State Taxation of Business Trusts: Limits, Concerns, and Opportunities

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1 State Taxation of Business Trusts: Limits, Concerns, and Opportunities By: Jordan M. Goodman This article appeared in, and is reproduced with permission from, the Journal of Multistate Taxation and Incentives (February 2000), 2000, RIA Group. Warren, Gorham & Lamont s journals website address is < As any multistate business owner knows, most states have developed a taxing methodology designed to tax the state s fair share of business income. The states generally have focused on the business income generated by C and S corporations, limited liability companies (LLCs), general partnerships, limited partnerships, and limited liability partnerships. These taxing methodologies, although clearly not identical, are somewhat consistent. Certain other entities, however, particularly business trusts, have not always been addressed with the same specificity or consistency. As a result, one must make an effort to be informed in this area in order to avoid problems and secure benefits. I. General Rules The income earned by most business entities that operate in multiple states is apportioned to each state in which they do business. The amount apportioned to a particular state constitutes the business s income tax base for that state. When a state attempts to assert its taxing power over a trust, however, various other issues must be examined in assessing the enforceability of the tax. The primary issue is the residency of the trust a state generally may tax all of the income of its residents, whether or not the income was earned in the state. 1 Thus, an 1 See New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937); Cream of Wheat Co. v. Grand Forks County, N. (continued...) important determination is the degree of contact with a state that is necessary before a trust may be considered a resident and, consequently, subject to taxation on all of its income. For business trusts, the determination of residency is not always clear. A trust may not have a specific domicile, and the determination of trust residency has been heavily litigated. 2 This determination is vitally important, as all undistributed income of the trust will be subject to taxation by states in which it is a resident. Nonresident trusts can be taxed only on income derived from the foreign state, and may even be able to completely avoid state income taxes. 3 Beyond the issue of residency, states face constitutional limitations on their power to impose income taxes. States are constitutionally permitted 1 (...continued) Dak., 253 U.S. 325 (1920); District of Columbia v. Chase Manhattan Bank, 689 A.2d 539 (D.C., 1997). 2 See generally District of Columbia v. Chase Manhattan Bank, supra note 1; Chase Manhattan Bank v. Gavin, 249 Conn. 172, 733 A.2d 782 (1999); In re: Swift, 727 S.W.2d 880 (Mo. banc, 1987); Westfall v. Director of Revenue, 812 S.W.2d 513 (Mo. banc, 1991). 3 For example, a trust consisting of intangible incomeproducing assets, such as stock, that is not considered a resident of any state may escape state tax if the income from the stock cannot be attributed to any particular state. See Fogel, What Have You Done For Me Lately? Constitutional Limitations on State Taxation of Trusts, 32 U. Rich. L. Rev. 165 (1998).

2 to tax any nonresident entities that operate within the state. 4 Unlike resident entities, however, nonresidents may be taxed only on the income attributable to the taxing state. The two central federal constitutional provisions controlling state taxation of nonresident entities are the Due Process Clause and the Commerce Clause. To justify the taxation of a nonresident for due process purposes, the state must show that the entity has some minimum connection to the state and that the business activity in the state is rationally related to the values the state provides. 5 The Commerce Clause requires a greater degree of contact with the taxing state before a tax may be imposed. The U.S. Supreme Court has held that in order to survive Commerce Clause scrutiny, the tax must be related to an activity with a substantial nexus to the taxing state and be fairly apportioned to reflect only the activity in the state. 6 The jurisprudence relating to these two provisions demonstrates that they are the cornerstones for state taxation of nonresident entities, and they must be examined by the tax practitioner whenever a tax is imposed on a nonresident entity. Clearly, state taxation of business trusts must be considered in both a resident and nonresident context. Opportunities may exist to structure a trust s activities so as to preclude a determination of state residency. Further, as a nonresident, a trust may be able to bypass apportioned taxation if it avoids maintaining substantial nexus with the taxing state. In large, multistate trusts, these factors have the potential to significantly reduce state income tax burdens. Correspondingly, ignoring state tax issues may result in multiple taxation of a trust s income. II. Taxation of Resident Trusts One of the primary factors to consider when examining potential state tax liability is the residency of the entity to be taxed. The U.S. Supreme Court has clearly established the principle that a state may tax all of the income of its residents. 