On November 6, the IRS announced the official estate and gift exclusion amounts for 2020 in Revenue Procedure 2019-44.

For an estate of any decedent dying during calendar year 2020, the applicable exclusion is increased from $11.4 million to $11.58 million.  This change increases not only the applicable exclusion amount available at death, but also a taxpayer’s lifetime gift applicable exclusion amount and generation-skipping transfer exclusion amount.  This means a husband and wife with proper planning could transfer $23.16 million estate, gift and GST tax free to their children and grandchildren in 2020.   If no new tax law is passed, the increased exclusion amounts are scheduled to expire on December 31, 2025, which would mean a reduction in the exclusion amounts to $5 million (adjusted for inflation).

The estate, gift and GST tax rates remain the same at 40% and the gift tax annual exclusion remains at $15,000.

The gift tax annual exclusion to a non-citizen spouse has been increased from $154,000 to $157,000.  While gifts between spouses are unlimited if the donee spouse is a United States citizen, there are restrictions when the donee spouse is not a United States citizen.

The New York exclusion amount was changed as of April 1, 2014, and does not match the federal exclusion amount.  In 2019, the New York exclusion amount is $5.74 million.  The 2020 New York exclusion amount has not yet been released.  It is important to note that, unlike the Federal exclusion amount, the New York exclusion amount is not portable, meaning if the first spouse to die fails to utilize his or her full exclusion amount, the surviving spouse will not be able to utilize the first spouse to die’s unused exclusion amount.

Seasoned trusts and estates practitioners know certain truths, such as:

  • Stuff happens.
  • Some estate tax disputes should not be litigated, but they are anyway.
  • Sometimes justice is done.

The recent case of Estate of Skeba (Civil Action No 17-cv-10231, D NJ Oct 3, 2019)) in the District Court of New Jersey reflects all of the above.

In Skeba, the decedent died on June 10, 2013.  The estate was valued at approximately $13.1 million and was largely illiquid, as $10.2 million of value was real estate.  On March 6, 2014, a few days before the due date of the estate tax return, the executor filed for a six month extension of time to file the return and pay the estate taxes.  The executor included a payment of $725,000, and explained that the estate was illiquid, they were working to complete a mortgage on a substantial commercial property in the estate, there had been delays in getting valuations and contested estate litigation, and that they expected the mortgage would be complete in 14 days.  Stuff happens.

About two weeks later on March 18, 2014, the refinance was completed and the estate made a second tax payment of $2.745 million.

On June 25, 2014, the IRS approved the estate’s application for an extension of time to file the estate tax return, granting a six month extension.

On July 8, 2014, the IRS approved the estate’s application for an extension of time to pay the estate tax, granting a six month extension (even though the estate tax had already been paid).

The estate didn’t file the estate tax return for another year.  There was an ongoing Will contest, so the executor did not know if he had authority to act for the estate.  There were postponements due to illnesses of the litigants and one of the lawyers.  The executor was told several times by IRS officials that there would be no penalty as long as the tax was paid.  Stuff happens.

On June 30, 2015, the estate filed the estate tax return, reporting an overpayment of $941,000.

The IRS agreed with the overpayment of tax, but also found that the estate was subject to a “failure to file” penalty of $451,000, equal to 25% of the unpaid tax because the return was filed late.  The IRS calculated the unpaid tax as the amount of tax due less the $725,000 that had been paid on the original due date of the return.

The estate filed for an abatement of the penalty due to reasonable cause.  This was rejected in November, 2015.  The IRS said the estate did not establish reasonable cause or show due diligence.  On these facts?  Really?

The estate filed an appeal with IRS Appeals.  Appeals never responded.

In the litigation that followed, the IRS ignored that it had granted extensions of time to file and pay, and that its representatives had told the executor there would be no penalty as long as the tax was paid. The IRS ignored that the estate had overpaid the tax due by $941,000 eight days after the original due date of the return.  Instead, the IRS instead argued that the return was filed late, the tax had not been paid in full on the original due date, and therefore, the failure to file penalty should apply.  Some disputes should not be litigated, but they are anyway.

Judge Sheridan of the District Court imposed some sense on the government, finding for the estate, and holding that the IRS’ denial of the request for abatement of penalties was arbitrary and capricious.  Sometimes justice prevails.

