Posts Tagged: Tax Law Update

Massachusetts Guidance Regarding Opportunity Zone Investments

TIR 19-7: Massachusetts Treatment of Investments in Qualified Opportunity Zones

Massachusetts Guidance Regarding Opportunity Zone Investments

Authors: Joshua Caswell of Howland Evangelista Kohlenberg LLP

The Tax Cuts and Jobs Act amended the Internal Revenue Code (the “Code”) to add Sections 1400Z-1 and 1400Z-2 (collectively, “Subchapter Z”) related to Opportunity Zones. Subchapter Z was designed to spur investment in designated distressed communities throughout the country by granting investors preferential tax treatment. Section 1400Z-1 includes definitional and procedural rules for designating Opportunity Zones. Section 1400Z-2 allows taxpayers to elect to receive certain federal income tax benefits to the extent that those taxpayers timely invest eligible gains into Opportunity Zones through a Qualified Opportunity Fund (“QOF”), an investment vehicle organized as a corporation or partnership for the purpose of investing in qualified opportunity zones.

Generally, investments in QOFs come with three main tax benefits: (1) investors can defer tax on capital gains timely invested into a QOF until no later than December 31, 2026; (2) investors that hold the QOF investment for five or seven years upon the expiration of the deferral period can receive a 10% or 15% reduction on their deferred capital gains tax bill; and (3) investors that sell the QOF investment after holding the investment for at least 10 years can receive the added benefit of paying no tax on any post-acquisition realized appreciation in the QOF investment.

The Massachusetts Department of Revenue (“DOR”) issued a Technical Information Release on June 17, 2019 (the “TIR”) intended to inform taxpayers and practitioners of the DOR’s official position on the treatment of QOF investments. TIR 19-7.

The TIR provides that because the Massachusetts personal income tax rules (including partnership tax rules) are based upon the Internal Revenue Code as amended on January 1, 2005 and not upon the current code, individuals and partnerships that invest in QOFs will not be able to take advantage of the tax benefits enumerated under Subchapter Z. For personal income tax purposes, a taxpayer who elects to defer gains under Subchapter Z must recognize such gains for Massachusetts income tax purposes in the year of the sale or exchange giving rise to such gains. Additionally, the basis adjustment rules under Subchapter Z do not apply in calculating future gains that must be recognized (for Massachusetts income tax purposes) upon the sale or exchange of a QOF investment.

The TIR also provides that because Massachusetts generally conforms to the Internal Revenue Code as currently in effect for corporations, for corporate excise tax purposes taxpayers who elect to defer capital gains under Subchapter Z will also defer such gains for Massachusetts purposes. Similarly, the federal basis adjustment rules under Subchapter Z will apply to corporations for Massachusetts purposes.

U.S. Supreme Court Decides Kaestner Case in Favor of Taxpayer in Narrow Holding

North Carolina Department of Revenue v. Kimberley Rice Kaestner  1992 Family Trust, 588 U.S.  (June 21, 2019)

U.S. Supreme Court Decides Kaestner Case in Favor of Taxpayer in Narrow Holding

Authors: Joshua Caswell and Leigh Furtado of Howland Evangelista Kohlenberg LLP

A. Executive Summary.

In a unanimous opinion, the Supreme Court held that North Carolina’s efforts to tax the income of a trust based solely on the trust beneficiary’s residence in the state violated the Constitution’s due process clause.  After analyzing the beneficiary’s right to control, possesses, enjoy or receive trust assets, the Court concluded that North Carolina had not proven the necessary minimum connections between the state and the trust.  However, the ruling was a narrow one in light of the fact that the beneficiary had not received any distributions during the relevant time period and did not have the power to demand distributions.  Many questions remain as to whether a state could successfully base a tax on beneficiary residency where the beneficiary’s relationship to the trust assets differed from the facts of this case.

B. Case Summary.

In an opinion issued on June 21, 2019 and authored by Justice Sotomayor, the Supreme Court held that North Carolina’s efforts to tax the income of a trust based on the trust beneficiary’s residence in the state violated the Constitution’s due process clause.

In 1992, Joseph Lee Rice III (“Rice”) formed a trust for the benefit of his children (the “Trust”) in his home state of New York.  Rice named a fellow New York resident as the initial trustee.  In 1997, Rice’s daughter, Kimberley Rice Kaestner (“Kimberley”), moved to North Carolina.  In 2002, the Trust was divided into sub-trusts for Rice’s children.  The instant case relates to the sub-trust for Kimberley and her three children (“Kimberley’s Trust”), which was controlled by the same agreement that controlled the Trust.  Critically, this meant that Kimberley’s Trust was a so-called fully discretionary trust (the trustee had exclusive control over the allocation and timing of trust distributions).

