Residuary Trust A (Kassner) v. Director, Docket No. 0A-3636-12T1 (App. Div. Unpublished May 28, 2015)
By Andrew J. DeMaio
June 17, 2015
More than thirty years ago, the New Jersey Tax Court limited the power of the State of New Jersey to impose income tax on trusts that have only tenuous contacts with the State. In Pennoyer v. Taxation Div. Dir., 5 N.J. Tax 386 (1983) and Potter v. Taxation Div. Dir., 5 N.J. Tax 399 (1983), the court held that the State’s attempt to impose income tax on the undistributed income of trusts whose trustees, assets and current beneficiaries were all outside the State violated the Due Process Clause of the 14th Amendment to the U.S. Constitution and Article I, Section 1 of the New Jersey Constitution.
In a 2013 opinion, Residuary Trust A u/w/o Kassner v. Director, (N.J. Tax 1/3/2013), the Tax Court confirmed the protection established by the Pennoyer and Potter cases.
Fred E. Kassner lived in New Jersey at the time of his death in 1998. His will created a trust, which later owned stock in four New Jersey S corporations. The corporations earned some of their income in New Jersey and some from operations out of state. The trustee of the trust was a resident of New York during 2006, the year in question. According to the opinion, the trustee administered the trust exclusively outside of New Jersey.
The trust filed a New Jersey Fiduciary Income Tax Return and paid tax on the income allocated to New Jersey activities. However, it paid no tax on the income derived from out-of-state activities or on interest income earned by the trust. The Division of Taxation argued that all of the trust’s income, even that derived from out of state, was taxable because the trust was created under the will of a New Jersey resident, and because the trust owned assets in New Jersey.
The Tax Court quickly disposed of the first argument. It affirmed the conclusion reached in the 1983 Pennoyer case: that the availability of the New Jersey courts to resolve disputes involving a trust is not a sufficient basis for the State to impose income tax on the trust.
The court also held that the trust did not own any assets in New Jersey. The S corporations’ ownership of New Jersey assets could not be imputed to the trust. Thus, while the State may impose tax on the trust’s income from New Jersey sources, the Tax Court held that the State’s attempt to tax other income of the trust violated the Due Process Clause.
On appeal, the State conceded that the trust owned no assets in New Jersey. However, it argued that the trust’s receipt of income from a New Jersey source was a sufficient nexus to allow the State to tax all of its income. This rule – that the receipt of any income from New Jersey allows the State to tax all income received from inside and outside of the State – was set forth in technical guidance published by the Division of Taxation in 2011.
The Appellate Division held that it need not address the constitutional issue because another restriction prevented New Jersey from imposing tax on the trust. In guidance published in 1999, the State announced that, based on the Pennoyer and Potter decisions, a trust would not be taxed on its undistributed income if “all trust assets and all trustees are located outside New Jersey.” The State’s attempt to retroactively impose a third requirement – that the trust have no income at all from New Jersey sources – violated principles of fundamental fairness. The State, according to the Appellate Division, must “turn square corners” when dealing with the public. Under the “square corners” doctrine, a public agency may not spring a new policy upon the community and later seek to apply it retroactively.
The question left unanswered – whether New Jersey, after 2011, may constitutionally tax the undistributed income of trusts that have no assets or trustee in the State but have some New Jersey income – will almost certainly arise in a future case.