Kaestner and Fielding: SCOTUS Implications Create Opportunities

Kaestner wins, Fielding Denied: What we can learn when analyzed together. 

On June 21, 2019, in North Carolina v. Kimberley Rice Kaestner 1992 Family Trust, Docket No. 18–457, the United States Supreme Court (SCOTUS) ruled that the residency of a beneficiary in a U.S. state alone was not sufficient nexus (connection) for a state to tax the undistributed net income of a trust. 

Many commentators have written about the case and its implications. However,  SCOTUS declining the writ of certiorari to Minnesota’s Fielding case right after deciding on Kaestner should not be overlooked.

Declining to Hear Fielding

By refusing to grant a writ of certiorari in Fielding, et al. v. Commissioner of Revenue, 916 N.W.2d 323 (Minn. 2018), the Minnesota Supreme Court’s decision in favor of Fielding remains. It is still unconstitutional to tax a trust solely based on grantor residency at the time the trust became irrevocable.

As applied to the Fielding trusts, the nexus between the state and the trust is not substantial enough to warrant state taxation. 

Two States Impact Our Entire Country

While some analysts believe the Kaestner decision was relatively narrow, the implications of both cases combined are broad, likely resulting in trust taxation changes in North Carolina and Minnesota. However, the implications extend to many other states limiting a state’s ability to tax undistributed income held within trusts.

It’s unlikely that SCOTUS will entertain another trust taxation case anytime soon. It’s now up to the state courts to interpret Kaestner and make the appropriate amendments to their laws.

North Carolina and Minnesota and states with similar tax laws have many estate planning opportunities even before states’ legislatures act.

But where will the lines be drawn? 

Comparing Kaestner and Fielding

First, let’s take a look at the facts in the two cases. Kaestner and Fielding have distinctly different fact patterns, as shown below.

  Kaestner Fielding
Residence of the Grantor New York Minnesota
Trustee Not a North Carolina resident Not Minnesota residents
Trust law New York Minnesota
Trustee physical presence None in North Carolina None in Minnesota
Beneficiaries North Carolina Three of the four beneficiaries lived outside of Minnesota
Trust Documents and records New York Colorado
Trust Established in New York Minnesota
Asset Custody Massachusetts Outside of Minnesota
Direct in-state investments None in North Carolina Included an MN S Corp
Physical Property None in North Carolina None in Minnesota
Pre-case Taxation: Only while a beneficiary was an N.C. resident If established as a resident trust, the trust would have been taxed in Minnesota for its entire existence

 

Broad or Narrow Implications? You Decide.

In Kaestner, the only connection to North Carolina is the beneficiary’s residence in the state. SCOTUS ruled that having a beneficiary in the state was not sufficient to tax the trust.

In the Fielding case, the Minnesota Supreme Court ruled that despite additional connections there was not sufficient nexus to permit Minnesota to tax the undistributed net income of a trust.

The United States Supreme Court’s decision in Kaestner was decided somewhat narrowly.

The Court relied on three key facts concerning the beneficiary in North Carolina:

“First, the beneficiaries did not receive any income from the Trust during the years in question. Second, they had no right to demand Trust income or otherwise control, possess, or enjoy the Trust assets in the tax years at issue. Third, they also could not count on necessarily receiving any specific amount of income from the Trust in the future.”

It is not entirely clear how SCOTUS might decide a case where the beneficiary received some distributions from a trust. It’s also unclear what a case decision would be if it had trust terms that permitted more control over the trust. It’s unknown whether the beneficiary would receive some or all of the corpus from the trust in the future.

The Kaestner decision does not address whether a beneficiary’s ability to assign a potential interest in the income from a trust would afford that beneficiary sufficient control or possession over the trust. It also does not address whether the beneficiaries were guarenteed to receive funds (or enjoyment of the property) in the future to justify North Carolina’s taxation based solely on the beneficiary’s in-state residence. 

Finally, SCOTUS did not consider the trust’s broader argument that the trustee’s contacts alone determine the state’s power over the trust.