7 State residency has been determined by a variety of factors, such as the entity s state of formation or where its primary business activities take place. A business trust likely will be subject to taxation by any state that claims the trust as a resident. As noted above, however, certain constitutional issues must be considered before a state s claim of residency will be upheld. A trust that can avoid being classified as a resident of a state may avoid taxation by that state altogether. 8 Therefore, it is vital to be aware of the activities that may be sufficient to establish residency in a particular state. A. The broad standard under Chase. Several state courts have considered the degree of connection necessary before a trust may be 4 See generally Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), which was analyzed in Lieberman, Complete Auto Transit, Inc. v. Brady: How Many Parts Are There?, 3 JMT 4 (Mar/Apr 1993). 5 See Quill Corp. v. North Dakota, 504 U.S. 298 (1992) (citing Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954)); see also Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978). 6 See Complete Auto, supra note 4. 7 See, e.g., Oklahoma Tax Comm n v. Chickasaw Nation, 515 U.S. 450 (1995); New York ex rel. Cohn v. Graves, supra note 1. 8 For example, New York s personal income tax regulations provide that no income tax will be imposed on a trust unless the trust is a resident. Nevertheless, taxes will not be imposed if all of the following conditions are met: 1) no trustee is domiciled in New York; 2) no trust assets are located in the state; and 3) the trust has no New York-source income. N.Y. Comp. Codes, Rules, & Regs (1997).

3 considered a resident. Recently, in Chase Manhattan Bank v. Gavin, 9 the Connecticut Supreme Court applied factors to determine the residency of both testamentary and inter vivos trusts. In a 5-2 decision, the court found that a relatively low standard may be used to determine residency, and held that Connecticut could tax all undistributed income of the trusts in question. Chase involved one inter vivos and four testamentary trusts that were established in Connecticut but had only slight connections to the state following their creation. 10 For the years at issue, the trustee (Chase Manhattan Bank) and all of the assets were in New York. Moreover, the trusts derived all of their income from sources outside Connecticut and no aspect of trust administration was conducted in the state. Nevertheless, under Connecticut law each trust was deemed a resident. The Connecticut statute defined a resident trust, in part, as a trust... consisting of property transferred by will of a decedent who at the time of his death was a resident of this state, and... a trust... consisting of the property of... a person who was a resident of this state at the time the property was transferred to the trust if the trust was then irrevocable. 11 The trustee argued that the imposition of the tax violated both the Due Process and Commerce Clauses. The state countered that it had a right to tax the trusts incomes because each trust was established through the transfer of assets from an individual who was a Connecticut resident when the transfer was made. This one-time act, the state argued, was sufficient to subject the trust to Connecticut income tax for the remainder of its existence, regardless of any future contacts in the Conn. 172, 733 A.2d 782 (1999), cert. den. 120 S.Ct. 401 (1999). 10 Three of the five trusts had at least one Connecticutresident beneficiary. 11 Conn. Gen. Stat (a)(4). state. The Connecticut Supreme Court agreed, holding that each trust still was benefitting from the protection of the laws of the state, and thus could be taxed. 12 The court s analysis. In Chase, the court began its analysis by discussing Quill Corp. v. North Dakota, 13 in which the U.S. Supreme Court provided guidelines for determining when a state may tax an entity without violating the Due Process Clause. In reading Quill as an announcement of a relaxed due process standard, the Chase court found that the establishment of the trusts in Connecticut provided sufficient minimum contacts with the state for the trusts to be deemed residents. The court discussed several factors that ordinarily would lead to a determination of the residency of a trust, including where the trustee and the assets are located and where the trust is administered. Each of these factors necessarily involves an ongoing activity and, in Chase, none of these factors existed in Connecticut during the years at issue. Nevertheless, the court held that the forum state for the establishment of a trust was also entitled to treat the trust as a resident throughout its existence. The basis for this holding was that each testamentary trust was established under the will of a Connecticut resident, and the state s judicial 12 With regard to the inter vivos trust, the court limited its holding so that the portion of the undistributed income subject to tax took into account the ratio of instate noncontingent beneficiaries to all noncontingent beneficiaries. 13 Note 5, supra. This significant case regarding the constitutional limits on the states power to impose their taxing jurisdiction on nonresident entities is examined more fully below. The case was analyzed in depth in Eule and Richman, Out-of-State Mail-Order Vendors Need Not Collect Use Taxes Yet!, 2 JMT 163 (Sep/Oct 1992). See also Nolan, Crossing the Bright Line: Evaluating Physical Presence in Quill s Shadow, 7 JMT 244 (Jan/Feb. 1998).

