The U.S. Supreme Court recently declined to hear Bauerly v. Fielding, a case in which the Minnesota Commissioner of Revenue sought to overturn the Minnesota Supreme Court’s finding that the state’s income taxation statute was unconstitutional as applied to the trusts in question. The Fielding petition arrived closely on the heels of North Carolina v. Kaestner, presenting the Court with a second case this year concerning state income taxation of trusts. The Court’s denial of certiorari in Fielding, taken with its narrow holding in Kaestner, suggests that although recent attention to state taxation of trusts may inspire activity that will impact state trust taxation regimes, the Court won’t immediately be an engine for refinement or consolidation of Constitutional nexus and due process principles in the area of tax law.
Facts in Fielding
Minnesota assesses a tax on the worldwide income of a trust it deems a “resident.” Minnesota Statutes Section 290.01 causes a trust to be Minnesota resident if created by a grantor domiciled in Minnesota at the time the trust became irrevocable. Four irrevocable trusts (the trusts) created by a grantor domiciled in Minnesota met this definition. The trustee, William Fielding, arguing that the statute as applied to the trusts was unconstitutional, sought a refund of significant capital gains taxes paid by the trusts on the sale of business interests owed to Minnesota based solely on the resident status attributed to the trusts. In saddling the trusts with that status, the statute considered only the grantor's residence and didn’t take into account the trust’s otherwise tenuous connections with Minnesota: the grantor had since left the state, the assets and records of the trusts were held out of state, the trusts weren’t administered in the state, and William himself (along with prior trustees) never resided in Minnesota. Nor, on the other hand, did it take into account that the primary business interests sold were of a Minnesota S corporation, and a beneficiary of one of the trusts was a Minnesota resident. The state tax court found the statute violated the state and U.S. Constitutions, as did the Minnesota Supreme Court.
Minnesota Court Ruling Stands
Following the Court’s denial of certiorari, the decision of the Minnesota Supreme Court stands: the Minnesota statute is unconstitutional as applied because the nexus it relied on between the trusts and the State didn’t satisfy traditional notions of due process and, as such, didn’t provide Minnesota a constitutional basis to tax the trusts. Likewise, because the decision of the Minnesota Supreme Court hinged on the statute as applied, the statute itself still stands. This case poses an invitation to other trusts taxed by Minnesota to consider whether this law as applied to their facts is similarly unconstitutional and to the Minnesota Legislature to revisit this law to withstand future challenges.
Another Piece in the (Disjointed) Puzzle
States take differing approaches to the taxation of trusts, including those that impose no income tax at all. Although states generally tax based on whether a trust is deemed a “resident,” states consider different elements in reaching that determination. Current methodologies employed by states are sensitive to both the factors considered in assessing the tax, as well as the facts to which such factors are applied. Nowhere is that sensitivity better highlighted than in the petition for certiorari in Fielding versus the Respondent’s brief in opposition: whereas the Commissioner described a “split” among state court decisions on the constitutionality of trust taxation based on the domicile of the grantor, the trustee countered with another fact to refute the split—whether the trust in question was an inter-vivos trust (as are the trusts in Fielding) versus a testamentary trust.
The variety in state approaches to taxing trusts, coupled with their fact sensitivity, limits the national impact of any one decision on the constitutionality of trust taxation. Nevertheless, these cases—certainly Fielding and Kaestner, but also a number of other state court decisions—suggest that state tax regimes using a single-factor analysis to establish nexus may be particularly vulnerable to constitutional challenge. The Court’s recent decision in Kaestner—the trust income taxation case the Court did hear this spring term—held that the residence of a discretionary beneficiary alone provides insufficient nexus for a state to tax retained income of a trust. The Court’s denial of certiorari in Fielding lets stand a state court holding that a grantor’s residence alone similarly provides insufficient nexus for taxation and, as such, is another blow to a single-factor analysis. Taken together, the outcomes of both cases point to the weakness of a single-factor analysis of nexus, and inversely, to the potential relative strengths of a multifactor analysis.
Looking Ahead After Kaestner and Fielding
In Kaestner, the Court set an absolute floor for the constitutionality of state taxation of trusts but also expressly declined to rule on what approaches would meet constitutional standards. Taken in concert with the denial of certiorari in Fielding, the Court appears disinclined to offer a standard for review or act as a force toward consolidation in states’ approaches. But activity on this subject is hardly confined to the highest court in the land, as it remains a live issue at the state level. Going forward, we can expect heightened activity in this arena in Minnesota (as in North Carolina), as well as heightened awareness nationally of the potential value of income tax planning with trusts. That awareness, and the scrutiny that will follow, may also result in increased challenges to similar trust taxation regimes in other states—all of which should be welcome to practitioners seeking predictable, principled outcomes for their clients.
The authors wish to thank William J. Kambas and James I. Dougherty for their assistance with this article.