In contrast, declining the Fielding writ and allowing the Minnesota Supreme Court decision to stand suggests that the location of the trustee (not the location of the grantor) is most relevant in determining the domicile of a trust.

Will Minnesota follow Michigan?

Bill Lunka, the founder of SALT Partners, a state and local tax consulting firm in Minneapolis, said:

 “Now that the U.S. Supreme Court has denied review of the Fielding case, it is a good time for trustees and their advisors to consider filing claims for refund for those trusts that had Minnesota residents at the time the trust became irrevocable. 

There may also be opportunities to file claims for refunds in North Carolina and other states provided that the beneficiaries are similarly situated to the beneficiaries in the Kaestner case. The combination of the Kaestner and Fielding decisions suggest that the location of the trustee will be most relevant in determining where a trust is domiciled.”

Mr. Lunka further noted, “It is possible that Minnesota will follow, at least for now, Michigan’s lead on using administrative, rather than legislative, tools to change trust taxation. Given the current environment in the Minnesota Legislature where the Democrats control the House of Representatives (and the governor’s office), and the Republicans control the Senate, it may not be easy for the Minnesota Department of Revenue to get legislation passed to change the definition of a resident trust. 

Because Fielding found that the Minnesota definition of resident trust was unconstitutional only as applied to the Fielding trusts, the definition currently in Minnesota law still stands because the Minnesota Supreme Court did rule that the definition facially violated the Due Process Clause. 

Therefore, the Minnesota Department of Revenue can continue to apply the definition of a resident trust in Minnesota for other taxpayers. Of course, the Department is likely to continue to receive claims for refund for those trust that irrevocable while the grantor was a Minnesota resident, and they will review those on a case-by-case basis until legislation can be passed, or then issue guidance.”

The Current Trust Climate According to Michael Redden of Redden Law

Trusts are becoming more like corporations and the implications of that, such as taxes, must be considered. Michael Redden of Redden Law provides the following insight:

“Trusts are going to be treated more like corporations now. Corporations, though fictional, are treated like people and have their own rights. The trust and estates in our country have not been discussed in this context much until recently. For corporations, there are many wide implications. The most obvious implication for trusts is for taxation. 

Here, the U.S. Supreme Court has recognized that trusts have the same rights as individuals. A state must be able to get personal jurisdiction over an individual to tax that person or exercise any power over them. The same is now true for a trust. I predict that we will continue to explore how the personhood of trusts affect other policies in the future. This is especially true since dynastic trust planning is becoming more and more common.

The U.S. Supreme Court, in Kaestner, alluded to the Fielding case when it limited its opinion. The Court likely sees that there are many more circumstances that might need review. By limiting the opinion, the Court likely expects to hear more about these situations. The Minnesota law is different than North Carolina’s. 

By focusing so much on the grantor, it creates many more factual situations that are not as clear cut at Kaestner. In short, it is prone to more grey areas. I agree that the Court should have declined to hear the case. The Minnesota Supreme Court used the same line of analysis when it decided Fielding. The result is one that the Court would likely have upheld.

For now, all taxpayers and their advisors and lawyers should consider how a trust that is sitused in Nevada, South Dakota, or another taxpayer-friendly jurisdiction might help. The worst case scenario is that you will pay taxes at the same rate that you pay now. The best case is that you might end up with a much lower tax burden in the future. It is also very attractive since these same jurisdictions also have special trusts for asset protection.”

 

Estate Planning Strategies Practitioners Should Consider

Those filing refunds for applicable trusts with Minnesota grantors or North Carolina beneficiaries should consult their advisors. It’s important to discuss whether a case could be due refunds for relevant tax years.

It will be interesting to see if taxpayers in other states will use these precedents to challenge their statutes.

Decanting Trusts

For existing trusts, practitioners should look for decanting opportunities to states like Nevada, that have no income tax. Note that Nevada trust laws may provide additional benefits for asset protection and dynasty provisions as well.

Create Your Own Facts

Residents in states outside of Minnesota and North Carolina will benefit from careful planning by structuring around the rulings in Kaestner and Fielding.

