Taxation of Trusts—Guidance Coming From the Supreme Court?

Taxation of Trusts—Guidance Coming From the Supreme Court?

The U.S. Supreme Court recently heard oral arguments in a case, North Carolina Department of Revenue v. Kaestner 1992 Family Trust, Docket No. 18-457 (argued on April 16), in which a trust challenged a North Carolina law that taxes resident-beneficiaries on the income earned and retained by a nonresident trust. The trust prevailed at the trial level, appellate level and in the North Carolina Supreme Court, but the U.S. Supreme Court granted the North Carolina Department of Revenue’s petition for a writ of certiorari on the question of whether the due process clause of the Fourteenth Amendment prohibits states from taxing trusts based on trust beneficiaries’ in-state residency. The petitioner asserted that there was a split among the nine states that had considered taxation of trust income based on a beneficiary’s residence and that the split could only be resolved by the Supreme Court. While we await the court’s decision, this case presents an interesting mix of arguments regarding the proper analysis of the minimum contacts inquiry and a public policy appeal by the petitioner to “modernize” trust taxation along the lines of a recent court decision that eliminated the physical-presence requirement in the sales tax context.

General Trust Taxation Rubric

Taxation of income from trusts involves looking at federal law, state law, the language of the applicable trust, and the identity and location of the grantor, trustee, beneficiaries and assets held by the trust. In short, the analysis can be complex. Some states, looking to bring in additional revenue, have passed laws expanding the reach of their power to tax trust beneficiaries. One distinguishing feature of the North Carolina law is that it taxes beneficiaries who have not actually received taxable income from a trust.

There are a few preliminary trust tax issues to understand. Income from a trust is sometimes taxed at the trust level, while at other times it is taxed to beneficiaries. Trusts known as revocable (or living) trusts permit the grantor of a trust to revoke the trust. These trusts are generally ignored for both federal and Pennsylvania trust tax purposes and income is taxed just as if the individual grantor had received it. There are also other types of irrevocable grantor trusts which are taxed to the grantor for federal tax purposes and, in a minority view, to the trust itself for Pennsylvania purposes. These grantor trusts can be utilized by estate planning attorneys to leverage estate and gift tax savings. This leaves the traditional nongrantor irrevocable trust, which is the type of trust at issue before the court.

For these nongrantor trusts, most forms of taxable income actually distributed to a beneficiary or that are required to be distributed to a beneficiary are taxed to that beneficiary. Essentially, the trust takes a deduction for the distributed income, with possible limitations for some forms of income such as capital gains, and distributes a K-1 to the beneficiary. States that impose an income tax would generally require that the individual beneficiaries then report the income on their individual tax return just as they would report any other income received. A trust that retains income and is not required to distribute it, on the other hand, will pay tax at the trust level. For federal income tax purposes, this can have negative consequences since the tax brackets are compressed and trusts reach the highest rate of taxation at just $12,750 in annual income. For a trust with a Pennsylvania grantor, Pennsylvania trustee and Pennsylvania beneficiaries, the state tax consequences are what one would expect: the taxable income, whether paid by the trust or the beneficiary is taxed at Pennsylvania’s flat tax rate of 3.07%. 

For Pennsylvania, as well as some other states, a distinction must be made regarding income sourced to a particular state, such as rental income from a property in Pennsylvania or a trust’s income from ownership of a company operating in Pennsylvania, versus nonsource income. Nonsource income would include investment income from ownership of stock of a company not located in Pennsylvania. Current Pennsylvania law provides that it can tax income of a nonresident trust that receives Pennsylvania-sourced income or a nonresident trust beneficiary who receives a distribution from such a trust, but only to the extent that income relates to the Pennsylvania source property. Merely having a beneficiary who resides in Pennsylvania, however, with no other ties to Pennsylvania will not trigger taxation by the state. Of course, Pennsylvania would tax actual distributions of income made to a Pennsylvania resident by a nonresident trust.

North Carolina’s Statute

North Carolina’s law is more expansive. The heart of the dispute presently before the court is whether North Carolina may tax undistributed income of a trust if the only contact with the trust consists of a beneficiary who lives in North Carolina. The Kaestner trust was originally formed in New York and the trustee had no operations or residence in North Carolina. As a constitutional matter, the trust argued that the due process clause should not allow North Carolina to tax the income of the trust since it would be unable to exercise jurisdiction over the trust in a judicial proceeding. Considering the issue in terms of a minimum contacts analysis, the court will likely analyze whether a trust, its trustee and effectively other beneficiaries can be subject to a state’s taxation merely because one of its beneficiaries happens to live in that state.