4 system was responsible for determining the validity of the wills. The court further noted how two of the testamentary trusts were created by using the probate courts of Connecticut. Even though both of these services were provided in the past, and no present relationship existed between the trusts and the state, the court found that the viability of the trust as a legal entity is inextricably intertwined with the benefits and opportunities provided by the legal and judicial systems of Connecticut. In considering the Commerce Clause, the court held that the risk of double taxation (a key issue in Commerce Clause jurisprudence 14 ) is permissible when the income being taxed is from intangibles, such as stock. That is, although Connecticut law generally provides a credit for income taxes paid by a resident trust to another taxing state which would eliminate the risk of multiple taxation it extends only to taxes paid on income derived from real or tangible personal property or from a business, trade, occupation, or profession, and does not extend to taxes paid on income derived from intangible personalty, such as dividends, interest, or capital gains from the sale of securities. Further, the court held that any risk of double taxation was too remote and speculative to constitute a violation of the Commerce Clause. The court thus rejected both of Chase Manhattan s claims and upheld the tax. 15 The dissent. According to the dissent, the imposition of the tax based on the availability of the 14 See, e.g., Complete Auto, supra note 4; see also Quill, supra note This holding is consistent with holding in District of Columbia v. Chase Manhattan Bank, supra note 1. There, the Court of Appeals (D.C. s highest court) held that the District could tax all of the income of a testamentary trust created under the will of an individual who died while domiciled in the District, even though the trustee, trust assets, and trust beneficiaries were all outside the District. Connecticut judicial system was constitutionally insufficient to survive scrutiny under the Due Process Clause. The dissent pointed out that all of the trusts income was realized in New York, and thus any benefits that had been provided to the trusts by Connecticut were not fiscally relevant. Therefore, with no relevant connection between the state and the entity being taxed, the tax must fail on due process grounds. The dissent further reasoned that the taxing scheme also was invalid under Commerce Clause principles. It argued that the risk of double taxation of the trust s income required Connecticut to apportion the tax liability in order for the tax to be valid. Relying on Goldberg v. Sweet, 16 in which the U.S. Supreme Court expressed the requirement of apportionment for taxes that impede interstate commerce, the dissent argued that Connecticut s tax violated the Commerce Clause. B. A critique of the Chase decision. The court s reasoning in Chase can be criticized on a variety of grounds. Questionable reliance on Quill. First, and foremost, is the court s questionable reliance on the due process analysis from Quill. The Chase court viewed the holding of Quill as authority for finding that an entity that has minimum contacts with a state will be subject to taxation as a resident of that state. Quill, however, involved the taxation of a nonresident entity. This distinction is important. The U.S. Supreme Court s holding in Quill was based on the line of cases that began with International Shoe Co. v. Washington 17 and represents the progression of the Court s due U.S. 252 (1989) U.S. 310 (1945).

