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The Supreme Court of Minnesota recently struck down the State Tax Commissioner’s attempt to impose an income tax on trust income from the sale of shares in a Minnesota corporation.  The Court issued its opinion in Fielding v. Commissioner of Revenue on July 18, 2018, finding that the tax violates constitutional due Process protections against extraterritorial taxation. 

FOUR TRUSTS CREATED TO HOLD STOCK

The Fielding case addresses four trusts created in 2009 and initially funded with shares of a Minnesota S Corporation, Faribault Foods, Inc., which held physical assets in Minnesota.  Minnesota resident Reid MacDonald created the trusts and initially organized them as grantor trusts generating income taxable to himself as the grantor. At all times the Trusts had non-Minnesota trustees, first a trustee in California and later trustees in Colorado and Texas.  The Trusts had one individual beneficiary domiciled in Minnesota, but otherwise had non-Minnesota beneficiaries.

In 2011, MacDonald relinquished his power to substitute assets in the trusts and the court determined the trusts, by doing so, ceased to be grantor trusts. The court further determined, under Minnesota law, the trusts were then taxable as irrevocable Minnesota resident trusts. For tax years 2012-13, the trusts, not MacDonald, therefore filed returns and paid Minnesota income tax on the trusts’ “income or gains from intangible personal property,” including investment income, “not employed in the business of the recipient of the income.” See, Minn. Stat. § 290.17, 2(c).  

TAX ON GAIN RULED UNCONSTITUTIONAL

But in 2014, the trusts sold all of their shares in Faribault Foods and incurred a large gain. The trusts paid Minnesota income tax on the gain under protest while alleging the tax violated the Due Process Clause of the Fourteenth Amendment to the U.S. Constitution. The Trusts then filed a refund claim for the amount of tax they had paid under protest.

The Supreme Court of Minnesota ruled in the trusts’ favor to allow the refund and strike down the income tax from the trusts’ gain on the sale of Faribault Foods shares. The court first disregarded the trusts’ connections to Minnesota through MacDonald as grantor of the trusts. The court held these connections were “not relevant” because the trust had its own “legal existence,” despite MacDonald’s connections as a Minnesota resident in 2009 when the trusts were created, in 2011 when the trusts became irrevocable, and in 2014 when the Trusts incurred the gain from the sale of shares.

The court next ruled the trusts did not have any physical property in Minnesota that might create a basis for Minnesota taxation. Even though the trusts held shares in a Minnesota corporation holding physical assets located in Minnesota, the Court held the trusts themselves did not. According to the court, the trusts’ shares are “intangible assets [that] were held outside of Minnesota, and thus do not serve as a relevant or legally significant connection with the State.

The court similarly ruled the trusts’ other connections to the State of Minnesota were “tenuous” despite several arguably significant connections: Minnesota law governs disputes regarding the trusts’ terms, the shares the trusts held are in a corporation organized and governed by the laws of Minnesota, and one of the trusts’ beneficiaries resides in Minnesota.  The Court instead focused on the administration of the trusts through out-of-state trustees. 

TWO JUSTICES DISSENT

Two justices dissented in the
Fielding case, arguing the Minnesota tax statute should be upheld.  Justice Anne McKeig joined an opinion authored by Justice David Lillehaug to argue the State of Minnesota had established the necessary connection and provided benefits, protections, and opportunities to the trusts to constitutionally impose the tax. The dissenting opinion asked the following question: “When a Minnesota grantor knowingly chooses to create a Minnesota resident trust and the trust itself incorporates [under] Minnesota law, why would it be unconstitutional for Minnesota to tax that trust?”

In the dissenting justices’ view, Minnesota had a sufficient connection to the trusts because they were organized under the laws of Minnesota and held shares in a corporation created under Minnesota law. Furthermore, the gain at issue arose from the trusts’ sale of shares in a Minnesota corporation, Faribault Foods, that itself held physical assets in Minnesota.

The dissenting opinion relied upon a 2016 Ohio case that addressed similar facts in Ohio. In T. Ryan Legg Irrevocable Trust v. Testa, the Supreme Court of Ohio upheld Ohio tax statutes imposing an income tax on a trust’s gain from the sale of an Ohio S corporation, where the corporation held physical assets in Ohio and the grantor and beneficiaries were Ohio residents.

SEEK ADVICE GOING FORWARD

Against this background, the Minnesota Supreme Court’s ruling in Fielding v. Commissioner remains controversial and individuals should consult with tax professionals to carefully consider family planning strategies that minimize tax exposure. 

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