Recent developments in estate planning.

Author:Ransome, Justin

This is the first in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and fiduciary income tax between June 2018 and June 2019. Part I discusses trusts, GST tax, and inflation adjustments for 2019. Part II will discuss estates and gifts.


State taxation of trusts

In North Carolina Department of Revenue v. Kaestner 1992 Family Trust, (1) the U.S. Supreme Court unanimously affirmed the N.C. Supreme Court's ruling that the state could not tax the income of a trust based solely upon the presence of a contingent in-state beneficiary.

The settlor formed the trust for the benefit of his children in his home state of New York. The trustee later divided the trust into three trusts, one for the benefit of each of the settlor's children. One of the resulting trusts was the Kimberley Rice Kaestner 1992 Family Trust. The beneficiary, Kimberley Rice Kaestner, became a resident of North Carolina, where she resided during the period at issue (2005 through 2008). The trust was governed by New York law and administrated in the state of New York. The trust did not have a physical presence, make any direct investments, or hold any real property in North Carolina. Furthermore, the trust instrument, financial books and records, and legal records were kept in New York, and all tax returns and trust accountings were prepared there. The custodians of the trust's assets resided in Massachusetts, and all trust income was generated from investments outside North Carolina. For the years at issue, the trustee resided in Connecticut. Under the trust instrument, the trustee had absolute discretion to distribute trust assets. The beneficiary had no right to any distributions and did not receive any while she resided in North Carolina.

North Carolina law taxes a trust's income that is for the benefit of a resident of the state. The North Carolina Department of Revenue interpreted this to mean that a trust owes income tax whenever its beneficiaries live in the state, even if they received no income from the trust, had no right to demand it in the relevant tax year, and could not count on ever receiving it. Thus, North Carolina assessed more than $1.3 million in tax on the trust's accumulated income, based solely on the beneficiary's residence in the state.

The trust paid the assessment and sought a refund of tax paid for 2005 through 2008, arguing that the North Carolina law as applied to the trust was unconstitutional. The N.C. Business Court, the N.C. Court of Appeals, and the N.C. Supreme Court (2) each ruled in favor of the trust, holding that the statute, as applied to the trust, violated the Due Process Clauses of both the U.S. Constitution and the N.C. Constitution. The N.C. Department of Revenue appealed the decision to the U.S. Supreme Court.

The issue before the U.S. Supreme Court was whether the Due Process Clause of the U.S. Constitution prohibits states from taxing trusts based solely on the residency of the trust's beneficiaries. The Court limited its holding to the specific facts presented and concluded that North Carolina's taxation of a New York-based trust violated the Due Process Clause because the presence of in-state beneficiaries alone does not empower a state to tax trust income that has not been distributed to the beneficiaries, where the beneficiaries have no right to demand that income and are uncertain to receive it.

The Court began its discussion of the Due Process Clause by citing Quill Corp. v. North Dakota (3) and favorably quoted the observation made in Quill that "[t]he [Due Process] Clause 'centrally concerns the fundamental fairness of governmental activity.'" (4) Citing additional precedent, the Supreme Court stated that, although the ability to tax is a fundamental power of the states, taxation is legitimate only when it directly correlates to opportunities and/or benefits provided by the state. The Court found, citing Quill, that for a tax to satisfy due-process requirements, first, there must be some minimum connection between a state and the person, property, or transaction it seeks to tax, and, second, the income attributed to the state must be rationally related to values connected with the taxing state.

In the trust beneficiary context, the Court found that the due-process analysis of state trust taxes focuses on the extent of the in-state beneficiary's right to control, possess, enjoy, or receive trust assets. Here, the Court was unpersuaded that the beneficiary's residence in North Carolina supplied the minimum contacts to sustain the tax because the beneficiary did not receive any income during the years in question; had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in those years; and could not count on receiving any specific amount of income from the trust in the future. Thus, the Court held that the tax violated due process.