5 process standards. 18 In applying this doctrine, the Quill Court said that it had abandoned more formalistic tests that focused on a defendant s presence within a State in favor of a more flexible inquiry into whether a defendant s contacts with the forum made it reasonable... to require it to defend the suit in that State. The Chase court specifically cited this language in support of its holding. While this part of the Quill holding did renounce the previous due process requirement of a physical presence in a state before a tax may be imposed, its application was limited to out-of-state parties. The holding does not give authority to the illogical proposition that a party with no physical presence in a state may be considered a resident of that state. 19 It merely subjects the out-of-state entity to the state s jurisdiction (for both personal and taxation purposes). Indeed, the Quill Court provided that its due process analysis was based on whether the entity had fair warning that its activity may subject it to the jurisdiction of a foreign sovereign. 20 Therefore, the Chase court s reliance on Quill in order to classify as a resident an entity with only minimal in-state contacts is misplaced. 21 While the establishment of the trusts in Connecticut may have provided sufficient minimal contacts to 18 See Quill, supra note 5. This line of cases, each of which dealt with a state s power over a nonresident, includes Shaffer v. Heitner, 433 U.S. 186 (1977), and Burger King Corp. v. Rudzewicz, 471 U.S. 462 (1985). 19 According to Black s Law Dictionary, Sixth Edition (West Publishing Co., 1990), a state resident is [a]ny person who occupies a dwelling within the State, has a present intent to remain within the State for a period of time, and manifests the genuineness of that intent by establishing an ongoing physical presence within the State. 20 Quoting Shaffer v. Heitner, supra note 18 (Stevens, J., concurring in the judgment). Emphasis added; internal quotation marks omitted. 21 See the dissent in Chase, supra note 9. tax a portion of the out-of-state trusts income, that taxation must be limited to a nonresident context. Chase also may be criticized in connection with the court s reasoning regarding another part of the due process analysis the requirement that the income attributed to the State for tax purposes must be rationally related to values connected with the taxing State. 22 The Chase court held that the tax was justifiable because Connecticut had provided, and continues to provide, a panoply of benefits to the trusts. Among these benefits is the availability of the state s probate courts for determining the validity of the trusts and requiring that the trustees provide an accounting of trust assets. As the dissent reasoned, however, these benefits are not relevant when viewed in light of what is being taxed. The availability of the Connecticut probate courts in no way contributes to the earning of income by the trusts. 23 Perhaps Connecticut could charge a fee for the probate services afforded out-of-state trusts, or possibly institute a limited tax. As it stands, by continuing to subject an out-of-state trust to full taxation on all of its income, the state violates the due process requirement that it provide a benefit related to the tax base. Erroneous view of multiple taxation risks. A final criticism of Chase is that the court erroneously labeled the risk of double taxation as remote and speculative. This point relates to the classification of the trusts as residents. The incomes of the trusts in Chase were taxed in full by Connecticut, despite the tenuous connection to the 22 See Quill, supra note 5, quoting Moorman Mfg. Co., supra note 5. Internal quotation marks and citation omitted. 23 Moreover, as the dissent in Chase, supra note 9, points out, Connecticut courts are open to all persons, including residents of other states. Thus, the availability of the state s court system does not produce a benefit to justify taxation of all of a trust s income.

6 state. Because each trust s assets, administration, and trustees were all in another state, a clear risk of double taxation existed, which potentially violates the negative aspect of the Commerce Clause. 24 If the trusts are found to be residents of another state in addition to Connecticut, the danger of multiple taxation is clear. In such a circumstance, as noted above, the Commerce Clause requires that income be apportioned in order to prevent multiple taxation. As the dissent in Chase observed: Without any provisions for apportionment or tax credits, the Connecticut income tax on these trusts lacks internal and external consistency and violates the negative implications of the Commerce Clause. 25 In Chase, the trusts were deemed by statute to be residents of Connecticut, even though that state did not provide any material, contemporaneous legal benefits to the trusts. Also, a definite risk existed that the trusts would be considered residents of other states, and thus be subject to multiple taxation. The Chase court s analysis seems to allow complete income taxation of trusts without apportionment based on very liberal standards. Because of these circumstances, trusts created in Connecticut may be forced to use the state s banks as trustees or administrators in order to limit the 24 The negative or dormant Commerce Clause has been interpreted to prohibit certain state actions that interfere with interstate commerce. (It is discussed more fully in the text, below, in examining the taxation of nonresident entities.) See, Quill, supra note 5, citing South Carolina State Highway Dept. v. Barnwell Bros., Inc., 303 U.S. 177 (1938). 25 Internal consistency, with regard to a tax apportionment formula, means that the formula, if applied by every jurisdiction, would result in no more than all of a business s income being taxed. External consistency requires that the factors used in the apportionment formula actually reflect a reasonable sense of how income is generated. See Container Corp. of American v. Franchise Tax Bd., 463 U.S. 159 (1983). trusts tax exposure to only one state. Whether such restrictions unfairly interfere with interstate commerce and violate federal constitutional principles is yet to be determined. C. Swift and contemporaneous legal benefits. An alternative to Chase s view on the taxation of resident trusts takes into account the risk of multiple taxation and requires a continuous connection between the trust and the state before a tax may be imposed. In In re Swift, 26 the Missouri Supreme Court established a multifactor test to determine when a state has a connection sufficient to justify its imposition of tax on a trust s entire undistributed income. Swift involved various testamentary trusts that were created on the death of a Missouri resident. As in Chase, the trusts earned no income in the state attempting to impose the income tax (i.e., Missouri). In addition, none of the trusts assets, beneficiaries, or trustees were in Missouri. The Missouri Department of Revenue argued that the trusts creation in Missouri a one-time event was sufficient to allow the state to treat the trusts as residents, and therefore subject it to taxation on all undistributed income. The Missouri Supreme Court disagreed, however, holding that the tax could be justified only when contemporary benefits and protections are provided [to the trusts] during the relevant taxing period. Six-factor test. In Swift, the court instituted a comprehensive analysis of the type and degree of contact an entity must have with the taxing state in order to support the imposition of an income tax. The court looked to six factors that, when taken together, would determine whether there was sufficient tax nexus. 26 Note 2, supra.