The law is well-established that a state may tax an actual distribution received by a trust beneficiary in a state in which the trust does not reside. From a practical standpoint, this makes sense. As a beneficiary, one can choose to live in any state. Such beneficiaries have made a choice to subject themselves to the jurisdiction of that state. A beneficiary motivated to save taxes on distributions from a trust might choose to live in Florida, which has no state income tax. The trust, however, cannot exercise control over where its beneficiaries live. Therefore, if the trust’s income is retained by the trust and not distributed, the question is whether a foreign state could then subject any portion of that income to taxation.

A key component of the court’s analysis is likely to be whether serving in a fiduciary relationship to a beneficiary constitutes a sufficient nexus to allow a nonresident trust to be taxed and whether the tax imposed is sufficiently related to values connected to North Carolina. The petitioner argues that there are sufficient minimum contacts because, in what it termed a “fairness-based analysis,” the mere status as beneficiaries of a trust who avail themselves of the benefits of living in North Carolina, such as public roads, police and fire services, is enough to constitute sufficient minimum contacts with the state.

Another component of the court’s focus may be whether the speculative interest of that beneficiary, who had not actually received a distribution, allows North Carolina to impose tax on the trust in this situation. In its brief and at oral arguments, counsel for the trust stressed that the North Carolina beneficiary at issue was a contingent beneficiary of the trust. The trustee had complete discretion whether to make distributions to the beneficiary at issue in this case and there were no distributions made to that beneficiary during the relevant time period. Not only did the trust retain the income, it was conceivable that no trust assets might ever be distributed to that beneficiary. Instead, the trust assets could be distributed to other contingent or remainder beneficiaries who might live in any one of several states at the time they receive the assets.

The petitioner also argues that prohibiting its tax on due process grounds would open up the use of trusts as a tax shelter since individuals could forum shop for a state that does not impose income tax and allow the trust to grow without being taxed. The counter to this position is that states may choose to tax undistributed income in the place where the trust is administered or may impose a throwback tax that would tax the previously untaxed income of a beneficiary in the year that the beneficiary actually receives a distribution.

In sum, this case presents an opportunity to learn how the court will apply due process arguments to trust taxation in light of an increasing focus on income tax planning as the federal estate and generation-skipping transfer taxes impact fewer families.

Reprinted with permission from the May 20, 2019 issue of The Legal Intelligencer. © 2019
ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

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Budgeting for Prevention: Getting the Most Out of Your Legal Services Dollars

Budgeting for Prevention: Getting the Most Out of Your Legal Services Dollars

One of the quickest ways a business can incur legal expenses is to be involved in contentious litigation. Sometimes litigation is just a fact of business life. Businesses can be sued without justification or as an effort to intimidate rather than resolve a dispute. Other entities behave so badly that their conduct compels even the most litigation adverse clients to sue them.

While sometimes litigation is the only option, our litigators spend a fair bit of time on litigation that could have been avoided – or at least made easier – if attorneys had been involved earlier in the process. Unfortunately, many smaller and even mid-market businesses fail to properly budget for legal support for their ongoing business operations. Although this may result in meager short-term savings, any savings are more than outweighed by expensive and disruptive litigation.

Before you write off this post as shameless self-promotion, keep in mind that we are not suggesting that attorneys need to be involved in every business activity. There are certain areas, however, where prospective legal counsel can help to avoid costly litigation later. Here are a few ways you can maximize the bang you receive for your legal buck.

Corporate Formation and Relations Among Owners

Some of the most contentious litigation we handle arises from disputes among owners of closely-held companies. Often, such “business divorce” litigation could have been avoided completely if the owners had sought counsel at the formation of the business and properly documented their decisions in an operating agreement.

Dividing equity can trigger difficult conversations among owners and many owners avoid the practical realities by dividing ownership interests equally among all owners. Experienced attorneys can provide advice on how to approach the allocation of interests and identify common areas of future disagreement. Addressing and resolving such issues early in the business venture can create the conditions for smooth operations and reduce the possibility of acrimonious litigation.

Legal advice is especially critical when there is a change of ownership. Adding new investors or accommodating investors who want to “cash out” can present hidden legal risks. Investing additional capital whether in the form of a loan or capital contribution frequently triggers changes in the ownership structure, while selling the business outright potentially creates significant legal issues for years after the event. Knowledgeable counsel can help owners navigate both immediate and long term issues and can work to resolve them in a non-adversarial way.

