Tax Notes Quotes Megan Wernke on Fielding and Kaestner Cases
The Supreme Court’s recent actions on trust tax cases may not seem particularly illuminating at first glance, but some practitioners say reading between the lines of the Court’s language reveals unexpected insights into its thinking.
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Megan E. Wernke of Caplin & Drysdale observed that in Fielding, the Minnesota Supreme Court raised the idea that connections with a state must be evaluated yearly, rather than relying on a historical connection, like a settlor creating a trust when he was a resident of a state decades ago. The Minnesota Court said those kinds of connections can decay over time and that the state needs to consider the current status of the settlor because the state is trying to impose current income taxes, according to Wernke.
That makes sense as an analysis of the due process clause, Wernke said during a July 18 American Law Institute conference in Boston. However, she continued, “I think it behooves us to stop and consider for a moment what that kind of standard means realistically for setting up a regime of law.”
Meeting that difficult standard would require looking year by year at every interaction between the various trust constituents and the state, Wernke said.
The Kaestner Connection
The Supreme Court seems to have implicitly applied that same year-by-year analysis in its Kaestner holding, albeit in the context of a beneficiary rather than a settlor, according to Wernke.
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Wernke said the Court discussed the relationship to the beneficiary in the present tense. “In other words, they don’t say, ‘Ten years ago, the beneficiary was able to control these assets; she used to have withdrawal rights, etc.’” Rather, it questioned whether the taxpayer controls the trust or enjoys the trust, she said.
Wernke said she suspected the Court’s choice of language “indicates that the analysis in the Fielding case and in some of the other lower court decisions about how a due process claim is brought year by year seems to have been implicitly adopted here as well.”
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According to Wernke, the Court didn’t seem fazed that the beneficiary in the Kaestner case was originally scheduled to receive all the trust’s assets at age 40, but the trust was decanted under New York law and that provision was removed so that the trustee retained control of the assets indefinitely. The trust decanting took place after the tax years in question — 2005 through 2008 — but before the litigation began, she noted.
“Certainly, absent the decanting, Ms. Kaestner was entitled to receive that trust income in just a few short years,” Wernke said.
As such, the Supreme Court may have implicitly recognized that states’ trust decanting laws can affect the taxation of trusts, something the “the IRS pushes back on regularly,” according to Wernke.
Wernke explained that she has seen the IRS question the validity of decanting in her practice, telling Tax Notes that the IRS often takes “a very narrow view of state statutes or authority to decant in the instrument, in order to invalidate the tax benefits parties have achieved through decanting.”
She also noted that in various chief counsel advice memos, the IRS has denied an income tax deduction for charitable payments that were made by a trust that had been modified. Section 642(c) requires charitable payments to be made “pursuant to the governing instrument,” and the IRS “refused to recognize the modifications as part of the ‘governing instrument,’” she said.
“The same analysis would prevent income tax deductions that were available only because of a decanting,” Wernke added.
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Wernke likewise predicted a slew of litigation.
“On one end, we know that a beneficiary who’s uncertain to ever receive income cannot be a sufficient basis for the trust to be taxed,” Wernke said. And on the other end of the spectrum, it’s clear that if a beneficiary actually receives distributions, that beneficiary can be taxed on those distributions, she continued.
“But there’s a large grey area in between, where we’re uncertain about what types of relationships the beneficiary might have that would cause a court to distinguish the Kaestner facts,” she said.
Wernke said there are many lingering questions, like whether assets are taxable to the trust if a beneficiary has a demand right to get 5 percent out of a trust each year but doesn’t exercise that right. She said another question would be whether the assets would be taxable if the trust distributed income according to an ascertainable standard — like the health or maintenance of the beneficiary — rather than being purely discretionary as in Kaestner.
“These questions are all open and we do anticipate some more aggressive litigants challenging each and every one of them,” Wernke said. She added that those aren’t all necessarily aggressive positions for a taxpayer to take, but the Court’s ruling in Kaestner left a lot of room for the facts to be expanded and to better define in future litigation the bounds of what relationships are sufficient to establish state residency.
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