State Estate Taxes and the Due Process Clause

After two decades of relative dormancy, we are witnessing a resurgence in state estate tax controversies. Federal estate tax amendments beginning in 2001, which eliminated the federal credit for state estate taxes, greatly diminished the general significance of state estate taxes, as most states repealed their preexisting “pickup” or “sponge” taxes designed to absorb the maximum federal estate tax credit.¹ Indeed, as of 2020, of the 50 states that had some form of federally based “death tax” in 2001, 32 had no death tax at all and only 18 states had some form of death tax.² Recently, however, five state courts have addressed the due process clause implications of state estate taxes. Each court considered the question of whether the due process clause permitted the state to impose estate tax on qualified terminable interest property. The U.S. Supreme Court has thus far declined to consider this question, having denied petitions for certiorari from two of the state court decisions that raised it (most recently just two weeks ago³). In 2019, however, the Court did address a related state trust tax issue in Kaestner,⁴ which informs the QTIP due process analysis.

Background

QTIP trusts have become popular estate planning tools.⁵ These trusts are commonly used when individuals remarry and want to provide for their new spouse during that spouse’s life, but to bequeath the remainder of their estate to their children from a prior marriage.

QTIP trusts can also provide significant federal estate tax benefits. Under the federal estate tax, the marital deduction allows an estate to reduce the estate’s taxable value by specific property that passes or has passed from the decedent to the decedent’s surviving spouse.⁶ In general, a marital deduction defers the estate tax on the property subject to the marital deduction until the death of the surviving spouse; it does not eliminate the tax liability altogether. An estate generally may not make use of the marital deduction when conveying terminable interest property (the “terminable interest rule”).⁷ There is an exception, however, to the terminable interest rule for QTIP.⁸ To qualify as QTIP:

• the property must pass from the predeceasing spouse;

• the surviving spouse must have a qualifying income interest for life in the property; and

• the executor of the estate of the predeceasing spouse must elect to designate the property as QTIP.⁹

Using a QTIP trust allows for the deferral of the federal estate tax on the assets used to create the QTIP trust until the surviving spouse dies.

Recent State Estate Tax Due Process Clause Challenges

In recent years, controversies have arisen over the states’ constitutional power to impose their estate taxes on QTIP trust property. The fact patterns of most of these cases are essentially the same. The predeceasing spouse, a domiciliary of State A, creates a QTIP trust under his or her will for the benefit of the surviving spouse. The surviving spouse dies while a resident of State B, with intangible property in the trust passing to beneficiaries designated by the predeceasing spouse’s will. Although the decedent’s federal estate tax return includes the value of the QTIP assets, the estate maintains that for state estate tax purposes, the transfer of the QTIP assets occurred in State A and State B had no constitutional connection with the transfer or the assets, although the decedent was a domiciliary of State B.

Massachusetts

In Shaffer v. Commissioner of Revenue,¹⁰ the predeceasing spouse (Robert) died in 1993 while domiciled in New York, and his will established a QTIP trust for the benefit of his wife (Adelaide). Adelaide died in 2011 while domiciled in Massachusetts. Although the value of the QTIP assets, all of which were intangibles, was included in Adelaide’s federal estate tax return, it was not included in the estate’s Massachusetts tax return. The estate’s position was that there was only one transfer of the QTIP assets, which took place when Robert died in New York, and that any effort by Massachusetts to tax the transfer of the assets would violate the due process clause because it had no constitutional connection with the transfer. The commissioner’s position, with which the Massachusetts Appellate Tax Board agreed, was that:

Under this analysis, because Adelaide was domiciled in Massachusetts at the time of the second transfer, the state had a due process connection with the transfer of the QTIP trust’s intangible assets at the time of transfer.

The Massachusetts Supreme Judicial Court agreed with the commissioner’s position and held that the state’s estate tax on the transfer of the QTIP trust’s assets at the time of Adelaide’s death did not violate the due process clause. After reviewing the governing constitutional principles,¹² the court focused on the key question presented, namely “what constitutes a ‘transfer’ for estate tax purposes,” and specifically, for due process purposes.¹³ In examining this question, the court relied upon the U.S. Supreme Court’s analysis of the meaning of “transfer” for estate tax purposes in Fernandez v. Wiener,¹⁴ which involved the meaning of transfer in the context of an estate tax levied on the termination of marital community property. The Shaffer court noted that in Fernandez, “The Court stated that an estate tax is not limited to literal transfers at death, but ‘extends to the creation, exercise, acquisition, or relinquishment of any power or legal privilege which is incident to the ownership of property.’”¹⁵ The Shaffer court further observed:

Based on this reasoning, the court agreed with the commissioner’s and the board’s position that two transfers of QTIP property occurred for estate tax purposes. Accordingly, because Adelaide was domiciled in Massachusetts at the time of the second transfer, Massachusetts had a sufficient due process connection with the transfer to allow the state to impose an estate tax on the value of the QTIP assets.