Growing the Business

Growing the business through acquisition of another business or a franchise can be a stressful process. Even “small” acquisitions carry the risk of hidden liabilities that can impact the new owner. We routinely assist clients in their legal due diligence and can facilitate financial due diligence by recommending other knowledgeable professionals. We can advise or participate in negotiation with sellers, lenders, suppliers and possible investors and prepare transaction documents. Once agreement is reached, we can ensure proper recording and transfer to enable a smooth and timely closing. Most importantly, we can assist with the post-sale obligations and adjustments that are frequently part of the acquisition process.

Customers And Supplier Disputes

Customer relations are both important and challenging. Not every job goes perfectly and contrary to popular wisdom, the customer is not always right. If a customer fails to pay, alleges defects in your product or service, or posts defamatory statements on the web, a call to counsel can be timely. We routinely work in the background to help resolve customer disputes before the relationship degrades into litigation. This may be as simple as providing advice in anticipation of your meeting with the customer, ghost writing a letter to send to the customer, or writing a “nastygram” on our letterhead. Even if the dispute cannot be resolved without to litigation, letters we have drafted for clients can favorably frame the issue if litigation does occur.

Issues with key suppliers can also pose serious issues for businesses. Suppliers may impose significant restrictions on customers, and defects in materials or services can cause businesses to incur operational and reputational damages in excess of the costs of the materials. Moreover, in the case of an exclusive supplier or a distribution arrangement, businesses may need to proceed cautiously in an effort to preserve the relationship. Our goal in such disputes is not simply to “win the issue” but to arrive at a workable solution that can preserve a business relationship that is worth saving.

Dealing with Problematic Employees

Terminating an employee is never easy; it frequently represents a hiring failure. The process is stressful for both the employer and the employee and is fraught with legal risks. When it is necessary to terminate an employee, discussing the matter with your legal team prior to the termination allows them to help you build a record and handle the termination in a way that will put you in the strongest position possible if the employee initiates litigation later.

Early legal help can significantly reduce the risk of employment-related litigation. There are many laws that impact the employment relationship and every disgruntled employee thinks that they have a legal claim. Misclassification of workers as independent contractors or non-exempt employees can be a source of significant liability for employers. The failure to pay or withhold taxes and overtime associated with these errors can expose a company to serious financial penalties that significantly exceed the cost of compliance. Legal counsel can ensure that the way you pay your employees, the hours they work, and the taxes you withhold all comply with the law and can prevent tremendous liability later.

Employees may also threaten an employer’s intellectual property by soliciting customers or suppliers, removing files or equipment or disclosing confidential information to a new employer. Employers may have legal recourse in such situations – even in the absence of a signed employment agreement. Timely conversation with an attorney is necessary in order to ensure quick action to protect disclosure of proprietary information. Having someone available who is knowledgeable about the law and about your business is the first step in protecting intangible business assets.

Creating Form Agreements

Many clients retain us to review and negotiate significant contracts. That’s great… but they often overlook their form agreements – statements of work, terms and conditions, bid proposals, construction contracts, license agreements, purchase orders, master service agreements – that are part of their daily operations. “Boilerplate” has legal consequences and well drafted provisions can provide a significant advantage in the event of litigation. For example, form agreements we have prepared for clients have successfully forced disgruntled customers into arbitration, limited our clients’ liability to nominal amounts, and allowed them to collect attorneys’ fees from deadbeat customers that exceeded the amount initially in dispute.

Counseling on Major Business Decisions

Although most businesses think of attorneys primarily with respect to litigation, the firm also functions as counselors providing impartial advice on how the law might affect potential decisions and identifying legally compliant alternatives that might meet the client’s needs. Businesses considering entering a new market or a new business channel have been well served by a discussion of legal issues. Many products and services are regulated by specialized state or federal agencies and the impact of such regulations should be considered before entering such a market. For example, serving liquor at an establishment, accepting payment in bitcoin, on-line marketing to children, ad claims that a product “kills germs” or running a promotional sweepstakes – all require regulatory compliance. We can help to identify regulatory hurdles so ensure that your new initiative does not result in unexpected legal liability.

Strategic Advantage

Timely and proactive interaction with counsel – not just in response to litigation – not only avoids problems but can also result in a competitive advantage for the business. Law can be an important tool to protect small businesses from unscrupulous competitors, preserve intellectual property and properly secure payments. Regular communication with counsel on operational and strategic issues is the best way to ensure that the law works for your business and that entities get the most out of the money they spend on legal issues.

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