In a news release on July 26, 2019, the IRS announced that it was sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax.  See IR-2019-132.

The announcement is an indication of increased IRS collection and enforcement activity in the area of virtual currency.  The IRS recently received information about approximately 13,000 taxpayers with virtual currency transactions through a subpoena of the virtual currency exchange, Coinbase.  The IRS expects to send letters to more than 10,000 taxpayers by the end of August.

For taxpayers receiving a letter from the IRS, there are three variations:  Letter 6173, Letter 6174 or Letter 6174-A.  The IRS has previously released Notice 2014-21, which explains that the IRS treats virtual currency as property for federal tax purposes, and discusses the tax treatment of the sale or exchange of virtual currency and mining operations.

The news release also states that taxpayers who do not properly report the income tax consequences of virtual currency transactions may be liable for tax, penalties and interest.  In some cases, taxpayers could be subject to criminal prosecution.

In a closely-watched decision, the U.S. Supreme Court unanimously ruled that a beneficiary’s residence within a state alone does not subject a trust to such state’s income tax.  In North Carolina Dept. of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. Jun. 21, 2019), North Carolina attempted to tax the income of the Kimberley Rice Kaestner 1992 Family Trust because the trust’s beneficiaries were all North Carolina residents, even though the grantor was a New York resident, the trust was governed by New York law and there was no requirement that the trustee distribute the trust’s income to the beneficiaries.

In an opinion authored by Justice Sonia Sotomayor, the Supreme Court held that North Carolina’s attempt to tax the trust’s income violated the due process clause of the 14th Amendment to the U.S. Constitution because North Carolina (1) lacked the minimum connection between the taxpayer (i.e. the trust) and the state, and (2) there was no rational relationship between the income and North Carolina.  The court’s opinion hinged on a determination as to whether a beneficiary’s presence in a state alone would be sufficient to meet the requisite minimum connection.  The court determined that since no trust income was distributed to the in-state beneficiaries, and such beneficiaries had no right to demand any income, such beneficiaries lacked the requisite control or possession of the trust’s assets to establish a connection to North Carolina.

In addition, in its opinion, the Supreme Court indicated that this test could be applied to any “position” in a trust, stating:

“In sum, when assessing a state tax premised on the in-state residency of a constituent of a trust – whether beneficiary, settlor, or trustee – the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax.  Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee.”

Although the Supreme Court attempted to keep the scope of the ruling narrow, Kaestner could pave the way for future attempts to challenge the taxation of trusts by states.  In fact, many states tax trust income based on the grantor’s residence when creating the trust, the location of the beneficiaries and/or the location of the trustees.

New Jersey taxes both non-exempt resident trusts and the New Jersey source income of non-resident trusts.  In New Jersey, an irrevocable trust created by a New Jersey domiciliary or under the Will of a New Jersey domiciliary will be considered a New Jersey resident trust for income tax purposes.  See NJSA 54A:1-2(o)(2).  However, New Jersey case law provides that a New Jersey resident non-grantor trust is exempt from New Jersey tax if it (i) does not have tangible assets in New Jersey, and (ii) does not have any trustees who are residents of New Jersey.  See Pennoyer  v. Director, 5 NJ Tax 386 (Tax 1983), Potter v. Director, 5 NJ Tax 399 (Tax 1983), and Kassner Residuary Trust A v. Director, 27 NJ Tax 68 (Tax 2013).

Similarly, New York taxes both non-exempt resident trusts and New York source income of non-resident trusts.  In New York, an irrevocable trust created by a New York domiciliary or under the Will of a New York domiciliary will be considered a New York resident trust for income tax purposes.  See New York Tax Law 605(b)(3).  Under New York tax law, a resident non-grantor trust can become exempt from New York income tax if the following conditions are met: (i) all of the trustees are domiciled outside of New York, (ii) all of the property held in the trust is located outside of New York, and (iii) the trust cannot receive any New York source income.  See New York Tax Law 605(b)(3)(D)(i).

Note that with “incomplete gift non-grantor trusts,” New York will tax the trust as if it were a grantor trust.  See New York Tax Law 612(b)(41).

