NJ Barred from Taxing Out-of-State Income of a Trust – New Regulations on the Horizon?
Facts
The plaintiff in the case was the Residuary Trust A U/W/O Fred E. Kassner (the “taxpayer” or the “trust”) and the defendant was the New Jersey Division of Taxation (” NJ” or the “Division”). The taxpayer is a NJ resident trust which was created under the will of Fred Kassner, a NJ resident who died in 1998. In 2006, the assets of the trust consisted of cash, bonds and the stock of four NJ S corporations. During 2006, the trustee lived in NY State and the administration of the trust took place entirely outside of NJ. The S corporations issued NJ K-1s to the trust which reported the trust’s share of corporate income apportioned to NJ of approximately $3M. The S corporations also allocated approximately $2M of income earned in states other than NJ and $100k of interest income to the trust. The trust did not make any distributions during 2006. When the trust filed its NJ Form 1041 for 2006, it paid NJ tax on the income sourced to NJ, but not on the out of state income or the interest income. NJ issued a notice of deficiency in 2009, taking the position that 100% of the trust’s income was taxable in NJ and therefore, the trust owed $192k in tax including penalties and interest. The trustee protested the notice of deficiency and in November 2009 the Division issued a final determination letter stating that since the trust had assets located in NJ, all of its undistributed income was taxable by NJ.
Tax Court
There were two fundamental issues for the tax court to decide:
- Can NJ tax the undistributed income of a testamentary trust?
- Does ownership of stock in a NJ S corporation constitute ownership of NJ assets?
Yes, under N.J.S.A. 54A:5-3, NJ has the right to tax the undistributed income of the trust, but prior NJ tax court cases such as Pennoyer v. Division of Taxation and Potter v. Division of Taxation have held that in order to do so, the due process requirement of the U.S. Constitution must be met. Specifically, there must be a minimal link between a state and a taxpayer in order to assess a tax and the state must grant some benefit to the taxpayer in return for the tax assessed. The tax court has decided in these prior opinions, that the mere creation of the trust in NJ is not enough to establish due process. Rather, the court has followed prior guidance issued by the Division that the trust must have assets, a trustee, or a beneficiary in NJ in order for NJ to meet due process and assess a tax. The taxpayer says that since the trust has no assets or trustee in NJ, no link has been established and the non-NJ income is not taxable. On the other hand, the Division says the trust filed a NJ Form 1041 listing a NJ address and owns NJ assets through its ownership in the S corporation stock. The court ruled that just using a NJ address alone is not sufficient to overcome the due process requirement.
As far as the contention that the trust owns NJ assets, the Division claims that the flow through nature of S corporations means that the shareholders own the underlying assets. The court did not agree and mentioned that the flow through nature of S corporations relates solely to the reporting of income and does not stretch to ownership of assets. The Division argued that N.J.A.C. 18:35-1.5(d)(5)(i) states that a resident shareholder must report the entire pro-rata share of income, regardless of where it is apportioned. The court held that it would not apply this statute as written because as determined in the Pennoyer and Potter cases, this treatment would violate due process. Finally, the Division began to reference guidance that it issued in a 2011 Tax Topic which added that having even $1 of NJ income would require a trust to pay tax on all of its undistributed income. The court noted that attempting to apply guidance issued in 2011 to a tax return filed in 2006 would violate the “square corners doctrine” which requires governmental agencies to treat the public fairly and equitably. For these reasons, the court issued summary judgment for the taxpayer and therefore, NJ could not tax the out of state income or the interest income.
Appellate Court
The Division appealed the case and in May 2015, the NJ Appellate Court affirmed the Tax Court’s decision. In a final attempt to gain ground, the Division abandoned the argument that the Trust owned assets in NJ and focused on the guidance issued in 2011 along with a new argument that the trust had actually consented to be taxed on all of its undistributed income. The judge quickly shot down both arguments. Specifically, the Court stressed the importance of the square corners doctrine in the area of taxation. If the Division were allowed to change the rules and apply them retroactively, then taxpayers would not have the opportunity to effectively utilize tax planning strategies. Finally, the Appellate Court would not allow a new legal argument to be introduced for the first time during the Division’s appeal. The Appellate Court held it was simply unfair to apply guidance retroactively and it was unnecessary to even decide the issues of whether the Division’s attempt to tax the out of state income was constitutional or whether new regulations would need to be issued to change policy rather than just mentioning the change in a Division newsletter.
Looking Forward
This case adds to the body of case law in NJ which bars the Division from imposing tax on a trust’s out of state income when the trust does not have assets, trustees, or beneficiaries in NJ. However, the Division made their position clear that trust having even $1 of NJ sourced income would make all of its income taxable to NJ based on the 2011 newsletter. Therefore, practitioners and taxpayers will have to be on the lookout to see if new regulations will be issued by the Division to enforce the policy that any NJ income earned by a trust will cause the Division to tax all of the trust’s income. Then it will be up to the courts to decide, yet again, whether it goes against the constitutional due process to do so.
If you have any questions or would like to discuss this matter further, please contact a member of Withum’s Estate and Trust Services Group.
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