7 1. The settlor s domicile. 2. The state in which the trust was created. 3. The location of the trust property. 4. The beneficiaries domicile. 5. The trustees domicile. 6. The state in which the trust is administered. According to the court, the first two of these factors would indicate the existence of an ongoing relationship between the trust and the taxing state only to the extent that at least one of the other four factors was present. In Swift, although the trusts had been established by a Missouri domiciliary, they did not have any relationship with the state during the period at issue. All trustees, beneficiaries, trust property, and trust administration were in Illinois. The court therefore held that because there was no connection with Missouri under the final four factors, the state did not provide any contemporaneous benefits to the trusts. This lack of a connection prohibited Missouri, under the Due Process Clause, from taxing the trusts as residents. In 1991, four years after Swift, the Missouri Supreme Court applied its six-factor test to find that a trust maintained a connection with the state, and therefore the trust s income was taxable. In Westfall v. Director of Revenue, 27 a testamentary trust was established in Missouri under the will of an individual who was a domiciliary of that state. Thus, the first two factors of the Swift test were met. Included among the trust s assets was a parcel of Missouri real estate that generated annual rental income of approximately $3,500. The Missouri Supreme Court held that because one of the trust s assets was in Missouri, a third factor was satisfied and, thus, there was sufficient justification to tax all 27 Note 2, supra. of the trust s income. 28 D. Evaluating the divergent views. Swift represents one of the most comprehensive decisions regarding the taxation of resident trusts. Other state courts also have held that some continuing benefit must be provided by the taxing state before a tax on all of a trust s income may be found valid. For example, in Blue v. Department of Treasury, 29 the Michigan Court of Appeals ruled that the imposition of a state income tax on a trust that owned no income-producing property in the state violated the Due Process Clause. The court found the tax to be unconstitutional, even though one of the trust s assets was a parcel of real estate in Michigan that generated no income. Thus, Blue represents a step beyond the rigid multifactor test imposed in Swift and Westfall to look to the ongoing legal protections provided by, and income earned in, the taxing state. 30 The two recent cases involving Chase Manhattan Bank (Connecticut s decision in Chase Manhattan Bank v. Gavin, 31 discussed above, and D.C. s opinion District of Columbia v. Chase 28 A dissent argued that the state must also apportion its tax to reach only the income generated by the Missouri property. The dissent felt that taxing the entire income of the trust, including income from intangible property, violated the Due Process Clause Mich. App. 406, 462 N.W.2d 762 (1990). 30 See also Pennoyer v. Tax n Division Director, 5 N.J. Tax 386 (1983); Taylor v. N.Y.S. Tax Comm n, 85 App. Div. 2d 821, 445 N.Y.S.2d 648 (3d Dept., 1981); Mercantile-Safe Deposit & Trust Co. v. Murphy, 19 App. Div. 2d 765, 242 N.Y.S.2d 26 (3d Dept., 1963). 31 Note 9, supra.

