August 06, 2018

Fielding Decision Creates Opportunities (and Potential Obligations) for Minnesota Trusts

On July 18, 2018, the Minnesota Supreme Court issued its decision in Fielding v. Commissioner, declaring that it was unconstitutional for the state to consider four trusts to be Minnesota “resident trusts” — and tax them accordingly — based on the sole statutory factor that the grantor was domiciled in Minnesota when the trusts became irrevocable. Therefore, Minnesota was not entitled to tax 100 percent of the trusts’ income, and the trusts were entitled to significant refunds of taxes they had paid on interest, dividends and capital gains.

The ruling affects certain irrevocable trusts that have paid or are paying Minnesota income taxes as a “resident trust,” which generally includes any taxable trust (i.e., not one whose income is taxed to the grantor) created after 1995 by a grantor who was a resident of Minnesota when the trust became irrevocable. Under Minnesota law, a “resident trust” pays taxes to Minnesota on 100 percent of its income from intangibles such as stocks and bonds (interest, dividends and capital gains). Income from real estate is generally sourced to the state where the property is located, and income from privately held businesses (such as S corporations and partnerships) is apportioned among all states in which the company does business.

The Fielding Trusts: Challenge and Ruling

The Fielding trusts challenged the Minnesota law that applies to trusts that became irrevocable after December 1, 1995, which would have subjected them to Minnesota income taxes for their entire duration based solely on the fact that the grantor of the trusts, Reid V. MacDonald, lived in Minnesota on December 31, 2011, when the trusts became irrevocable for income tax purposes (when Mr. MacDonald relinquished his power to substitute trust assets).

The Minnesota Tax Court declared taxation of the trusts to be unconstitutional on due process grounds, holding that the fact that the grantor resided in Minnesota on that date was insufficient for the Department of Revenue to tax the trusts on income indefinitely. In an opinion from Justice Natalie Hudson, the Minnesota Supreme Court affirmed the Tax Court’s decision.

Both courts recognized that due process requires an analysis of all relevant factors. While the Minnesota Tax Court determined that the plain language of the statute specified a single relevant test — the domicile of the grantor when the trust became irrevocable — the Minnesota Supreme Court examined all of the trusts’ connections to Minnesota. In examining the facts, the Supreme Court sought to determine if the relationship between the income attributed to the state and the benefits the taxpayer received from its connections with the state was sufficient for the taxation of the trusts as Minnesota residents to be constitutional.

After rejecting the single factor identified in the statute (the historical domicile of the grantor), the Minnesota Supreme Court ultimately held that Minnesota could not fairly ask the trusts to pay taxes as residents because taxation of all income was not rationally related to the limited benefits received by the trusts from Minnesota during the tax year at issue.

With the caveat that the Minnesota Supreme Court’s decision was made only with respect to the four trusts in front of it — and there is no guarantee that it will apply the same analysis in future situations — the Court’s determinations regarding constitutionally relevant factors are as follows:

Relevant

  • Minnesota’s connection to the trustee
  • Location of trustee
  • Location of trustee’s decisions
  • Location of trust administration activities
  • Location of trust records of assets and income
  • Probate in Minnesota court
  • Existing relationship with Minnesota courts (e.g. a testamentary trust probated in Minnesota)

Not Relevant

  • Grantor’s connections to Minnesota
  • Contacts of the trusts to Minnesota outside the tax year at issue (e.g. historical contacts)
  • Minnesota residency of beneficiary
  • Grantor’s decision to use a Minnesota law firm to draft the trust documents
  • Storage of original trust documents in Minnesota
  • Ownership of stock in a Minnesota corporation that owns real property in Minnesota
  • Representation by Minnesota law firm in Minnesota tax challenge
  • Choice-of-law clause designating Minnesota law

What Does This Mean for Minnesota Trusts?

Trustees of trusts that may be affected by the decision — inter vivos trusts formed after 1995 that filed Minnesota income tax returns as resident trusts — should discuss with their attorneys whether the trusts could file refund claims, stop filing resident tax returns, or take certain actions to be considered nonresidents in future tax years. Trusts potentially eligible for refunds may need to take action quickly, as the statute of limitations for claiming a refund is three-and-a-half years from the date prescribed for filing the return, plus any extension of time granted for filing the return (if the return is filed within the extended time). The availability of any of these options will depend on facts specific to the trust and whether the trust’s contacts with Minnesota are sufficient to be constitutionally taxed as a “resident trust.”

Minnesota grantors establishing new irrevocable trusts should seek assistance from a trust attorney regarding how to structure their trusts strategically so that they are not subject to Minnesota tax from the outset.

The Fielding decision is a victory for trusts tied to Minnesota based on the historical residence of the grantor (or any of the other factors the Supreme Court determined to be irrelevant). Although the decision does not provide a bright line rule for when a post-1995 irrevocable trust can constitutionally be considered a resident for income tax purposes, it does create opportunities for potential refunds of taxes paid or elimination of future taxes for those trusts.

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