The Kaestner ruling, as well as New Jersey’s case law and New York’s statute, demonstrates the importance of consulting with practitioners when establishing trusts or changing trust fiduciaries.  A careful analysis of the laws of different jurisdictions should be made to ensure that the trust’s income does not incur unexpected state taxes.

Reprinted with permission from the 3/28/19 edition of the New Jersey Law Journal© 2019 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.


In light of ever-present budget shortfalls in most states’ coffers, a go-to revenue generating technique affecting all business owners is a “nexus” audit. The U.S. Supreme Court decision last summer in South Dakota v. Wayfair, 138 S.Ct. 2080 (2018), overturning the longstanding precedent in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), has lengthened the states’ reach to audit an out-of-state business without regard to whether the business ever physically crossed the state’s borders.

In the “post-Wayfair” nexus landscape, many small and mid-size businesses are learning for the first time about their income and sales tax obligations from business activities (nexus) inquiries sent by taxing authorities invigorated by the changes in the law. The business can be blindsided by the substantial assessments over a period of six to eight years, including interest and penalties and potential personal liabilities for the owners.

This article analyzes what it means for a business to have physical and/or economic nexus through, respectively, its activities and receipts generated in another state. In addition, we discuss the importance of a prophylactic nexus study and tax savings that can be achieved with a proper allocation analysis.

Pre-’Wayfair’ Definition of Physical Nexus

Since the 1992 Supreme Court ruling in Quill, an out-of-state (also known as “foreign”) business with significant physical presence in another state is deemed to have nexus with that state. The Quill case specifically addressed a state’s ability to impose sales tax, but stands broadly for the “physical presence” nexus test in the income tax arena as well.

A business with physical contacts in a state is considered to avail itself of that state’s benefits and privileges (this assumption is automatic for domestic businesses). In turn, the state is considered to have jurisdiction to impose taxes on the nonresident business.

Physical contacts, beyond outright ownership or leasing of property, may include, among other things, in-state deliveries (other than by common carrier) and banking activities in the state. For sales tax purposes, such contacts also include solicitation of sales, whether by employees, independent contractors or other agents.

State income tax is generally imposed on an out-of-state business on income sourced within the state. Federal protection is provided under 15 USC §381 (commonly known as “P.L. 86-272”), for businesses whose only activity in the state is solicitation. However, it does not protect a business from the obligation to collect sales and use tax. It also does not protect against non-income franchise tax. For this reason, states have enacted statutes that calculate tax based on gross receipts, apportioned capital, net worth and other non-income measures, such as the Washington Business and Occupancy Tax, Michigan Business Tax, Texas Margin Tax, and Ohio Commercial Activities Tax.

Over the past decade, states have pushed the boundary to assert nexus based on tenuous contacts in the state, such as licensing a trademark (Lanco v. Div. of Taxation, 188 N.J. 380 (S.Ct. 2006)), or storing website “cookies” on local computers (Mass. Regs. Code 830 CMR §64H.1.7(2). In addition, under “Amazon laws,” states created a rebuttable presumption of nexus when a business entered into referral agreements with residents. New York’s highest court upheld such a statute against constitutional challenge in Overstock.com v. N.Y.S. Dept. of Tax’n & Fin., 20 N.Y.3d 586 (Ct. of App. 2013), a ’g Amazon.com v. Dept. of Tax’n and Fin., 913 NYS2d 129 (App. Div. 2010).

States have also asserted claims of physical nexus when a business enrolls in the Fulfillment By Amazon (FBA) program. This is a logistics service offered by Amazon to e-commerce businesses. The FBA directs a business to send inventory to a warehouse in a particular state, and subsequently, unbeknownst to the seller, may redistribute it to a warehouse in another state. That second state will often claim that inventory stored there creates nexus. The quantity of inventory or length of time the inventory spends in the warehouse seemingly does not make a difference.

Since states continued to insist that nexus was created through tenuous physical contacts and tortured interpretations of case law under Quill, it was only a matter of time before the Supreme Court would be asked to bless “economic nexus” rules, which do not require any physical presence at all.

Economic Nexus under ‘Wayfair’

In at least the second half of the past quarter-century since Quill was decided, pressure has been mounting to overturn this precedent because of perceived unfairness to
brick-and-mortar businesses. States also began to feel the pinch from not being able to collect tax from the elusive and sometimes anonymous online marketplace. This culminated in several state campaigns to “Kill Quill.”