8 Manhattan Bank 32 ) each represent the broadest interpretation of when the imposition of an income tax is proper. Both cases held that a trust receiving no contemporaneous legal benefits from a jurisdiction could nonetheless be subject to that jurisdiction s income tax on all trust income. This standard exposes a trust to the risk of multiple taxation while disregarding the constitutionally mandated requirement of fair apportionment. The more rigid standard of Swift and its progeny attempts to ensure that the trust being taxed maintains at least some connection with the taxing state. Nevertheless, this standard does not look to the degree of benefits received but, rather, permits full taxation if certain residence conditions are satisfied. As Westfall demonstrates, a slight continuing connection with the state of establishment may result in that state s taxation of the trust s entire income. Thus, the Swift doctrine disregards fair apportionment in the imposition of an income tax. A more reliable standard, as advocated by the dissent in Westfall and by the Michigan appellate court in Blue, would handle the taxation of trusts like most business entities. This standard would permit taxation of a trust s income only when the trust receives some ongoing legal benefit from the state, and even then the method of taxation must contain some measure of fair apportionment. Such a standard would comply with the U.S. Supreme Court s interpretation of both the Commerce Clause and the Due Process Clause. It would eliminate the risk of multiple taxation, and also would greatly reduce the artificial limitations on the selection of a trust situs that can be inferred from the Connecticut decision in Chase. In Blue, the Michigan court analogized the state s attempt to tax the trust to a hypothetical statute authorizing that any person born in Michigan to resident parents is deemed a resident and taxable as such, no matter where they reside or earn their income. The court observed that such a statute clearly would be beyond the state s taxing powers. Imposing such a taxing scheme on trusts should be found to similarly violate the constitution. Simply put, in order to impose a continuing tax, the taxing state should provide some continuing benefit, and the tax should be fairly apportioned. III. Taxation of Nonresident Trusts As seen from the above discussion, all the income of a trust that is a resident of a given state generally is subject to taxation by that state. By contrast, a nonresident trust may completely avoid taxation in states where it engages in activity. This all or nothing taxing mechanism fails to apportion the income of a business trust to the states in which it is earned. A more reliable approach would be to use the apportionment standards commonly applied to other business entities, such as corporations. While a trust s state of residency is significant, the imposition of some form of taxation on the business income should not turn exclusively on that determination. Also, the income of a nonresident trust could then be subject to taxation on an apportioned basis. A. The Quill inquiry. As noted above, in Quill Corp. v. North Dakota, 33 the U.S. Supreme Court outlined the standards that must be met in order to justify a tax on a nonresident entity. The Court found that the due process analysis for purposes of taxation should be the same as that for personal jurisdiction, i.e., a minimum contacts standard. Beyond due process, the Commerce Clause is concerned primarily with the four-part test for the constitutionality of a state tax as set forth by the 32 Note 1, supra. 33 Note 5, supra.

9 Court in Complete Auto Transit, Inc. v. Brady. 34 Taken together, these two standards, as discussed in Quill, provide the framework for state taxation of nonresident entities. Due process analysis. The first step in a constitutional inquiry as to the validity of a state tax on nonresident entities is to determine whether the tax complies with the requirements of the Due Process Clause. Quill concerned the validity of a use tax collection liability imposed by North Dakota on an out-of-state mail-order business. Quill Corp., a vendor of office supplies and equipment, was incorporated in Delaware and had offices and warehouses in Illinois, California, and Georgia. It had no physical presence in North Dakota and all of its business there was conducted through catalogs, flyers, advertisements in periodicals, and telephone calls. In 1987, North Dakota expanded its imposition of use tax collection responsibility to include all retailers engaged in regular or systematic solicitation of a consumer market in th[e] state. 35 Under regulations, regular or systematic included three or more advertisements in North Dakota over any 12-month period. 36 Quill came within these provisions but refused to collect and remit the tax, claiming that North Dakota did not have the power to assess the tax under the Due Process and Commerce Clauses. In rejecting Quill s due process claim, the U.S. Supreme Court announced a relatively low standard for determining when a nonresident business entity may be subject to a state s taxing jurisdiction. According to the Court, a tax will comply with due process standards if two factors exist. 1. There must be some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax The income attributed to the State for tax purposes must be rationally related to values connected with the taxing State. 38 In Quill, the Court was primarily concerned with the first of these requirements, as it relates to nonresident businesses. Even though Quill had no physical presence in North Dakota, the Court held that the company had sufficient minimum contacts with the state to justify the imposition of a tax. The Court found that Quill had purposefully directed its activities toward North Dakota through the regular solicitation of customers in the state via catalogs and advertisements. These activities were enough to show that Quill enjoyed the benefits of the economic market in North Dakota. For purposes of taxation, Quill was not required to have an actual physical presence in the state. The Court ruled that the magnitude of the regular solicitation of customers was more than sufficient to establish the requisite minimum contacts for due process purposes. The Court s holding in Quill essentially equated the due process requirements concerning the power to tax with the requirements concerning personal jurisdiction. A state tax scheme will not violate the Due Process Clause when the entity being taxed has minimum contacts with the taxing jurisdiction. This standard established a low threshold for determining when a nonresident entity may be taxed without violating due process. But that is not the end of the inquiry. Beyond due 34 Note 4, supra. 35 N. Dak. Cent. Code (6). 36 N. Dak. Admin. Code (1988). 37 Quoting Miller Bros. Co. v. Maryland, supra note 5. Internal quotation marks omitted. 38 Quoting Moorman Mfg. Co. v. Bair, supra note 5. Internal quotation marks and citation omitted.

