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Jamie C. Yesnowitz
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On July 18, 2018, the Minnesota Supreme Court found unconstitutional the application of a Minnesota income tax statute defining a “resident trust” to four related, irrevocable inter vivos
trusts whose primary link to Minnesota was the grantor’s Minnesota domicile.1
In its decision, the Supreme Court determined that this contact proved too irrelevant—and that other, ancillary ties proved too attenuated—to support Minnesota’s taxing the trusts’ income from all of its intangibles and investments in a constitutional manner.
In 2009, grantor Reid MacDonald created four separate trusts for his children as beneficiaries, initially funding each with nonvoting common shares in Faribault Foods, Inc., an S corporation headquartered in Minnesota. MacDonald was a Minnesota domiciliary when he created the trusts, and he remained so afterwards. At all times, the trusts’ sole trustee was domiciled outside Minnesota.
MacDonald retained control over the trusts’ assets through the end of 2011. During this time, the trusts were considered by Minnesota law as “grantor-type trusts,” the income or gains of which were taxable to the grantor.2
But on Dec. 31, 2011, while still a Minnesota domiciliary, MacDonald surrendered his control, an action that made the trusts irrevocable.
Upon becoming irrevocable, the trusts fell under the purview of Minn. Stat. Sec. 290.01, subd. 7b(a)(2), providing that the definition of a “resident trust” includes “an irrevocable trust, the grantor of which was domiciled in this state at the time the trust became irrevocable.”3
Accordingly, and without protest, the trusts began filing Minnesota income tax returns as resident trusts, in 2012 and 2013.
But in 2014, the ramifications of this status were amplified. Shortly after William Fielding, a domiciliary of Texas, assumed the role as sole trustee of the trusts in July 2014, all shareholders of Faribault Foods—including the trusts—sold their shares of stock in the corporation. Being considered resident trusts by Minn. Stat. Sec. 290.01, subd. 7b(a)(2), the trusts were consequently subject to Minnesota income tax on the full amount of gain on the sale of their shares, as well as on the income realized through investment of their proceeds from the sale, despite the shares and the investment funds having been held outside Minnesota by the trustee. Had the trusts instead been considered nonresident trusts, such gain and income would not have created a Minnesota income tax liability. Only the trusts’ apportioned share of flow-through operating income from Faribault Foods would have been taxed.
Considering this difference in classification between resident and nonresident trusts in 2014 represented a tax variance in excess of $250,000 for each of the trusts, the trusts filed Minnesota income tax returns as resident trusts in 2014 under protest, paying the additional tax but arguing that Minn. Stat. Sec. 290.01, subd. 7b(a)(2), was unconstitutional as applied. The trusts then proceeded to file amended returns claiming refund of these amounts. The refund claims were denied by Minnesota’s Commissioner of Revenue.
Upon denial of the trusts’ refund claims, Fielding appealed to the Minnesota Tax Court, maintaining that application of Minn. Stat. Sec. 290.01, subd. 7b(a)(2), represented an unconstitutional violation of the state and federal Due Process Clauses and the federal Commerce Clause. In May 2017, the Tax Court ruled in favor of the trusts, noting that the only relevant contact between the trusts and Minnesota, MacDonald’s status as a domiciliary at the time the trusts became irrevocable, was not “a connection of sufficient substance” to support Minnesota’s taxing all the trusts’ income in a manner consistent with due process requirements.4
The Commissioner then appealed to the Minnesota Supreme Court.
Extent of the Supreme Court’s due process review
In its ruling, the Minnesota Supreme Court took care to first evaluate the extent to which it should analyze the trusts’ contacts with Minnesota. Although the only factor contained within Minn. Stat. Sec. 290.01, subd. 7b(a)(2), for determining residency of an inter vivos
trust is the domicile of the grantor at the time the trust is made irrevocable, the Supreme Court recognized that a Due Process Clause challenge to the application of a taxing statute requires a broader analysis of the facts. Here, the Supreme Court relied on Minnesota case law to support a holistic review “beyond the statutory definition... in order to evaluate the relationship between the income taxed and the benefits provided by the state.”5
This meant the Supreme Court would look beyond the mere fact of MacDonald’s status as a Minnesota domiciliary at the time he yielded control of the trusts’ assets to determine whether Minnesota could tax the trusts’ income from intangibles and investments under the constraints of due process.
Sufficiency of the trusts’ contacts with Minnesota
In assessing the overall sufficiency of the trusts’ contacts with Minnesota for justifying Minnesota taxation of the trusts’ income from intangibles and investments, the Supreme Court cited Minnesota and federal case law in looking for a “minimum connection” between the state and the taxpayer and a “rational relationship” between benefits provided and income taxed.6
The Commissioner contended the connection and relationship were evident in the trusts’ having been established by a Minnesota resident, association with a Minnesota law firm, holding of stock in a Minnesota corporation, and reliance upon Minnesota law. The Commissioner also commented that the beneficiary of one of the trusts was himself a Minnesota resident. Fielding rebutted, noting that the trusts had never been represented by a Minnesota resident as trustee, were never administered in Minnesota, retained records outside Minnesota, and derived income from investments with no direct connection of their own to Minnesota.