This case arose when North Carolina attempted to tax the income earned by Kimberley’s Trust from 2005 to 2008.  Under N.C.G.S. § 105-160.2, the income tax of an estate or trust “is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of [the] State.”  Applying this statute, the North Carolina Department of Revenue assessed a tax of more than $1.3 million.

During the relevant period, the beneficiaries of Kimberley’s Trust were all residents of North Carolina.  However, the trust’s grantor was a resident of New York, the trust was governed by New York law, the trust’s documents and records were kept in New York and the custodians of the trust’s assets were all located in Boston, Massachusetts.  At no point during the relevant period was the trustee a North Carolina resident.  Moreover, the trust earned no income in North Carolina, made no distributions to Kimberley or her children and the trustee had only “infrequent” contact with Kimberley.  Finally, Kimberley’s Trust maintained no physical presence in North Carolina, made no direct investment the state and held no real property therein.

Kimberley’s Trust alleged that North Carolina’s imposition of its tax violated the due process clause because the trust lacked the necessary minimum contacts with the state.  North Carolina argued that the presence of in-state beneficiaries was sufficient to satisfy the minimum-contacts requirement under the court’s modern jurisprudence.

The Supreme Court rejected the state’s arguments, beginning its analysis by observing that tax due process cases are analyzed under a two-step framework that requires (1) “some minimum connection” between the taxpayer and the state, and (2) a rational relationship between the income the state seeks to tax and the state.  The opinion focuses on the first part of this test, which is determined under the same minimum-contacts framework used to analyze questions of personal jurisdiction under International Shoe Co. v. Washington, 326 U. S. 310 (1945), and subsequent, related cases.

In cases like this one, the hard question is not whether the beneficiary’s contacts are sufficient, but whether they matter for purposes of the minimum-contacts analysis.  The opinion holds that whether a beneficiary’s in-state contacts are relevant at the trust level depends on “the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets.”

Applying this test to Kimberley’s Trust, the court concluded that the in-state beneficiaries lacked the requisite control or possession for their contacts with North Carolina alone to establish jurisdiction.  They neither received money from the trust during the relevant period nor had any right to demand trust distributions.  Furthermore, because the Trust gave the trustee sole discretion over distributions, there was no guarantee that a particular beneficiary would ever receive a distribution.  As such, North Carolina’s statute violated the Constitution’s due process clause of the Constitution.

C. Remaining Questions and Considerations.

Not unexpectedly, the Court’s holding was quite narrow and limited by the facts of the case at hand where Kimberley had not received any distributions during the relevant time period.  The justices took great care to emphasize that the Court was not ruling on the appropriateness of state taxation of trust income under many other factual scenarios where the relationship of the beneficiary to the trust assets differed from the case at hand.  In the concurrence, Justice Alito stated that the connection of North Carolina to the trust income was “unusually tenuous” in this matter and that therefore the Court’s opinion is circumscribed.

As a result, the Court provided little guidance on the following scenarios:

