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Tax Law Update: August 2019

David A. Handler and Alison E. Lothes highlight the most important tax law developments of the past month.

U.S. Supreme Court rules on fiduciary income tax based on residency of beneficiary—The U.S. Supreme Court affirmed the North Carolina courts and held for the taxpayer that the residence of a discretionary beneficiary in the state of North Carolina isn’t enough, on its own, to justify taxing trust income by the state.

In North Carolina Dept. of Rev. v. Kaestner 1992 Family Trust, North Carolina assessed income tax on a trust established 30 years ago by a New York resident. The only contact to North Carolina was that a beneficiary of the trust lived there. No trustee lived in North Carolina. The assets were located in Massachusetts, and the trust records were kept in New York. The trust had no physical presence in North Carolina and had no investments or real property in the state.

North Carolina taxes any trust income that’s “for the benefit of” a resident. The Department of Revenue assessed income tax of over $1.3 million on the trust for the years 2005-2008, during which the income of the trust was accumulated and never paid out to the beneficiaries. The trustee paid the tax, but then sued in state court arguing that the tax was unconstitutional, violating the 14th amendment’s due process clause.

The Supreme Court agreed with the taxpayer and held that the residence of a discretionary beneficiary, who hasn’t received trust income and doesn’t have any right to demand trust income, in the absence of other factors, doesn’t empower a state to tax the trust income.  

The due process clause requires that a person must have some minimum contacts with a state to be subject to its tax. The fact that the beneficiary didn’t receive any distribution of trust income and couldn’t withdraw the income was critical to the decision. The Court explained that a state’s constitutional ability to tax a trust based on beneficiary residency depends on the extent of the beneficiary’s rights to possession, control or enjoyment of the trust property. Prior cases established that a state may tax trust income actually distributed or subject to the control of a resident beneficiary. That wasn’t the case here. 

The Court’s holding was limited, and the opinion specifically noted its holding doesn’t apply to other situations in which the resident beneficiary has different rights or entitlements to trust income or when the residency of the beneficiary is one of several factors on which the state bases its right to tax. 

If the trust had distributed income to the beneficiary, would that subject all of the trust’s income to tax in North Carolina? It’s unclear from the holding what facts, if different, would have been enough to tax the trust without violating the due process clause.

• Internal Revenue Services issues final regulations and Notice relating to deductibility of state and local tax payments—The Tax Cuts and Jobs Act enacted Internal Revenue Code Section 164(b)(6), which limits the annual deduction of state and local tax (SALT) payments to $10,000. Many states have enacted legislation to allow their residents to circumvent the restriction by providing a credit against state or local income, real estate or other taxes in return for certain charitable contributions. This essentially converted a tax payment subject to the $10,000 limitation into a charitable contribution that isn’t subject to the limitation.

The final regulations (T.D. 9864) under IRC Section 164(b)(6) establish the general rule that if a taxpayer receives or expects a state or local tax credit in return for a charitable contribution, that tax credit (as a quid pro quo) reduces the taxpayer’s federal charitable tax deduction. There’s a de minimis exception —if the tax credit doesn’t exceed 15% of the charitable contribution, it won’t be treated as a quid pro quo that reduces the federal charitable deduction. These regulations also apply to payments made by a trust or estate when determining its charitable deduction under Section 642(c).

Two other IRS publications relating to Section 164(b)(6) were published as well. Notice 2019-12 provides a safe harbor for taxpayers whose total state and local tax liability is under $10,000 for the year. For those taxpayers who also itemize deductions and make a charitable contribution in return for the state or local tax credit, the regulations would preclude the charitable deduction, but if they had paid the state or local tax instead, they would have been able to deduct the state or local tax up to the limitation amount. Notice 2019-12 provides a safe harbor and allows these taxpayers to deduct the disallowed charitable deduction as a payment of state and local tax under Section 164.

In addition, Revenue Procedure 2019-12 provides further guidance regarding the application of these rules to businesses. 

The final regulations do have broad application, and although they were enacted to target the legislative reactions to the SALT limitation, they may also apply to pre-existing tax credit programs that, in the past, have encouraged donations to various charitable and educational institutions through the incentive of the charitable deduction.

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