US Supreme Court Hands Two Massive Tax Wins To High Asset Families & Business Owners by Forbes – Entrepreneurs

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It seems that some states, hungry for tax revenue, want to tax as a matter of whim as opposed to as a matter of law.

Trust law has been around for over 2000 years.  You read that correctly — two thousand years. Since ancient Rome.  And, certain fundamental rules regarding taxation have been around for about the same period of time.  Culturally, they are in the fabric of our sense of fairness and equity.

Of course, embedded in foregoing is a detailed discussion based on general rules, exceptions, etc.  And, certainly, as time moved forward, subsequent governments added to these rules or modified these rules to fit their respective societies.  But, the point is made.  

(If anyone asks what the Romans ever done for us — for those who remember, the question was asked by the Monty Python troupe — they gave Western Civilization these long-standing rules of trust law and tax law.)

One of the ancient rules on taxation related to any given Roman province’s ability to tax individuals, their assets, and their income.  In short, there needed to be a connection to the province. (The legal term — in Latin, of course — is “nexus.”) The individual needed to live there or the assets needed to be located there or the income needed to be sourced from there.  

But, what happens when two or more provinces had a connection?  Let’s say the individual lived in one province, had land in another province, and had a business enterprise in yet another province.  Which province was allowed to tax and what was it allowed to tax? Whether a province had the legal right to tax a given person, asset, or income was a matter of law and not a matter of whim.  And, the province needed prove it had jurisdiction to tax — it needed to prove nexus.  This concept of proving jurisdiction to tax falls under a legal concept called “due process.”

So, in addition to the aquaduct, sanitation, roads, irrigation, medicine, education, wine, public safety, and peace, the Romans gave us a rich body of law that includes fair and equitable rules regarding taxation of individuals, their property, and their income.  

To recap, 1) taxation was a matter of law, 2) a government’s legal right to tax required nexus, and 3) the government needed to prove nexus via due process.

A Little Bit More On This “Nexus” Thing

These concepts from Roman law can be found in the English Common Law system that we use.  They are there from the Magna Carta to the U.S. Constitution and they are affirmed by case law.  In the 1950s, the American Bar Association formalized a draft uniform statute for the states regarding these concepts.  And, the two wins from the Supreme Court involved questions directly on point: What level of nexus must a state government prove to establish jurisdiction to tax trusts?

For income tax purposes, trusts fall into two basic categories: 1) a trust is a standalone taxpayer, it pays its own taxes, and no person is liable for the trust’s tax liability and 2) a trust is not a standalone taxpayer, it does not pay its own taxes, and a person IS liable for the trust’s tax liability.  The cases in play are both of the first type — the trust is a standalone taxpayer.

Typically, a state government will enact a statute that identifies who it will tax and what it will tax.  When it comes to taxation of trusts, there are several moving parts. There is the person who created the trust.  There is the beneficiary. There are the assets and income of the trust. And, there is the trustee. Each might be located in a different state.  It would seem that four different jurisdictions are licking their chops for tax revenues. This is where “nexus” comes into play.

For the purposes of our discussion, the long-standing rules provide:

  • The trustee’s state of residence gets to tax all trust income
  • A trust’s tangible property (real and personal) in a given state can be taxed by that state
  • A trust’s income from tangible property sourced from a given state can be taxed by that state
  • A trust’s intangible property is only taxed by the trustee’s state of residence
  • A trust’s income from intangible property is only taxed by the trustee’s state of residence
  • Assets and income actually distributed to a beneficiary are taxed by the beneficiary’s state of residence
  • Assets and income to which a beneficiary has a “non-contingent” right are taxed by the beneficiary’s state of residence
  • There are exceptions based on one’s unique facts and circumstances
  • Typically, rules provide offsets to prevent double-taxation by multiple states

In spite of these long-standing rules — upon which there is about 150 years of US Supreme Court rulings — some states attempt to tax without sufficient nexus.  Unless a taxpayer protests and asserts there is not sufficient nexus, the state gets away with it. And, often, the dollar amount in play is too little to fight for.  But, occasionally, there is enough money in play and the taxpayer victim fights. (I use the harsh term “victim” because these states offend our cultural sense of fairness and equity when they pull this stuff in light of the US Supreme Court’s long standing position.)

In recent years, taxpayers who have asserted a lack of nexus and due process have won . . . with their own states’ supreme courts overturning the states’ offending statutes.  But, this has occurred one state at a time. What taxpayers and tax planners have wanted was a newer US Supreme Court ruling that left no doubt . . . involving a state that had a ridiculously weak case . . . to finally put the issue to rest.  North Carolina gave it to us.