Connecticut

In a closely analogous case, on which the Shaffer court had heavily relied, the Connecticut Supreme Court reached a similar conclusion. In Estate of Brooks v. Commissioner of Revenue Services,¹⁷ the predeceasing spouse (Everett) died in 2000 while domiciled in Florida, and his will established a QTIP trust for the benefit of his wife (Helen). Helen died in 2009 while domiciled in Connecticut. Although the value of the QTIP assets, all of which were intangibles, was included in Helen’s federal estate tax return, it was not included in the estate’s Connecticut tax return. The estate’s position in Brooks, like the estate’s position in Shaffer, was that the state of the decedent’s domicile lacked a sufficient connection with the transfer of the trust assets to satisfy due process limitations on the state’s power to impose an estate tax on the transfer.

In an extraordinarily thorough opinion that carefully reviewed the relevant Supreme Court precedent, the Connecticut court, like the Massachusetts court, relied on the Fernandez case in discarding earlier case law and embracing a “broader concept of transfer” reflecting the Court’s contemporary “evaluation of the practical economic and legal shifts occasioned by death rather than a reliance of formalistic property law distinctions in determining whether a properly taxable transfer has occurred.”¹⁸ Within this framework, the court concluded that “the tax in the present case is directly targeting the changes in legal and economic relationships to the property, not a prior transfer.”¹⁹

As for whether Connecticut had a sufficient connection with the transfer to satisfy due process restraints, the court first described the controlling constitutional criteria:

Under these forgiving standards, the court had little difficulty in concluding that Connecticut had a sufficient due process connection with the transfer of the QTIP assets to satisfy due process strictures: The decedent was a domiciliary of the state at the time of her death; she enjoyed all the benefits of the state associated with her residence there; and she enjoyed the economic benefits of her beneficial life interest in the trusts. “This nexus is sufficient for due process.”²¹

Oregon

If one were looking for further authority for the proposition that states possess the constitutional power to impose an estate tax upon the transfer of QTIP trust assets upon the death of a resident decedent that was the beneficiary of the QTIP trust, one can find it in the Oregon Tax Court’s decision in Estate of Evans v. Department of Revenue.²² In Evans, the predeceasing spouse (Donald) died in 2012 while domiciled in Montana, and his will established a QTIP trust for the benefit of his wife (Helene). Helene died in 2015 while domiciled in Oregon. Although the value of the QTIP assets, all of which were intangibles, was included in Helene’s federal estate tax return, her estate maintained that Oregon lacked the power under the due process clause to impose an estate tax on the value of the QTIP assets that were transferred at her death.

In yet another extraordinarily thoughtful and detailed opinion, which reviewed the controlling due process principles bearing on states’ power to impose estate taxes on the transfer of QTIP trust assets, the court concluded that “inclusion of the trust property in Helene’s estate does not violate the federal Due Process Clause because Helene had an exclusive lifetime interest in the trust property and was an Oregon domiciliary at the time of her death.”²³ Although the Oregon court’s ruling should be of no surprise to anyone who has had the patience to read through the preceding discussion, perhaps the one additional point worth noting regarding the Oregon court’s opinion was its consideration of the implications of the U.S. Supreme Court’s recent decision in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust²⁴ on the question presented.

In its discussion of Kaestner, the Oregon court observed that “the Court restated a longstanding two-step analysis to decide whether a state tax abides by the Due Process Clause, which this court now applies.”²⁵

In applying the minimum contacts test, the Oregon court noted that “the Court has long recognized that the domicile of a person whose death brings about a transfer affords an adequate constitutional basis for the state to impose the tax.”²⁷ The Oregon court proceeded to summarize the U.S. Supreme Court’s opinion in Curry v. McCanless.²⁸ While noting that “Curry predates the United States Supreme Court’s two-step formulation of the due process analysis,”²⁹ the court read Curry as establishing that the requisite minimum connection to impose an estate or inheritance tax always exists between the state of a person’s domicile and rights that the person holds in intangible property.³⁰ Then, turning to Kaestner, the court observed:

As for the “rational relationship” test, which the Kaestner Court did not address, the Oregon court, after a detailed review of the controlling Supreme Court precedent, had little difficulty in joining the other courts that have considered the question. The Oregon court concluded that Oregon, as the state of the decedent’s domicile, “could rationally measure its tax by the value of the entire property” in the QTIP trust.³²

Maryland

Maryland’s highest court also addressed the QTIP state estate tax issue, although the majority opinion declined to consider the due process argument. In Comptroller of the Treasury v. Taylor,³³ the predeceasing spouse (John) died in 1982 while domiciled in Michigan, and his will established a QTIP trust for the benefit of his wife (Margaret). Margaret lived in Michigan until 1993 but died in 2013 while domiciled in Maryland. Although the value of the QTIP assets, all of which were intangibles, was included in Margaret’s federal estate tax return, it was not included in the estate’s Maryland tax return.

