.S. 298 (1992). The Wayfair court held that the internet disrupted the basis for using physical presence as the linchpin for taxation. The test now is that “some definite link, some minimal connection, between the state and the person, property or transaction seeks to tax” is the test.
Obviously, Wayfair and Fielding are not the same. Sales tax cases involve a product or service that is delivered to the purchaser who is engaged in the transaction within the state that wishes to tax the transaction. To the extent that a trust makes a distribution to a beneficiary residing in the state, that distribution is taxed if the state of the beneficiary has a state income tax. It would be quite a leap to apply the Wayfair standards to Fielding. Whether the Supreme Court will grant cert and, if so, how it will determine the tax situs issue is difficult to predict, however. Obviously, the trust companies in tax-free jurisdictions are concerned that a change from the Kaestner and Fielding holdings could adversely affect their business model.
Each Maryland trust lawyer at our firm will continue to keep track of the tax and non-tax issues affecting trusts in order to bring you the most up-to-date information possible. Feel free to contact our office with any questions on negotiating trust creation or administration.