10 process are the more-stringent requirements under the Commerce Clause. Quill recognized that in order to justify taxation of a nonresident business, the taxing state must satisfy both constitutional standards. Commerce Clause analysis. The negative or dormant application of the Commerce Clause prevents state taxation that unfairly burdens interstate commerce. As noted above, a state tax that meets the requirements of due process also must satisfy the Commerce Clause, which imposes a somewhat higher standard. 39 In Complete Auto, the U.S. Supreme Court reviewed its precedent regarding the negative Commerce Clause and outlined a four-part test for determining when a tax unfairly burdens interstate commerce. In Complete Auto, Mississippi levied a tax solely on the in-state activities of the nonresident taxpayer, an interstate carrier of automobiles. The taxpayer argued that its activities were part of a single interstate transaction, which were unfairly burdened by the tax in violation of the Commerce Clause. The U.S. Supreme Court, affirming Mississippi s high court, rejected the taxpayer s claim. According to the Court, because the tax related to the taxpayer s in-state activities only, a risk of unfair taxation did not exist. The Court s unanimous opinion also outlined four key factors for determining when a state tax satisfies the requirements of the Commerce Clause. A tax imposed on activities involving interstate commerce will be upheld if it meets all of the following requirements: 1. It is applied to an activity that has a substantial nexus with the taxing state. 2. It is fairly apportioned, so as to reduce the possibility of double taxation. 39 See Tyler Pipe Industries, Inc. v. Washington State Dept. of Revenue, 483 U.S. 232 (1987). 3. It does not discriminate against interstate commerce. 4. It is fairly related to the services provided by the state. Substantial nexus and physical presence. The four-part test was reaffirmed by the Court in Quill. There, the Court also reaffirmed that, unlike due process, the Commerce Clause requires that a taxpayer have a physical presence in a state in order for the state to justify taxation. 40 This physical presence requirement is the measure by which a court will determine whether the activities of a nonresident business have a substantial nexus with the taxing state. The U.S. Supreme Court has not announced a clear standard for determining substantial nexus. That must be determined based on the facts and circumstances of each case. The degree of physical presence will indicate whether the necessary nexus exists. The Court has clearly held, however, that the mere slightest presence in the state will not meet the constitution nexus requirement. 41 To illustrate, in Quill the taxpayer s ownership of a few floppy diskettes in North Dakota manifested a minimal nexus but the substantial nexus requirement was not met. Because this important determination may be made by similar hairsplitting, the nexus determination remains a heavily litigated issue. While no clear guidelines exist, the absence of any physical presence will show that 40 This holding reaffirmed the bright line requirement of physical presence, first espoused by the Court in National Bellas Hess, Inc. v. Illinois Dept. of Revenue, 386 U.S. 753 (1967). 41 See, e.g., National Geographic Society v. California Bd. of Equalization, 430 U.S. 551 (1977). There, the taxpayer maintained two offices in the state, and its employees solicited approximately $1 million in advertising sales per year. The Court held that this conduct went beyond a slightest presence.