The Maryland Tax Court sustained the tax.³⁴ The estate had asserted a due process argument, and although the tax court considered the issue during the hearing,³⁵ it did not explicitly address the issue in its ruling.³⁶ On appeal, the Maryland Circuit Court reversed the tax court on both statutory and due process grounds.³⁷ On further appeals to the Maryland Court of Special Appeals and the Maryland Court of Appeals, both courts declined to address the due process argument because the Maryland Tax Court decision had not explicitly addressed it,³⁸ although they both agreed with the tax court that Maryland had the statutory authority to impose estate tax on the QTIP trust property.

The dissenting opinion in the Maryland Court of Appeals, however, embraced the opportunity to analyze the due process clause issue and concluded that Maryland was constitutionally barred from imposing the estate tax on the QTIP trust property.³⁹ The dissent recognized that Maryland had the constitutional authority to tax intangible property of a resident domiciled in Maryland, but found that the surviving spouse had no legal ownership of the QTIP trust property. In essence, the dissent rejected the fictional deemed transfer from the predeceasing spouse to the surviving spouse that other courts had adopted in rejecting due process concerns.⁴⁰

The dissenting opinion also supported its due process argument on the ground that the majority’s “interpretation of the QTIP scheme creates a serious risk of double or inconsistent taxation.”⁴¹ The dissent presented two hypotheticals to illustrate its double taxation concerns. In the first, John was domiciled in Maryland at his death and made a federal QTIP election but not a Maryland election.⁴² In this scenario, Maryland would tax the estate when John died and, because of the deemed transfer, again when Margaret died. In the second scenario, John was domiciled in Massachusetts when he died and made a federal and Massachusetts QTIP election.⁴³ When Margaret died domiciled in Maryland, both Massachusetts and Maryland would impose estate tax on the QTIP trust property.

The dissent recognized that “Maryland, despite having never afforded any benefits or privileges to Mr. Taylor’s estate in either of these scenarios, would receive a significant windfall based solely on the relocation of his surviving spouse.”⁴⁴ Thus, the dissent asserted that the due process clause precluded Maryland from imposing estate tax on the QTIP trust property.⁴⁵ While the dissent’s concerns may be warranted from the standpoint of sound tax policy, we are skeptical that they raise persuasive due process issues in light of the Court’s explicit repudiation of its briefly held view that the due process clause forbids double taxation of intangibles,⁴⁶ and its more forgiving approach to concerns of “inconsistent taxation” under the due process clause as contrasted with its approach to such concerns under the commerce clause.⁴⁷

Washington

No state QTIP estate tax discussion would be complete without mentioning one of the most notable recent retroactivity cases, which also implicated due process concerns. In In re Hambleton,⁴⁸ the predeceasing spouse died in 2005 and the estate made a federal QTIP election. Washington did not have an estate tax at the time. The surviving spouse died in 2006, by which point Washington had enacted an estate transfer tax, but it did not encompass the deemed transfer to the surviving spouse (as did the taxes in the QTIP cases discussed above).⁴⁹ Washington amended its estate tax statute in 2013 to impose an estate tax expressly on QTIP trust property when the surviving spouse dies, and did so retroactively to 2005. The estate challenged the retroactive aspect of the statute on due process grounds. The Washington Supreme Court concluded that the retroactive amendment did not violate the due process clause because the eight-year retroactivity period was rationally related to preventing a fiscal shortfall, and the U.S. Supreme Court denied the estate’s petition for certiorari.

Conclusion

State estate tax issues are not the first thing that come to most state tax practitioners’ minds in an era dominated by the tax challenges of COVID-19 and the digital economy. Nevertheless, as the foregoing discussion of QTIP trusts reveals, state estate taxes can raise challenging issues. Indeed, if the federal estate tax becomes more broadly applicable, either through reduced exemptions or other means, QTIP trusts may be the focus of additional estate planning strategies⁵⁰ that create state tax issues.

A further complicating factor is the QTIP election procedures at the federal and state levels.⁵¹ For example, New York recently amended its tax law to require the QTIP election to be made directly on a New York estate tax return for decedents dying on or after April 1, 2019.⁵² New York law also requires the inclusion of the value of any QTIP for which a New York marital deduction was previously allowed in the surviving spouse’s New York gross estate, whether the QTIP election was made on the transferring spouse’s New York estate tax return or on a federal pro forma return.⁵³ Maine likewise significantly amended its estate tax effective in 2013 and issued guidance addressing the QTIP election process.⁵⁴

In short, as QTIP trusts become increasingly complex both substantively and procedurally, state tax practitioners should not be surprised to confront variations on the issues that state courts have addressed in recent years.