Rulings in both cases focus on two key factors: the importance of the trustee’s domicile and not having physical property in the trust.

Develop Flexibility

You can build flexibility, including trust protectors, into a trust structure, even if the facts or laws will change in the future. However, practitioners should be careful. It’s possible to give too much power to an in-state trust protector and create a nexus to state taxation.

Carefully Select Trustees

Pick your trustee carefully! A trustee’s connections to your state can tip the scales in the eyes of the revenue authorities.

Practitioners should consider out-of-state trust companies as part of their process. It’s crucial to be mindful of out-of-state companies that have a significant presence in your state too.

Connections to the state may be scrutinized by state taxation authorities to meet “minimum connection” standards and tax the trust.

SCOTUS may take on another case in the future, which would clarify what connections with a state are necessary before a state can tax a trust. Until then, it’s best to be careful.

Employ Discretionary Trusts

The Kaestner decision was very explicit in favoring discretionary trusts. Practitioners should include a spendthrift clause, which prevents a beneficiary from assigning their interest, in their trust documents.

Conclusion

While Minnesota and North Carolina will need to redo trust taxation codes to comply with the two rulings, there are implications and opportunities in most states. We anticipate a lively dialogue in Minnesota and North Carolina governments to create respective new trust taxation structures.

Will other state tax codes be challenged by new precedents set in Kaestner and Fielding? Our guess is yes. It’s also likely that many states will experience a large volume of refund claims filed in light of the Kaestner decision.

While those challenges and discussions are occurring, we would encourage practitioners to evaluate their existing trust structures carefully. The imminent advantages (beyond the current benefits) of utilizing out-of-state trust structures are likely ideal for many clients. 

SCOTUS Highlights and Insights From the Kaestner Oral Arguments

The United States Supreme Court Hears Oral Arguments for North Carolina v. Kaestner

On April 17, 2019, the United States Supreme Court heard the oral arguments in perhaps the most significant trust case in 100 years: North Carolina Department Of Revenue, Petitioner, V. The Kimberley Rice Kaestner 1992 Family Trust, Respondent. 

The crux of the Kaestner case is whether the state of North Carolina should be able to constitutionally tax trusts where the only connection to the state is that the beneficiary is a resident.

In the state of North Carolina, the taxpayer won throughout the entire court system, but North Carolina appealed successfully to the U.S. Supreme Court.

Matthew W. Sawchak, North Carolina Solicitor General, argued on behalf of the Petitioner and David A. O’Neil, Esq., of Debevoise & Plimpton LLP  on behalf of the Respondent.

In the hour-long arguments, the Justices actively participated, frequently interrupting the counsels. Overall, based on our initial analysis of the transcript, the line of questioning from the majority of the Justices seemed to be slightly more sympathetic to the Respondent. However, there were several times the Justices were challenging the Respondent’s arguments.

As always with the Supreme Court, it is difficult to tell the outcome until the decision is published.

Hypothetical Outcomes

More Context By Including the Fielding Case?

The central argument seems to focus on what is the connection of a trust to a location – trustee, place of administration or the beneficiary. Interestingly, there was no discussion over the location of the grantor – which is the central argument in the Fielding case from Minnesota.

We are closely watching to see if SCOTUS will hear Fielding as well providing more context to taxing resident trusts.

In this case, there are many ways the court could decide whether to grant for the respondent, rule for the petitioner, or the send the case back to North Carolina for further analysis.

Michael Redden, Redden Law, PLLC, Provides Insight

We reached out to an estate planning attorney in Minnesota with whom we have been closely monitoring the Fielding case which carries similar trust taxation issues as the Kaestner case.

Click here to see our summary of both cases.

Michael Redden shared his insights with the oral arguments with us:

“The Court took note that the state was essentially asking the Court to overturn 100 years of tax precedent to reach the conclusion that the beneficiaries residence alone should determine. It is essentially a personal jurisdiction question. Who owns the trust assets? When do they own the trust assets? Traditionally, it has always been the trustee and not the beneficiaries.