11 there is no substantial nexus between the entity s business activities and the taxing state. Fair apportionment. When substantial nexus exists, a state may impose a tax on a nonresident entity without violating the Commerce Clause but only if the tax is fairly apportioned. Fair apportionment reduces the risk that a state might tax income not earned in the state, and therefore reduces the risk of multiple taxation. Each state may adopt its own statutory apportionment formula, using various factors designed to measure an entity s in-state business activity. The tax base to which the apportionment formula applies is the entity s total income, including both intra- and interstate income of the complete, unitary entity. The apportionment formula typically consists of a percentage that measures the entity s in-state business based on ratios of the entity s sales, property, and payroll in the taxing state compared to those factors for the entity everywhere. 42 This enables a state to determine the income attributable to the entity s activities in the state. The taxing state also must show that the formula results in a fair apportionment, which generally refers to the requirement that the formula be both internally and externally consistent. 43 Nondiscrimination. The third part of the Complete Auto test deals with discriminatory taxation laws that unfairly burden interstate commerce. A state tax that discriminates against interstate commerce violates the Commerce Clause unless the state provides a sufficient justification Sales, property, and payroll are the most common apportionment factors, and they are used in the Uniform Division of Income for Tax Purposes Act (UDITPA). 43 See note 25, supra. 44 See, e.g., South Central Bell Telephone Co. v. (continued...) The courts generally will strike down a state tax statute that facially discriminates against out-ofstate entities in favor of domestic businesses unless the taxing state can show that the tax is compensatory in nature and is necessary to offset a tax burden that domestic entities would otherwise bear alone. This exception permits a tax statute to discriminate against nonresident businesses provided a similar tax is imposed solely on domestic businesses, and the net effect of the taxes is roughly equal. 45 Fair relation to services provided. The final part of the Complete Auto test is the requirement that a tax be fairly related to the services provided by the state. The object of this requirement is to ensure that taxpayers receive some benefit in exchange for the taxes they pay. This part of the Complete Auto test has not been litigated with the frequency of the other three parts. A. Bringing the requirements together. Clearly, several issues must be considered when analyzing a proposed tax on a nonresident business. As opposed to the generally unrestricted taxation of resident entities, taxation of nonresidents must meet a variety of constitutional requirements. The most fundamental requisites are the due process requirements that the entity being taxed have some minimum connection with the taxing 44 (...continued) Alabama, 526 U.S. 160 (1999), which was discussed in Compton and Compton, Taxpayers Await Remedies After U.S. Supreme Court Voids Alabama Corporate Franchise Tax, 9 JMT 6 (August 1999). 45 See, e.g., Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), which was analyzed in Cummings, U.S. Supreme Court s Decision in Fulton May Lead to More Findings of Tax Discrimination, 6 JMT 52 (May/Jun 1996).

12 state and that the income attributed to the state be related to values connected with the state. In addition, the tax laws must not violate the negative aspects of the Commerce Clause, as determined under the four-part test of Complete Auto. Only if the law satisfies all of these tests will the taxation be permissible. Even then, the application of the tax is limited to income that can be fairly attributed to the entity s activities in the taxing state. In such a tax scheme, the tax paid by the nonresident entity is related to the income it earned in the taxing state. This approach clearly is more reliable than the all or nothing standard applied to business trusts. IV. Conclusion In many states, the taxation of business trusts is structured as an all or nothing proposition. Various courts have held that a trust established in a state by a resident of the state will be forever subject to taxation on all of its income by that state regardless of where the trust property, trustees, or administration actually reside. No distinction is made between where the income is generated and where it is taxed. For other forms of business, however, a variety of constitutional requirements ensure equitable taxation of nonresident entities. To illustrate, consider a business operating as, e.g., a corporation or partnership that, for some legal or business reason, changes its form to a trust. The business continues to operate in exactly the same fashion as before. In its previous form, as a taxpayer the business s income generally would have been apportioned among the states where the business carried on operations, and each taxing state would have imposed tax on its proportionate share of the tax base. Under the Chase decisions handed down in Connecticut and the District of Columbia, however, the state in which the trust is established may tax 100% of the business s income. Further, this result apparently does not change even if the business moves entirely out-of-state and has no further connection with the state where the trust was established. For a business that chooses to operate as a trust, the tax principles relating to a typical nontrust business should apply. The trust should be permitted to allocate income to the states where it is earned. That approach will limit the threat of multiple taxation and will significantly harmonize taxes paid and income earned.