Author: James F. Polese
Issue: January 11, 2019
Last year, the U.S. Supreme Court issued its decision in Wayfair that upheld South Dakota’s statute imposing a sales tax on internet sales to its residents when the seller has no physical presence within the State. Justice Kennedy’s 5-4 decision held that the historical “physical presence” test would no longer be a constitutional impediment to the imposition of sales taxes on sales by out-of-state companies to in-state residents. Wayfair was “teed-up” for the Supreme Court for the express purpose of overturning the National Bella Hess and Quill Corp. decisions that held that a state cannot impose on an out-of-state retailer the obligation to collect sales tax on sales made into that state unless that retailer also had a physical presence within the state.
Arizonans need not fear that the Wayfair decision means that Arizona now can collect sales taxes on internet sales – at least as long as Arizona maintains its current sales and use tax structure. The Wayfair decision is expressly predicated on the fact that South Dakota had adopted the Streamlined Sales and Use Tax Agreement, which requires a single, state-level tax administration, uniform definitions of products and services and simplified tax rate structures. By contrast, Arizona’s sales and use tax regimes are neither uniform nor simple.
But Wayfair may turn out to be Justice Kennedy’s parting shot that opens Pandora’s box, allowing states to tax the income of what historically have been viewed as out-of-state trusts. The sole limitation that the Wayfair Court imposes is that the tax regime must not place an undue collection burden on the payor. Income tax regimes – unlike sales tax regimes – are uniform and do not require extraordinary effort to either track income or impose tax on that income.
Prior to Wayfair, a number of states have been relentless in demanding withholding of monies by a trust or LLC that is deemed “state-sourced income” otherwise payable to non-residents. Wayfair has now eliminated the remaining constitutional barrier to aggressive income taxation by states and suggests that states may now be able to constitutionally tax non-resident trusts on its income irrespective of whether a trust beneficiary is a resident of the state or the trustee is a state resident.
In 2018, there were several judicial decisions that prevented the aggressive taxation of trusts, applying traditional constitutional analysis. In Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Dep’t of Rev., the State Supreme Court held that the state statute that imposed income taxation to the trust for its undistributed income was unconstitutional where the sole basis was that the trust beneficiary is a resident of North Carolina. No distributions had been made to the beneficiary and the trust had no nexus with the State of North Carolina: the trustee was a Connecticut resident; New York law governed the trust; and the assets were managed out of Massachusetts.
The dissent noted that advances in technology required changes in the traditional “physical presence” analysis for a trust to be deemed a resident trust for income tax purposes.
In Fielding v. Commissioner, the Minnesota Supreme Court struck down a ruling by the state tax commissioner that sought to tax irrevocable non-grantor trusts as resident trusts for state income tax purposes as unconstitutional under the Due Process clauses of the US and Minnesota state constitutions. A Minnesota resident created several “defective” grantor trusts with a California trustee. The trusts subsequently became non-grantor trusts when the settlor relinquished certain right over the trusts’ assets. Three of the four beneficiaries of the trusts were Minnesota residents and some of the trusts’ income was derived from within Minnesota. The commissioner argued that the relinquishment of rights by the settlor did not alter the prior characterization that they were resident trusts. Moreover, the state argued that there was a sufficient nexus with the State of Minnesota to justify state income taxation of all trust income.
The Minnesota Supreme Court disagreed. The Court framed the issue as whether the Commissioner could tax all sources of income of these irrevocable trusts simply because, in prior years, they had been treated as resident trusts. The Court held that the trusts’ contacts with Minnesota were either irrelevant or too attenuated to allow Minnesota’s taxation on all trust income under due process considerations.
However, one might well question whether these favorable taxpayer decisions would have issued if these courts had focused on the Supreme Court’s Due Process and Commerce Clause analysis as set forth in Wayfair.
It thus remains to be seen if high-income states – particularly California and New York – will seek to find new sources of revenue by taxing – as resident trusts – trusts that have been traditionally viewed as nonresident trusts.
If you have any questions about the taxation of trusts please contact me, Jim Polese, at 602 256-4499.
 South Dakota v. Wayfair, Inc., No. 17-494 (decided 6/21/2018).
 National Bella Hess v. Department of Revenue of Ill, 386 U.S. 753 (1967).
 In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the Court declined to overturn National Bella Hess but the Quill decision rejected that decision’s premise that Due Process required that the retailer have a physical presence in the state. Quill was founded on the notion that a physical presence was still required to satisfy the Commerce Clause.
 California is notorious for mandating withholding of any California-source income payable to non-residents, whether coming from a trust or a passive investment. Currently, a trust will be subject to taxation by California if a fiduciary or non-contingent beneficiary is a resident of California, regardless of the settlor’s place of residence. However, California has not yet attempted to tax IRA distributions payable to non-residents, even though the custodian has California nexus.
 No. 307PA15-2 (filed 6/8/2018), affirming N.C. Ct. of App. (No. COA15–896, decided. 7/5/2016.
 A17-1177 (decided 7/18/ 2018).