“This is analogous to the legal fiction that a corporation is a person. A corporation is a separate person from the shareholders. The shareholders ultimately benefit from the economic activity, but the corporation is separately taxed and has separate legal character. The same principle applies here but is even more powerful.

“Why?

“Because there is an actual person there: the trustee. The beneficiaries may ultimately benefit, but the ownership is held in the personhood of the trustee.

“Discretionary trusts further embody this. The court seemed to look to this ownership question: When does the beneficiary own the property?

“It’s when they control the property. Just like when stock options and incentives vest. The Court focused on this question.

“Interestingly enough, the Court also spent time considering the ability of a beneficiary to change tax residency and how that might affect the state of taxation. This topic will be central to any consideration of the Fielding case should the Court decide to hear it. One way or another, either 100 years of tax precedent will be adjusted or the tax regimes of 33 states will.”

Expectations and Speculations

Based on the arguments, we were pleased that the Court seems to be settling in that this is a Due Process case (and not a Commerce Clause case) and seems to be set on deciding either way based on the arguments.

Our expectation, given the arguments, is that we don’t think the Court will give practitioners broad constitutional direction on all state trust taxation laws, but narrower guidance on the taxation of beneficiaries.

It is possible that the Court could solely rule regarding the taxation of discretionary trusts as the arguments centered around them.

Much Chatter Regarding Throw-Back Taxes

It would not be unreasonable for the court to opine that current state income taxation of undistributed trust income would be unconstitutional, but throw-back taxes would be permissible.

A combination of a narrow ruling on Kaestner and the Court not granting a writ of certiorari on Fielding could lead to an interesting situation for practitioners.

Furthermore, given the discussion surrounding adjudication v. taxation, it will be interesting to see whether the Court’s opinion will impact out-of-state asset protection trusts, specifically states’ arguments over jurisdiction of trusts.

Highlights from the Oral Arguments

Below, we highlight some of the exchanges and questions from the discussion yesterday. For those who are interested in the full transcript, it is 69 pages.

You may check the transcript out here.

All text within quotations is taken from the SCOTUS transcript linked above.

Initial Questions from Justices Ginsburg and Sotomayor

Right away, Justice Ginsburg asked Mr. Sawchak: “But you couldn’t – you couldn’t tax the beneficiaries on that accumulated income when they haven’t received it?”

Justice Sotomayor chimed in a bit later to the Petitioner: “But it still begs the question. What makes it your right under any circumstance to tax all of the trust income where there’s no guarantee that she is going to receive all of it at any point?”

Justice Breyer weighs in

Justice Breyer had one of the most extended remarks from Mr. Sawchak: “Look, the trustee lives in New York, okay? The settlor is in New York. All the administration is in New York. There is one thing that’s going to happen in North Carolina. The thing that’s going to happen in North Carolina is if she is there when it’s distributed, she’ll get some money. Okay? Which you’re totally free to tax. But that isn’t what want to tax. You want to tax all these things which are everyone except her is in New York, and moreover, we don’t even know if she’ll ever get the money.

“Now there’s something wrong with that. I don’t know, it doesn’t say specifically about trusts in the Constitution, but, thus, I mean, lots of trusts say there are 10 beneficiaries, each one lives in a different state, and I, the trustee, have total discretion as to who give this money to and maybe I’ll give it to none of them.

“So here’s a woman who might get none of it, and you want to tax that. Is that right? Do I have the facts right?”

Justice Breyer later looked to simplify his line of questioning: “Let me make it simpler. There are five beneficiaries. One lives in North Carolina. As it turns out, that one in North Carolina gets $3. The others get $999,997. But North Carolina does not tax $3. What it taxes is 20 percent or $200,000. Do I have my facts right?”

Justice Sotomayor: is unequally taxing beneficiaries leading to changing grantor’s intent

Justice Sotomayor’s line of questioning is asking whether unequal state taxation could be interpreted as potentially changing the settlor’s intent and if the trustee needs to take that into account in distribution decisions.

