June 07, 2017

Tax Refunds for Trusts With Minnesota Grantors? Minnesota Trust Income Tax Statute Ruled Unconstitutional

Certain irrevocable trusts created by Minnesota residents after 1995 may be able to claim income tax refunds as a result of the Minnesota Tax Court’s decision in Fielding v. Commissioner of Revenue, handed down on May 31, 2017.

The ruling affects certain irrevocable trusts that have paid Minnesota income taxes as a “resident trust,” which generally includes any taxable trust (i.e., not one whose income is taxed to the grantor) created after 1995 by a grantor who was a resident of Minnesota when the trust became irrevocable. Under Minnesota law, a “resident trust” pays taxes to Minnesota on 100 percent of its income from intangibles such as stocks and bonds (interest, dividends and capital gains). Income from real estate is generally sourced to the state where the property is located, and income from privately held businesses (such as S corporations and partnerships) is apportioned to Minnesota based on business activities in Minnesota. The Minnesota definition of “resident trust” is based solely on a grantor’s having a Minnesota domicile when the trust became irrevocable, even if the trustee is located outside Minnesota and the trust assets are administered outside Minnesota.

The Minnesota Tax Court held the statute unconstitutional as applied to four irrevocable trusts that had a Minnesota-resident grantor and were created during the grantor’s lifetime (“inter vivos” trusts). One of the trusts had a beneficiary who was a resident of Minnesota; the other beneficiaries were residents of other states. The trustee was located outside of Minnesota, and the trust assets were managed outside Minnesota, but those facts were not essential to the Court’s holding that the trusts were not “resident trusts.” As a result of the ruling, the interest, dividends and capital gains earned by the trusts were not taxable by Minnesota. However, their flow-through income from owning S corporation stock was still taxed by Minnesota (on an apportioned basis).

The Department of Revenue may appeal the decision to the Minnesota Supreme Court. If it does, a final determination may not come until the latter part of 2018. The statute of limitations for claiming a refund is 3 ½ years from the date prescribed for filing the return, plus any extension of time granted for filing the return (if the return is filed within the extended time). Therefore, trusts that may be affected by the decision—inter vivos trusts formed after 1995 that filed Minnesota income tax returns as resident trusts—should discuss with their tax preparers whether the trusts could benefit from filing refund claims, especially since the statute of limitations for some tax years may expire before the case is concluded. The availability of refunds will depend on facts specific to the trust, such as how much interest, dividends and capital gains were earned, how much was paid out in distributions to beneficiaries, and whether the trusts claimed credits in other states for taxes paid to Minnesota.

Finally, the Fielding decision does not affect trusts that first became irrevocable prior to 1996 (unless the trust was “first administered in Minnesota” after 1995). Such pre-1996 trusts are subject to a different rule (based on place of the trust administration) for determining Minnesota residency. Also, because Fielding did not involve a testamentary trust, it is unclear how the decision would apply to a testamentary trust created under the will of a decedent who at death was domiciled in Minnesota. Such trusts are classified as Minnesota resident trusts, but the constitutionality of that rule has not been adjudicated.

Faegre Baker Daniels represented the trusts in Fielding v. Commissioner of Revenue.

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