  1. In the opinion and at oral argument, the Justices emphasized that Kimberley and her children could not count on receiving any specific amount of income from the Trust in the future. Would the outcome be different if a trust distributes to a beneficiary at a particular age?  It should be noted that the terms of the Kaestner Trust directed that Kimberley’s share be distributed to Kimberley when she reached aged forty, but the Trustee rolled over the trust estate to a new trust as permitted under New York law.
  2. North Carolina argued that a ruling in Kimberley’s favor would result in forum shopping and invalidate state taxation statutes around the country. The Court found this argument unconvincing and noted that only a small handful of states consider beneficiary residency as the sole basis for trust taxation, and even fewer rely on the residency of the beneficiary where it is uncertain if the beneficiary will receive distributions.
  3. The Court noted that “critically” the Kaestner trustee had exclusive control over the allocation and timing of distributions. Would the result have been different if the trust contained an ascertainable standard but did not require distributions?
  4. The Due Process clause requires that when a tax is based on the residency of a beneficiary, he or she must have some degree of possession, control or enjoyment of the trust property. But, the Court also refused to address what degree of possession, control or enjoyment sufficiently supports taxation.
  5. Similarly, the Court did not consider whether a beneficiary’s ability to assign an income interest would constitute sufficient possession, control or enjoyment to support taxation.
  6. Since the lack of distributions and/or the ability to demand distributions resolved the question in the Kaestner case, the Court did not consider the Trust’s broader argument that the trustee’s contacts alone determine a state’s power over a trust. This line of argument resulted from disputed interpretations of Hanson v. Denckla, 357 U.S. 235 (1958).  The Court did not explicitly rule out a circumstance where beneficiary residence provides sufficient minimum contacts for taxation.  The question remains as to what relationship between the beneficiary and the trust assets would be sufficient to satisfy the Due Process Clause.
  7. This decision does not address state laws that consider beneficiary residency as one of a number of factors. The question remains as to the appropriate weight to assign to this factor going forward when balancing the considerations outlined in those statutes.
  8. The Trust did not raise a challenge to the practice known as throw-back taxation where a state taxes accumulated income at the time it is distributed. By bringing this issue up on its own accord is the Court indicating a potential opening for future arguments?
  9. In drafting trusts, settlors will need to weigh the potential tax benefits of a completely discretionary trust where the beneficiary cannot demand distributions against the cost to the beneficiaries of less control over the trust assets.

D. Conclusion.

As the Supreme Court stated, North Carolina’s argument failed to grapple with the wide variation in the interests of beneficiaries to trust assets and the impact of different discretionary standards on beneficiary possession, control and enjoyment.  The sufficiency of minimum contacts in the trust taxation context will inevitably result in a fact-specific inquiry.  Although it is now clear that a state cannot base a tax on undistributed income to a beneficiary who has not received distributions and cannot demand such distributions, there are still many unanswered questions for practitioners involved in both the drafting and the administration of trusts.  As the State of North Carolina asserted in its brief, trust income nationally exceeded $120 billion in 2014, and states, beneficiaries and trustees are all motivated to protect their perceived slice of the pie.

Steinberg v. Commissioner

Net, Net Gifts: Donee Assumption of Section 2035(b) Tax Liability
Steinberg v. Commissioner, 141 T.C. No. 8, Code Sec. 2035(b), 2512(b)
Issued September 30, 2013

Author: Kerry Reilly, Esq.


In April 2007, Jean Steinberg (“Taxpayer”) entered into a “net gift agreement” with her four adult daughters.  Under the net gift agreement, Taxpayer made gifts of cash and securities to each of her four daughters (“Donees”).  In exchange, the Donees agreed to assume responsibility for any federal gift tax imposed as a result of the gift and any federal or state estate tax imposed on the gift under Section 2035(b) in the event the Taxpayer passed away within three years of the gift.

Taxpayer filed a timely Form 709 for tax year 2007 reflecting a net gift amount of approximately $71.6 million and total gift tax of approximately $32 million.  An appraiser, hired by the Taxpayer, calculated the amount of the net gift by reducing the fair market value of the gift by (1) the gift taxes paid by the Donees and (2) the actuarial value of the potential Section 2035(b) estate tax (approximately $5.84 million).

The Internal Revenue Service (IRS) mailed a notice of deficiency disallowing Taxpayer’s entire discount for the Donees’ assumption of the potential 2035(b) tax liability ($5.84 million) and increasing the gift taxes due by approximately $1.8 million.

The IRS requested a summary judgment on one issue only – whether a Donees’ promise to pay any federal or state estate tax liability that may arise under Section 2035(b) may constitute consideration in money or money’s worth within the meaning of Section 2512(b). (emphasis added)

Discussion and Analysis:

Under Internal Revenue Code Sec. 2035(b), the decedent’s gross estate is increased by the amount of any gift tax paid by the decedent or the decedent’s estate on any gift made by the decedent during the three years prior to the decedent’s death.  Under Internal Revenue Code Sec. 2512(b) the amount of the gift is the amount by which the value of the transferred property exceeds the value of the consideration received in money or money’s worth.

The IRS claimed that the Donees’ assumption of the potential Section 2035(b) estate tax failed to build-up or contribute to (“replenish”) Taxpayer’s estate, (monetarily or otherwise) providing only “peace of mind” and therefore failed as consideration under the “estate depletion” theory of gift tax.  The “estate depletion” theory determines what constitutes consideration in money or money’s worth.  If a donor’s estate has not been replenished, then that donor has not received consideration. The IRS rested its claims in part on the Tax Court’s holding in McCord v. Commissioner, 120 T.C. 358 (2003), rev’d and remanded sub nom. Succession of McCord v. Commissioner, 461 F.3d 617 (5th Cir. 2006) ((a) donees’ assumption of the taxpayer’s 2035(b) estate tax liability was too speculative to be reduced to monetary value and (b) any benefit from the donees’ assumption of the Section 2035(b) tax liability would accrue to the donor’s estate rather than the donor).