To provoke a constitutional challenge, South Dakota passed a sales tax law creating nexus if an out-of-state business generated over a certain dollar threshold of revenue ($100,000) from the state, or conducted a certain number of transactions (200) in the state. This new “economic nexus” law did not require physical presence in the state. South Dakota then proceeded to sue the largest out of-state vendors, including Wayfair and Overstock. Losing in the state courts that considered themselves duty-bound to follow Quill, South Dakota appealed to the U.S. Supreme Court and won.

Post-’Wayfair’ Legislation

New York passed a sales tax economic nexus statute decades before South Dakota did, but waited patiently for almost 30 years for constitutional approval to begin to enforce it. N.Y. Tax Law §1101(b)(8)(iv), and regulations under NYCRR 20 §526.10, require a vendor to remit sales tax if it conducts more than $300,000 of sales and more than 100 sales of tangible personal property in the state. Now, post-Wayfair, New York issued guidance in Notice N-19-1, in January 2019, that it will start enforcing this existing statute immediately.

New Jersey was the first state to pass an economic nexus statute after Wayfair was decided. The New Jersey thresholds exactly mimic the requirements of the South Dakota statute. In addition, in the case of remote sales, New Jersey has imposed a direct obligation for the marketplace “facilitator” to collect sales tax, as long as such middleman has access to the necessary information from the seller. We anticipate that New Jersey and other states will further develop audit programs that seek to aggressively enforce the new economic nexus laws.

Importantly, other middlemen, such as out-of-state wholesalers and distributors that do not sell goods to end users, generally do not need to register to collect sales tax, regardless of nexus to a state, because their sales are considered to be sales-for-resale. However, in light of the new laws implicating marketplace facilitators, under the more aggressive post-Wayfair audit programs, if such wholesalers and distributors cannot present valid resale exemption certificates to the taxing authorities, they may be held jointly liable for sales tax with the retail sellers.

Finally, note that the post-Wayfair legislation is intended to supplement and not replace the physical nexus test, which continues to apply to a business falling below the economic nexus thresholds. For such states, and for states that have not passed economic nexus legislation, inventory stored, employees located, orders taken, and affiliate contracts made in the state, along with many other physical contacts, continue to be relevant factors for determining nexus.

Income Allocation

An important aspect of the nexus analysis is to determine allocation of receipts in multiple states and whether income and/or sales tax returns need to be led in those states.

In the area of income or receipts-based tax reporting, states including New Jersey and New York utilize a single-factor sales receipts formula to allocate income of domestic and foreign businesses. This is a simplified method from previous statutes that also weighed property and payroll in a three-factor allocation formula. The calculation currently is a ratio of receipts derived from the state as numerator over the denominator of all receipts derived from all other jurisdictions. New Jersey used to “throw out” from the denominator receipts not subject to income tax in any jurisdiction, thus capturing this otherwise untaxed income, but in 2010 abolished this requirement to encourage businesses to come to New Jersey. N.J.S.A. §54:10A-6(B); N.J.A.C. §18:7-8.7(d).

A nexus analysis can ensure that income generated from states where the company may have no nexus is excluded from the total income allocated among states where the company does have nexus. This could be because the business does not have physical contacts with the state, falls below economic nexus thresholds and/or the state has not passed economic nexus legislation. If properly allocated, income (or other type of tax base) from states where the business does not have nexus can potentially completely escape tax in any state at the entity-level.

Conclusion

In light of potential pitfalls facing a multi-state business with regular ties to several states (direct or indirect, and now, under Wayfair, purely economic), as well as potential tax savings from proper income allocation, it is every Controller’s or Chief Financial Officer’s fiscal obligation to have a confidential (and, if conducted by attorneys, attorney-client privileged) state-by-state nexus study conducted of its business’ multi-state operations. If the business has exposure, it can apply for a voluntary disclosure program, or develop another compliance strategy to limit the look-back period, obtain a waiver of penalties and prevent personal liability to the owners that may not be dischargeable in bankruptcy.

Finally, income/receipts allocation for closely-held pass-through entities, such as S corporations and LLCs treated as partnerships, has tax implications for individual partners or shareholders. While outside the scope of this article, the individual tax consequences can be mitigated and even eliminated with proper residency planning.