Many trust practitioners had speculated that the Court might make a sweeping decision regarding the ability of states to tax the income of a trust and the necessary contacts. Instead, the opinion was limited to the law of North Carolina and may be applied only to states that tax in a similar manner, which the Court noted in a footnote were only five--three of which did not base tax solely on the residency of the beneficiary and one of which was phasing out a similar rule, leaving only California, which, unlike North Carolina, taxes trusts only when the beneficiary is noncontingent.

Another, perhaps even more interesting, state trust tax case, Fielding v. Commissioner of Revenue, (5) was appealed to the Supreme Court and, at the time of the Kaestner decision, was awaiting a decision whether the Court would grant certiorari. (6) In Fielding, the Minnesota Supreme Court analyzed the case under the second prong of Quill's Due Process Clause analysis, which was not addressed in Kaestner--whether a "rational relationship" existed between the income subject to tax and the protections and benefits conferred by the state.

Minnesota claimed that the trusts in dispute in Fielding had the minimum connections with the state for nexus under the Due Process Clause analysis identified in Quill: The grantor was a Minnesota resident when the trusts were established and subsequently, when they became irrevocable trusts; the trust documents relied on Minnesota law; all the assets of the trusts (i.e., stock of an S corporation that was sold) were in Minnesota; and the underlying business was in Minnesota.

The trusts, on the other hand, claimed that the connections between the trust and the state were not sufficient, noting that no trustee had been a Minnesota resident, the trusts had not been administered in Minnesota, the records of the trusts' assets and income had been maintained outside of Minnesota, some of the trusts' income was derived from investments with no direct connection to Minnesota, and three of the four trust beneficiaries resided outside of Minnesota.

The Minnesota Supreme Court agreed with the trusts, finding that the contacts on which the state relied were either irrelevant or too attenuated to establish that Minnesota's tax on the trusts' income from all sources complied with due process. According to the court, attributing all income, regardless of source, to Minnesota for tax purposes would not, as required by the second prong of the Quill due-process analysis, bear a rational relationship with the limited benefits received by the trusts from Minnesota during the tax year at issue. Therefore, it struck down the imposition of state tax on the Fielding trusts as "resident trusts." The Minnesota Supreme Court, however, did not devise a formula to determine how much, if any, income should be apportioned to Minnesota. The U.S. Supreme Court turned down the opportunity to hear the case just one week after having decided Kaestner, thus paving the way for continued litigation by trusts regarding a state's ability to tax them based on contacts with the state.

Deduction of trust and estate administration expenses

In Notice 2018-61, the IRS announced it intended to issue regulations clarifying the effect of new Sec. 67(g) on the deductibility of certain expenses described in Secs. 67(b) and (e) that are incurred by estates and nongrantor trusts.

Added to the Code by the law known as the Tax Cuts and Jobs Act (TCJA), (7) Sec. 67(g) suspends the deduction of certain miscellaneous itemized deductions for tax years 2018 through 2025. For purposes of Sec. 67, miscellaneous itemized deductions are defined as itemized deductions other than those listed in Secs. 67(b)(1) through (12), personal exemptions, Sec. 199A deductions, and above-the-line deductions.

The AGI of an estate or trust generally is computed for Sec. 67 purposes in the same manner as that of an individual, although certain additional deductions are allowed. Specifically, Sec. 67(e) provides that the following items may be factored into determining AGI: (1) costs paid or incurred in connection with the administration of the trust or estate that would not have been incurred if the property were held by an individual; and (2) deductions available under Sec. 642(b) (the personal exemption), Sec. 651 (income distribution deduction for trusts distributing current income only), and Sec. 661 (income distribution deduction for estates and trusts accumulating income or distributing corpus). Regs. Sec. 1.67-4(a) further explains that the first exception described above is for miscellaneous itemized deductions for costs paid or incurred in the administration of an estate or nongrantor trust if the costs would not have been incurred had the property been held by an entity other than an estate or nongrantor trust.

In the notice, the IRS points out that some commentators have read new Sec. 67(g) as forbidding estates and nongrantor trusts to deduct any expenses described in Sec. 67(e)(1) and Regs. Sec. 1.67-4 for tax years...

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