The Court agreed with the Court of Appeals and reversed its position in McCord with respect to the “too speculative” claim.  It held that assumption of the potential Section 2035(b) tax liability was not too speculative because a “willing buyer and seller in appropriate circumstances may take into account a donee’s assumption of [this] liability in arriving at a sale price.”  The Court noted that “many courts have held that the value of stock received by gift or bequest must be reduced by capital gains tax regardless of the lack of indication that the capital gains will be triggered by the donee or beneficiary in the near future.” E.g. Estate of Jelke v. Commissioner, 507 F.3d 1317, 1319, 1333 (11th Cir. 2007).  The Court also noted that these cases show it is possible to determine the value of built-in capital gains on the valuation date despite the uncertainty of surrounding factors (i.e. rates, potential repeal of tax, future sale/trigger date, amount of tax due from beneficiary/donee, etc.) and that there is a “possibility that an appropriate method may likewise exist to fix the value of the potential Section 2035(b) estate tax liability…”

The Court also reversed its position on McCord with respect to the “estate depletion” theory.  It held that its prior distinction between a donor and his/her estate was incorrect and that “they are inextricably bound.”  The Court also reasoned that when the Donees assumed the gift tax liability the Taxpayer’s assets were “replenished” by the amount of the gift tax liability assumed by the Donees because the “consideration may discharge [the donor] from liability…the benefit to the donor in money or money’s worth, rather than the detriment to the donee determines the existence…of consideration.” Commissioner v. Wemyss, 324 U.S. 303, 306-308 (1945). The Court reasoned that likewise the assumption of the liability for the potential 2035(b) tax by the Donees may also replenish the Taxpayer’s assets because the Taxpayer’s estate would be relieved of that liability.

Significant Holdings:

The IRS’ motion for summary judgment was denied.  The majority opinion stated that IRS failed to show, as a matter of law, that the Donees’ assumption of the Taxpayer’s potential Section 2035(b) estate tax liability cannot be considered money or money’s worth within the meaning of Section 2512(b).  The majority also held that there were disputes of material fact with respect to whether the Donees’ assumption of potential Section 2035(b) estate tax liabilities constituted consideration in money or money’s worth.  The majority did not enumerate any of these issues however.

A concurring opinion stated that this holding creates a potential valuation issue for the future – that the legal obligation of the Donees to pay the Section 2035(b) estate taxes could be considered an “asset” of the Taxpayer’s estate.  This new asset may result in a windfall to the Donees if the Taxpayer does not die within the three-year period, or could result in the Donees potentially paying an amount in estate taxes that is greater than the discount received.

A second concurring opinion stated that with respect to the “too speculative” theory, neither party had asked the Court to consider that issue, thus the Court’s discussion of that point was premature.  This concurring opinion reflected that with respect to the “estate depletion” theory, the IRS may be able to show that the Donees agreement to pay the Section 2035(b) taxes did not in fact increase the Taxpayer’s estate and was in fact merely (1) a way to apportion the tax within the estate and among the beneficiaries as the Donees will “pay” the taxes either as part of the net gift agreement or in the receipt of a smaller inheritance (if the taxes were paid by the Taxpayer’s estate), and further that (2) the net gift agreement simply memorializes an obligation that the Donees have under New York State law, thus the value of the net gift agreement as it relates to the Section 2035(b) obligation is merely as a “enforcement mechanism.”

The dissenting opinion provides numerous calculations detailing the difference in gift and estate tax amounts due for the gift and net, net gift scenarios if the taxpayer dies within three years of making the gift.  These calculations are provided as illustrative examples that the allowance of the Section 2035(b) payment by the Donees is contrary to Congress’ purpose in enacting Section 2035(b), i.e. to mitigate in part a disparity between the tax bases subject to the gift and estate tax, respectively.  The opinion provides that the allowance of the deduction for the potential Section 2035(b) taxes “allows the transferor to render more lenient the gift taxation (if no Section 2035(b) liability arises) and the estate taxation [(if that liability does arise)].”