On To The First Case

In the first case — North Carolina v. Kaestner — only the beneficiary was located in the state.  The person who created the trust was not a resident of the state. The trustee was not a resident of the state.  The trust had no assets in the state. The trust had no income from the state. Yet, the state asserted a right to tax ALL trust income — not just the income distributed to the resident beneficiary.

The state’s case was absurd.  As was mentioned above, the US Supreme Court had repeatedly ruled that in-state residency of the beneficiary alone was insufficient to create nexus so as to allow that state to tax anything more than the income distributed to the in-state beneficiary.  At the trial court level, the judge held that the nexus was too tenuous. The state appealed and North Carolina’s appellate court affirmed the trial court’s decision. The state appealed to North Carolina’s supreme court — it affirmed also and struck down the state’s statute.  Then, the state appealed to the US Supreme Court.

Only six minutes into oral arguments at the US Supreme Court, Justice Sotomayor asked a string of questions along the line of the long-standing rules.  Given the tone of the questions, one almost expected to hear “are you kidding me?” Very early on, one could tell that the North Carolina was going down in flames.  The Supreme Court’s decision was unanimous in favor of the taxpayer.  

The opinion released by the Supreme Court was written by Justice Sotomayor.  She quotes prior cases that found in-state residency of a beneficiary alone does not create sufficient nexus to allow a state to tax more than income distributed to that in-state beneficiary.  At the end of this recounting of cases, she writes, “Similar analysis also appears in the context of taxes premised on the in-state residency of settlors [the person who creates a trust] . . . “  Remember these words.

On To The Second Case

Some states attempt to tax all trusts created by residents of the state . . . forever.  So, consider great-grandparents who were residents of (let’s say) Minnesota.  They created a trust. They died 20 years ago. Fast forward to today. Let’s say that the trustee is a resident of a different state, no beneficiary resides in Minnesota, no trust assets are in Minnesota, and no trust income is sourced from Minnesota.  So, the only connection the trust ever had was that the long-deceased individuals who created it were residents.

Of course, such attempts are contrary to those long-standing rules.  The “forever” bit particularly offends one’s sense of fairness and equity.  Six generations and 200 years into the future? Seriously? What nerve!

The second case was Minnesota v. Fielding.  Minnesota sought to tax a trust “the grantor of which was domiciled in this state at the time the trust became irrevocable.”  This is express language from Minnesota’s statute.  While the facts of this case are a bit different from the example above, the rule of law in play is nonetheless the same.  Without requiring any nexus more than the residency of the person who created the trust, the trustee and beneficiaries objected.  The state lost at the Minnesota appellate court level and the Minnesota supreme court. On the heels of the North Carolina case — which expressly referred to states seeking to base nexus solely on the trust settlor’s residency — Minnesota appealed to the US Supreme Court.

The US Supreme Court denied certiorari to Minnesota’s tax authority — which means it refused to hear the case and the lower court’s decision stands.  So, the in-state residency of a trust’s creator alone does not create sufficient nexus to allow a state to tax the trust’s income. If the trustee is a resident of that state, sure.  To the extent that a trust has assets in or income from the state, sure. To the extent that a trust distributes income to an in-state beneficiary, sure. Those are the long-standing rules we know and love.

So, What Does This Mean To You?

The states that imposed “resident trust” rules have lost the means to tax certain kinds of trusts.  Residents of all states are now able to use the types of trusts for tax planning that we’ve mentioned in prior articles in this column.

We’ve talked about creating certain kinds of trusts to move specific assets from your high-tax home state to a zero-tax trust state.  It is important to note that not all zero-tax states are the same. Their trust laws differ. Depending on your objectives, the trust law of certain zero-tax states might not allow you to create the type of trust you need to reach those objectives.  So, you need to use a zero-tax jurisdiction that has the correct trust law.

If you are intended to diversify a concentrated position or are going to be selling your company, it is possible to create one of the previously mentioned trusts — such as a NING trust or a DING trust — to hold ownership of such assets and have no tax liability in your home state.  You can review prior articles on this topic.

Along the line of parry and thrust . . . if you are a California resident, tax Armageddon is on the horizon.  On the November 2020 ballot is a measure that would reinstitute the state-level estate tax (with a low threshold) and add a gift tax.  (Speaking of hungry for tax revenues.)  If passed by voters, the two taxes would become effective on January 1st, 2021.  That’s less than a year and a half away. More on this in a subsequent article.

July 9, 2019 at 05:42PM
https://www.forbes.com/sites/toddganos/2019/07/09/us-supreme-court-hands-two-massive-tax-wins-to-high-asset-families-business-owners/
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