Justice Sotomayor asks: “But you’re changing the trust instrument because you as a state are saying the trust must give them 20 percent each, because, regardless of what the terms of the trust are, I’m going to tax you on that 20 percent even though you might get none, even though you might get more. You’re still a trust, you’re being charged for 20 percent because you should have given her 20 percent. That’s really what you’re saying, isn’t it?”

Mr. Sawchak: “That –you’re right, Your Honor, to say there is a –assuming nothing’s in the trust instrument, there would be a full –”

Justice Sotomayor: “No, there is something in the trust instrument here. The trust instrument says that the trustee has absolute discretion to give her something or nothing, to give three people–I think there’s two or three children; I don’t know how many there are here, but let’s assume there’s four of them, her and three children, for using even numbers.

“The trustee could choose to –if she had a disabled child, to give it all to the disabled child or to divide it among the three because she’s very rich and they’re not. The trustee has a lot of discretion. But you, the state, are changing the terms of the trust instrument in saying each of them must still pay 25 percent.”

Mr. Sawchak: “That is correct, that nothing else appearing, we make the pro rata. And here’s why that’s fair. First of all, throughout the period in question, those people had true ownership of the accumulating assets. Secondly, also essentially on a pro rata basis, North Carolina is protecting each of them.”

Back-and-Forth Between Justice Gorsuch and Mr. Sawchak regarding overruling SCOTUS precedents

Justice Gorsuch: “And, counsel, along those lines, if I’m –if I’m understanding your position correctly, because you think that rule is inequitable, you’d have us overrule Safe Deposit and Brooke, two decisions of this Court that suggest that that’s the correct rule, is that right?”

Mr. Sawchak: “Not overrule them, Your Honor. They could be –”

Justice Gorsuch: “Well, what would you have us do with them if it’s not overruling them?”

Mr. Sawchak: “Two things, Your Honor. First of all, they can be distinguished in terms of being property tax cases versus income tax cases, because this Court –”

Justice Gorsuch: “Let’s say I don’t find that distinction particularly significant. It’s slicing the baloney a little too thinly. Then what?”

Mr. Sawchak: “Then we would be really within the proposition of the due process part of Quill, where these are decisions that have been superseded by the movement –”

Justice Gorsuch: “Right. You’re -you’re asking us to overrule them. I mean, it’s a polite way of saying overrule, isn’t it?”

Mr. Sawchak: “They’ve probably, frankly, already been laid aside by other –by the due process decisions, as this Court’s noted in -”

Justice Gorsuch: “But that’s a -that’s a really nice way of saying overrule them.”

(Laughter.)

Justice Gorsuch: “Right?”

Mr. Sawchak: “They’ve probably already been -”

Justice Gorsuch: “I’ve already been overruled; we just haven’t said so.”

Mr. Sawchak: “That’s probably right, Your Honor, and let me say why that’s –”

Justice Gorsuch: “Okay. All right. And –and you’d have us overrule them in the name of fundamental fairness, is that right?”

Mr. Sawchak: “In the name of fundamental fairness because –”

Justice Gorsuch: “And –and Justice Breyer’s problems notwithstanding, that–that fundamental fairness problem, we shouldn’t take into account?”

Mr. Sawchak: “No, there are criteria, a variety of criteria out there, and every one of them –”

Justice Gorsuch: “That’s more fundamentally fair than the existing rule of this Court that’s almost 100 years old?”

Mr. Sawchak: “So query whether that really is the existing rule, first of all. Those are –”

Justice Gorsuch: “Well, right, except for the fact that we haven’t overruled it, but we really have. Okay. But assuming we thought those were still precedents of the United States Supreme Court –let’s just spot me that for the moment.”

(Laughter)

Justice Gorsuch: “–you think it’s more fair to overrule them and proceed down the track we’ve just illuminated with Justice Breyer than to maintain them?”

And later Justice Sotomayor asks: “Hanson, you would be asking us to overrule because I don’t know how you can tax somebody you have no jurisdiction over, especially if they haven’t done anything like pay any money over or have no contacts with the person in your state. All the meetings were in New York. So add a third case you want to overrule.”

