tax918

Tax Law Update: September 2018

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

• Irrevocable trusts win their challenge of state income tax residency—In 2009, Reid MacDonald funded four irrevocable trusts with shares of a Minnesota S corporation (S corp). The initial trustee was a California resident. For almost three years, Reid retained certain powers over the trusts, causing them to be grantor trusts to him. Reid, as a Minnesota resident, therefore filed income tax returns reporting the trusts’ income.

Then, on Dec. 31, 2011, Reid relinquished his grantor trust powers. Under a Minnesota statute, because Reid was a Minnesota resident when he relinquished these powers, the trusts were classified as resident trusts. On Jan. 1, 2012, a new trustee, a Colorado resident, became the sole trustee of the trusts. Two years later, there was another trustee change, and a Texas resident became the sole trustee.

In 2014, the trusts sold their shares of stock in the S corp. As Minnesota resident trusts, the trusts were subject to Minnesota income tax on their worldwide income. The trusts filed their 2014 income tax returns under protest, asserting that the statute deeming them Minnesota residents was unconstitutional. The taxpayer trusts subsequently filed amended returns claiming refunds in excess of $250,000 for each trust as non-resident trusts.

The Commissioner of Revenue denied the trusts’ claims, and the trusts appealed to the Minnesota Tax Court. The trusts prevailed, and the Commissioner appealed to the Minnesota Supreme Court. In William Fielding, Trustee of the Reid and Ann MacDonald Irrevocable GST Trust for Maria V. MacDonald, et al. v. Commissioner of Revenue (July 18, 2018), the Supreme Court agreed with the taxpayer trusts, upholding the Tax Court’s decision. 

The issue was whether there were sufficient contacts between the trusts and the state to permit taxation under the due process clause of the Constitution. The taxpayers acknowledged that Minnesota source income (that is, operating income flowing through from the S corp) was taxable in Minnesota. The question before the court was whether Minnesota could tax all of the trusts’ income by classifying the trusts as Minnesota residents (for example, the gains from the sale of the stock in the Minnesota S corp).

The Supreme Court held that it was necessary to examine all relevant contacts between the trusts and the state of Minnesota in the year at issue, including the relationship between the income earned by the trusts subject to the tax and the benefits conferred by the state to the trusts in that year.

The following Minnesota connections were noted:

• The grantor was a Minnesota resident;

• The trusts were governed by Minnesota law;

• The trusts were established in Minnesota by a Minnesota law firm;

• The trusts held stock in a Minnesota S corp; and

• One beneficiary was a Minnesota resident during the tax year at issue

However, the following facts were also important to consider:

• The trustee wasn’t a Minnesota resident;

• The trusts weren’t administered in Minnesota;

• All trust records were maintained outside Minnesota;

• Some trust income had no connection to Minnesota; and

• Three beneficiaries resided outside of Minnesota

Two justices dissented, but the court’s majority held that in the tax year at issue, there weren’t sufficient contacts to justify Minnesota taxing all of the trusts’ income. It reasoned that the residency of the grantor in a prior year, or even the year at issue, wasn’t relevant to the determination of the trusts’ residency. It noted that the trusts didn’t hold any property in the state that served as a basis for taxation—holding intangible assets such as the S corp stock didn’t create a significant connection to Minnesota. The court wasn’t convinced that facts pre-dating the tax year at issue were relevant, nor was the governing law of Minnesota or the ability to settle disputes in Minnesota sufficient to categorize the trusts as residents and subject all trust income to Minnesota income tax.

Treasury to issue regulations on effect of Internal Revenue Code Section 67(g) on trusts and estates—In Notice 2018-61 (July 13, 2018) (Notice), the Treasury announced that it will issue regulations on the effect of IRC Section 67(g) as it relates to trusts and estates. That section, added by statute as part of the budget and tax law reform in 2017, provides that miscellaneous itemized deductions are no longer allowable until 2026. Some commentators have suggested that Section 67(g) could be read to eliminate the deduction for expenses described in Section 67(e)(1) for costs that are paid or incurred in the administration of an estate or trust that wouldn’t have been otherwise incurred, if not held in the estate or trust.

The Notice, however, explains that Section 67(e) removes the expenses listed in Section 67(e)(1) from the category of itemized deductions and moves them “above the line” to be deductions in determining adjusted gross income (AGI) (therefore taking them outside the ambit of Section 67(g)). It also notes that Section 67(g) doesn’t affect any deductions listed under Section 67(b).  

To clarify, the Treasury will issue regulations to confirm that estates and non-grantor trusts can deduct those administrative costs that are particular to estates and trusts under Section 67(e)(1), as well as certain other sections (including the appropriate portion of bundled fees), when determining an estate’s or trust’s AGI.

In addition, the Treasury will clarify the effect of Section 67(g) on a trust’s or estate’s beneficiary’s ability to deduct Section 67(e) expenses (through Section 642(h)) in a year when the estate or trust terminates.

Conditions subsequent don’t prevent completed gift—In Private Letter Ruling 201825003 (March 9, 2018), the taxpayer signed a deed of transfer with two museums located abroad. In the deed, the taxpayer donated the artwork to the museums but reserved a life interest. However, the deed also provided that the taxpayer intended the gift to be incomplete for tax purposes, and as such, the transfer would only take effect on receipt of a favorable ruling from the IRS that the deed wasn’t a completed taxable gift. The taxpayer structured the gift to be incomplete because the taxpayer would have been unable to claim a charitable deduction for a completed gift. (IRC Section 2522(c) permits a gift tax charitable deduction only for a remainder interest in certain proscribed forms, such as a charitable remainder annuity trust, unitrust, pooled income fund or guaranteed annuity, for example.)

In the deed of transfer, the taxpayer gave up her right to sell or dispose of any of the artwork. She could, however, revoke the transfer if: (1) the museums didn’t comply with certain requirements regarding the display of the artwork, (2) there were certain changes in the law in the countries where the museums were situated, (3) the museums become privately owned, or (4) there were changes in the tax laws of the museums’ resident countries that cause the taxpayer to be taxed as a result of the transfer.

Under Treasury Regulations Section 25.2511-2(b), a transfer is a completed gift of property if the donor gives up dominion and control over the property so that he has no power to change the disposition of the property. In addition, if the donor retains an interest that’s dependent only on an event beyond the donor’s control, that doesn’t constitute sufficient retained dominion and control to cause the transfer to be incomplete. Here, the taxpayer couldn’t sell or dispose of the artwork and had no power to change the disposition of the artwork. Although the transfer was subject to conditions subsequent, those conditions were all outside the taxpayer’s control. Therefore, the transfer would have been a completed gift, but for the deed’s condition precedent that it would only be effective on a favorable ruling from the IRS. Without that favorable ruling, the transfer wasn’t effective or complete.

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