Residuary Trust A u/w/o Kassner v. Director, Division of Taxation, No. 000364-2010; Tax Court; opinion by Bianco, J.T.C.; decided and approved for publication January 3, 2013. DDS No. 35-5-8636 [11 pp.]

The will of Fred Kassner, a New Jersey domiciliary, created Residuary Trust A, a resident trust for the benefit of his descendants. Beginning Jan. 1, 2006, and throughout that calendar year, Michelle Kassner, a resident of New York, served as the sole trustee of Trust A and administered it exclusively outside of New Jersey.

During 2006, Trust A owned cash, bonds and stock, including the stock of four S corporations. Each S corporation conducted some business in New Jersey and issued to Trust A a Schedule NJ-K-1 that reported Trust A’s ratable share of the corporation’s income and loss allocated to New Jersey and outside New Jersey. Trust A also earned interest in 2006.

Trust A filed a 2006 New Jersey Income Tax Fiduciary Return (Form NJ-1041) and reported $4,759,708 as its net pro-rata share of S corporation income, of which $2,986,482 was allocated to New Jersey, and $98,002 of interest income. It paid tax on the net pro-rata share that was allocated to New Jersey but not on the income that was allocated outside New Jersey or on the interest income. Trust A did not make any distribution to any beneficiary during 2006.

Concluding that Trust A was taxable under the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 et seq., on 100 percent of its undistributed income, including that allocated outside New Jersey, the director of the Division of Taxation issued a notice of deficiency. Trust A and the trustee appeal.

Held: Because Trust A was not administered in New Jersey, the trustee was a resident of New York, and the trust cannot be deemed to own assets in New Jersey merely because it was a shareholder in S corporations that owned New Jersey assets, it is not required to pay tax on its undistributed out-of-state income.

The Tax Court says N.J.S.A. 54A:2-1 imposes taxes on the New Jersey gross income of all individuals, estates or trusts. N.J.S.A. 54A:5-1(h) includes in gross income the “net gains or income derived through estates or trusts.” N.J.S.A. 54A:5-3 taxes “income or gains of the estate or trust … which has not been distributed or credited to its beneficiaries.”

Pennoyer v. Taxation Div. Dir., 5 N.J. Tax 386 (Tax 1983), and Potter v. Taxation Div. Dir., 5 N.J. Tax 399 (Tax 1983), held that the due process requirement of U.S. Const., Amend. XIV bars New Jersey from taxing the undistributed income of a trust if the trustee, assets and beneficiaries are located outside New Jersey.

The trustee argues that since there was no New Jersey resident serving as a trustee of Trust A during 2006, and no assets were located in New Jersey, Trust A lacks sufficient contacts with New Jersey for the state to tax it as a resident trust for GIT purposes. The director argues that Trust A has the requisite contacts with New Jersey to render its undistributed income taxable.

The director invokes District of Columbia v. Chase Manhattan Bank, 689 A.2d 539 (D.C. App. 1997), and Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Ct. 1999), for the proposition that testamentary trusts could be taxed on their accumulated income without violating due process even if the only connection is the testator’s domicile before his death.

The Tax Court says Pennoyer concluded that the creation in New Jersey of the trust at issue there and the resultant jurisdiction and availability of the New Jersey courts to enforce or interpret the trust were insufficient contacts to support an income tax assessment. It says Pennoyer does not leave room for a contrary interpretation of due process as it applies here. District of Columbia and Gavin have no precedent value in New Jersey and directly conflict with Pennoyer and Potter. Disregarding New Jersey’s case law in favor of contrary out-of-state authority would be inappropriate.

The court then considers the director’s argument that, simply by virtue of owning stock in the S corporations, Trust A can be treated as owning the assets of those corporations, and thus the corporate assets can create the requisite nexus to subject Trust A to tax on its undistributed non-New Jersey income.

The court finds the director incorrectly conflates pass-through taxation with ownership of underlying assets. As defined by 26 U.S.C.A. § 1361(a)(1), an S corporation is a domestic corporation that, having satisfied certain requirements, elects to pass its income through to its shareholders who are subject to taxation thereon. It does not mention any transfer of ownership of the underlying assets from the corporation to the shareholders. Therefore, the owner of stock in an S corporation does not own the underlying corporate assets.

The director also asserts that, pursuant to 54A:5-10, Trust A’s pro-rata share of S corporation income is defined as total S corporation income allocated in and outside New Jersey. Specifically, N.J.A.C. 18:35-1.5(d)(5)(i) provides that a resident shareholder report the entire pro-rata share, regardless of where it is allocated, and 18:35-1.5(d)(5)(ii) provides that a nonresident shareholder report the pro-rata share allocated to New Jersey as New Jersey source income and the entire pro-rata share as everywhere income.

The court says the same issue was raised in Pennoyer where the court, citing due process, refused to apply N.J.S.A. 54A:5-3 to tax income of a trust that has not been distributed or credited to a beneficiary and undistributed income from all sources both within and outside the state.

Similarly, here, N.J.A.C. 18:35-1.5 subjects Trust A to a tax on its income from all sources. Following Pennoyer, the Tax Court says it cannot apply 18:35-1.5 as written and subject Trust A to taxation on its out-of-state income because Trust A does not have sufficient contacts with New Jersey to satisfy due process.

Having determined that Trust A does not have sufficient contacts to New Jersey for the state to tax its undistributed income from sources outside New Jersey, the court says it follows that Trust A owes no taxes on the interest earned in 2006.

For plaintiff — John L. Berger (Lowenstein Sandler). For defendant — Ramanjit K. Chawla (Jeffrey S. Chiesa, Attorney General).