Justice Sotomayor’s exchange on trust location

Justice Sotomayor: “So how is the trust in your state?”

Mr. Sawchak: “Pardon me, Your Honor?”

Justice Sotomayor: “I thought the trust is represented by the trustee. And the trustee is not in your state.”

Mr. Sawchak: “The –the trust has its presence –”

Justice Sotomayor: “It’s not being administered in your state.”

Mr. Sawchak: “True, but its true owner, its central figure, is in North Carolina. Let me offer”

Justice Sotomayor: “So why didn’t we say that in Hanson?”

Mr. Sawchak: “So Hanson, first of all, is a situation where the burden of adjudication, by the way, not taxing, fell on the person of the trustee. This Court in Walden described –”

Justice Sotomayor: “The same thing here. You’re making the trustee liable for paying the tax. You’re doing exactly what happened in Hanson.”

A discussion on discretionary v. non-discretionary trusts with Mr. O’Neil, the counsel for Respondent

Justice Kagan: “Would your position be different if she were–if–if the–if the trustee did not have this discretion as to shares? Suppose that the –the trust instrument simply said, here are the five beneficiaries. The trust will be distributed pro rata. You know, if one dies, then it will be distributed pro rata as to the other four. But –but –but the beneficiaries all know that they’re going to get a fifth of this money. Would your answer be different?”

Mr. O’Neil: “If the trust instrument gave her a vested, current right to the income, then we wouldn’t –”

Justice Kagan: “Not a current right. She’s going to have to wait until she’s whatever years old, 30, 40, whatever. She can’t pull the money now. But she’s going to get the money one day.”

Mr. O’Neil: “No, that –that case would not be different because it would still be based on this speculative possibility that she will ultimately receive the money.”

Justice Kavanaugh brings up whether they can leave some points open

Justice Kavanaugh: “If –I thought we didn’t need to answer the question raised by Justice Kagan’s previous hypothetical, and just raised by you, which is, if we did know, in other words, if it were guaranteed or certain, that might or might not be a different case.

“But this case is one where we don’t know based on the nature of the trust contingent or discretionary beneficiary, and for that case, the answer, I thought you were arguing, should be that the state where the beneficiary resides cannot tax, but we could leave open the question raised by Justice Kagan’s hypothetical.”

Later, Justice Sotomayor added: “So the thing that Justice Kavanaugh and Justice Alito were reserving, and I assume Justice Kagan, was on the question of what happens if she is a guaranteed distributor–distributee, meaning she can’t call it today, but at age 40 or at the end of the trust life, at some point, she’s going to be the 100 percent owner or going to be a fixed 10 percent owner, whatever it might be, they’re saying we should reserve on that question?”

Justice Alito sympathetic to Respondent

Justice Alito: “But I thought this case was simpler than your argument seems to be making it. I thought this was a case about a state imposing a tax on someone for money that that person may never get. And if –and if the person ever gets some money, we’d have no idea how much that money would be. Isn’t that what this case is about?”

Could states impose throw-back taxes as the Federal Government does with offshore trusts?

Mr. O’Neil: “Can the trust? No, at that point, it won’t be trust property. At that point, it will be the beneficiary’s property. And this –you know, the federal government has the same issue. U.S. citizens can have trusts that are located abroad, and what the federal government does is impose a throw-back tax so that when the beneficiary actually receives the money, the beneficiary can be taxed not only on that distribution but also on –on income that had accumulated in previous years and that the trustee did not pay taxes on.”

Justice Kavanaugh: “And throw-back taxes are –are permissible, constitutional? You’re not challenging those in any way?”

Mr. O’Neil: “We are not. [ …] ”

Mr. O’Neil later said: “I’d like to just focus, if I could, on the –on the point of the throw-back tax because I do think –I do think it is an answer to why –to the state’s concern about all of the potential loss of revenue that it may –may –may lose out on here.

“If and when this money is actually distributed to the beneficiary, if she is a North Carolina resident at that time, the state can get all of this income tax back by taxing the beneficiary.”

Alliance Trust Company of Nevada will continue to monitor this case very closely.

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