Court defeat could cost Minnesota treasury $100 million

A pile of money
Minnesota came out on the losing end of a long-running court battle over the way it taxes some trusts. Now it will have to pay back some taxpayers.
Alex Friedrich | MPR News file

Minnesota’s Revenue Department estimates the state could be on the hook for $100 million in the short term after a loss in court over the way it had taxed some trust accounts for decades.

The estimated fallout was documented publicly for the first time in a required notice the state prepared in anticipation of an early August bond sale. The Department of Revenue confirmed to MPR News that it expects to collect $33.4 million less each year in trust-related taxes and, in the next two years, potentially award $66.8 million in refunds, plus interest, for taxes that were already paid.

Department officials wouldn’t provide the analysis used to produce the estimate, but said they estimate between 500 and 1,000 trusts per year are potentially affected by the decision.

All of it stems from a long-running dispute over the way Minnesota classified “resident” trusts for tax purposes.

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Trusts can serve to meter out inheritance payments, guard against creditors and lower the potential estate tax levied upon a person’s death.

In the mid-1990s, Minnesota changed its trust fund laws to try to clamp down on state residents attempting to reduce or avoid tax liability by setting up their trusts in places without income taxes, such as South Dakota.

“If you did that, you escaped Minnesota income tax on that trust. A trust can be locked up for years,” said Minneapolis certified public accountant Lori Peterson, who specializes in trusts and estate planning. “And in South Dakota, you could have actually have a trust into perpetuity, so you’re escaping state income taxation.”

Under the rewrite decades ago, Minnesota tried to put certain trusts back in reach of tax collectors by weighing the residency of the person who set up the trust. The change generated millions in tax dollars. But it also led to lawsuits by trustees, who administer the assets, and the beneficiaries who didn’t have a strong tie to Minnesota.

One lawsuit, which in trust planning circles is known merely as the Fielding case, weaved through the courts for several years. Fielding was a Texas-based trustee for four funds originally established by a Minnesota businessman on behalf of his children. The trusts contained shares of stock in a Minnesota corporation, and when those shares were sold, the state deemed the proceeds subject to taxes.

The trustees paid taxes under protest and then sought a refund. When a refund was denied, they appealed and won in the Minnesota Tax Court. The Minnesota Supreme Court eventually upheld that ruling and took issue with the way Minnesota’s law had been applied.

“It’s unconstitutional for Minnesota to tax the trust just because the grantor was a Minnesota resident at the time it was created,” said Paul Dinzeo, a Lake Elmo-based accountant and attorney who carefully tracked the case.

The outcome became final this summer when the U.S. Supreme Court declined to step in.

The Department of Revenue must pay out more than $1 million plus interest in the Fielding cases. But the agency also acknowledges that it expects more appeals from similar trust accounts, which will be reviewed on a case-by-case basis.

Of the $67 million in anticipated refund requests, the revenue commissioner expects a third would be paid out this fiscal year and the rest dispensed the year after.

Dinzeo said that could be a moving target.

“It seems to me we’re going to have a lot more cases here that are going to kind of define the law, the body of law around this unless the Minnesota Legislature decides to change the statute to kind of a whole different system,” he said.

A spokesman for the Department of Revenue said proposals for law changes are under consideration.

Minnesota House Taxes Committee Chairman Paul Marquart, DFL-Dilworth, said the anticipated revenue loss is troubling. But Marquart doubts legislators will be ready to address the matter next year.

“Any time you’re dealing with trusts, it is a complicated area of tax law. You wouldn’t want to just try to make some changes to try just to address one thing,” he said. “You’d have to take a bigger look at things and look at it in a bigger picture.”

Marquart’s Senate Tax Committee counterpart is Republican Sen. Roger Chamberlain of Lino Lakes.

“It’s not going to break the state,” Chamberlain said. “But these are significant dollars.”

Chamberlain doesn’t blame people for looking across state lines for ways to hold down their Minnesota tax burden. He said it’s human nature to shop for a better deal.

“I know CPAs personally -- and not just CPAs but financial advisors and planners -- that say you can save a lot of money by going out of state,” he said. “I’ve been to seminars where the seminars are filled with people and the whole point of the seminar is ‘How can you maximize your retirement by avoiding high taxes in the future.'”

Accountants say the outcome will increase the incentive for people to find a trustee outside Minnesota to manage their funds.

Minnesota isn’t the first state to watch its trust law fall in court.

Other states have modified their laws to apply a ratio test to trusts, giving tax collectors access to a percentage of gains in a portfolio without counting the whole value for tax purposes.

“I think Minnesota is going to have to change the way they define a resident trust,” said Peterson, a partner at the CliftonLarsonAllen accountancy. “They probably are going to have to come up with something that isn’t all or nothing but gets you some proportion.”

In the meantime, CPAs and financial planners are scouring their records to determine if their clients are eligible for a refund.

There is some time pressure because taxpayers have only a few years to file an amended return. Right now, they can stretch as far back as 2015.

Peterson said trust holders in a similar boat shouldn’t bank on a refund.

“I don’t think it will necessarily be easy to get the refund from Minnesota because 67 million, that’s a lot of money for the state,” she said. “I think they’re going to want to make sure before they pay it out that there isn’t a close enough connection where they’re still going to consider this a resident trust.”