Considering its mandate to perform a broad review of the facts, the Supreme Court ruled in favor of Fielding, concluding for three reasons that the contacts cited by the Commissioner were “either too irrelevant or too attenuated” to permit Minnesota’s taxation of the trusts’ income from intangibles and investments consistent with due process requirements. First, the Supreme Court stated that grantor MacDonald’s connections with Minnesota were irrelevant for purposes of determining the adequacy of the relationship between the trusts’ income and the benefits Minnesota provided the trusts. Here, the Supreme Court emphasized the trusts’ existence as discrete legal entities separate from grantor or beneficiary. MacDonald’s Minnesota domicile, the use of a Minnesota law firm to draft trust documents, and the Minnesota residency of the beneficiary of one of the trusts could not establish the requisite relationship between Minnesota and the trusts themselves. In these circumstances, only the Minnesota connections of the trustee could establish the requisite relationship.
Second, the Supreme Court observed that the trusts did not own any physical property in Minnesota that could empower Minnesota’s taxation of the trusts as residents. Although the trusts had owned shares of Faribault Foods, a Minnesota corporation with its headquarters and property located in the state, the trusts’ ownership interests and other investment accounts represented intangible property held on the trusts’ behalf by Fielding outside Minnesota. Such intangible property did not “serve as a relevant or legally significant connection with the State.”7
Finally, the Supreme Court articulated that any pre-2014 contacts cited by the Commissioner were irrelevant for determining whether the Due Process Clause allowed Minnesota’s taxation of the trusts’ income from intangibles and investments realized in 2014, the tax year at issue. Here, the Supreme Court clarified that, in reviewing a Due Process Clause challenge, “[t]he direct link between the activities that generated the income in the year at issue and the protections provided by the State in that same year establishes the necessary rational relationship that justifies the tax.” To hold otherwise, allowing the state to assert historical connections in justifying taxation, would implicate a paramount due process concern of leaving a taxpayer with inadequate notice of potential liability. Furthermore, focusing the analysis squarely on the tax year at issue served to minimize uncertainty as to when, precisely, a taxpayer establishes sufficient Minnesota contacts and when it does not.
Focusing its review on the trusts’ contacts with Minnesota in 2014, the Supreme Court recognized that all trust administration occurred outside Minnesota and that Fielding’s visit to Minnesota in a personal capacity in the fall of 2014 was “clearly not enough to establish residency [of the trusts] for taxation purposes.” Although the trusts relied on Minnesota law for resolving disputes in their governance and for protecting their ownership interests in Faribault Foods, such dependence could not, by itself, demonstrate the necessary connection and relationship. Indeed, as the Supreme Court noted, “[d]ue process does not merely require that some benefit be conferred on the taxpayer.”8
Instead, as the Supreme Court concluded, the tenuous contacts with and limited benefits enjoyed by the trusts did not support Minnesota’s taxation of the trusts’ income from intangibles and investments in a manner conforming to the requirements of due process.
Under Minnesota’s income tax law, a resident trust is taxed on its Minnesota source income and its income from intangible property or investments that are not employed in the business of the trust. A nonresident trust is taxed only on its Minnesota source income.
Since 1996, Minnesota’s income tax law has defined a resident trust as an irrevocable inter vivos
trust where the grantor was domiciled in Minnesota when the trust became irrevocable. In this case, the trustee was not a Minnesota resident and the trusts were not administered in Minnesota. As a result, the Minnesota Supreme Court held that it was unconstitutional to consider these trusts to be resident trusts simply based on the historical contacts that the trusts had with Minnesota. In order to satisfy Due Process Clause concerns, the Supreme Court held that the link between the activities that generated the income and the protections provided by the state must occur during the tax year at issue.
The Supreme Court was careful to merely declare the resident trust statute unconstitutional as applied to these trusts, rather than to declare the entire statute unconstitutional. As a result of this decision, will the 2019 Minnesota legislature react and change the definition of a “resident trust,” perhaps to a pre-1996 conception of the term? The pre-1996 law defined a “resident trust” as an irrevocable inter vivos
trust located in Minnesota under at least two of the following sourcing rules:
- The location where the majority of the discretionary investment decisions of the trustees are made;
- The location where the majority of the discretionary distribution decisions of the trustees are made; and
- The location where the official books and records of the trust are held.9
Finally, it should be noted that the decision governs inter vivos
trusts, not all trusts. The statutory definition of a “resident trust” that became irrevocable after 1995 and which was created by the will of a decedent was not at issue in this litigation. Under the statute, these testamentary trusts are considered to be “resident trusts” if the decedent who created them was domiciled in Minnesota when the person died.10
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