The state of Minnesota is potentially out more than $130 million this budget cycle after losing a court battle that will greatly limit the state's ability to collect taxes on trust accounts in other states.

Taxpayers successfully argued before the state Tax Court and the Minnesota Supreme Court that the state's attempt to tax "resident trusts" that are not actually in Minnesota violated the due process provisions of the state and U.S. Constitutions.

Now the Department of Revenue expects to take in $34.4 million less per year for the next two years and be forced to give out the same amount in rebates — plus interest — for overtaxing in previous years. The state's exposure, first reported by Minnesota Public Radio News, was revealed in recent state bond-sale documents.

Although a $130 million loss reflects just a fraction of the state's two year, $48 billion budget, it could eat into the state's fiscal flexibility in a time of growing uncertainty over the economy and the state's financial outlook. State tax revenue has been at or above forecast in recent months, but the state lost jobs in July and the unemployment rate ticked up, albeit leaving it still below the national average.

The budget deal negotiated between Gov. Tim Walz, DFL House Speaker Melissa Hortman and Republican Senate Majority Leader Paul Gazelka in the spring was a hard-fought compromise in which every dollar was contested.

"We sure could provide a lot of early childhood with that money," state Rep. Ryan Winkler, DFL-Golden Valley, said of the loss.

This is not the only budget issue Walz is dealing with since the Legislature left town in May. The Department of Human Services overbilled the federal government by more than $25.3 million for opioid addiction treatment.

But the tax issue is larger and will persist into the future. The trusts are popular among wealthy taxpayers seeking privacy, convenience and tax advantages. About 500 to 1,000 trusts will be affected by the change.

The Minnesota Tax Court case was filed by a Texas-based trustee representing separate funds set up by Reid MacDonald, the former CEO of Faribault Foods, Inc., on behalf of his four children. The legal challenge stemmed from the 2014 sale of stocks in the Minnesota business that the state determined was subject to state income taxes.

The family initially paid state income taxes under protest and then filed again seeking a refund of more than $250,000 for each of the trusts. They filed the lawsuit after the state revenue commissioner denied the refund claim.

The Minnesota Tax Court ruled in the family's favor in May 2017, and the Minnesota Supreme Court upheld the decision last year. The U.S. Supreme Court has since declined to review an appeal by the state.

Under Minnesota law, "resident trusts" are subject to taxation on income and gains from intangible assets even if they have no relation to the state, as long as the grantor was a Minnesota resident at the time the trust was established.

William Fielding, the trustee for the MacDonald family funds, persuaded the court that the statute violated the due process provisions of the Minnesota and U.S. Constitutions.

The trusts argued that Minnesota had no authority to tax them on gains from a sale of stock that was possessed by investment accounts managed outside of Minnesota.

The revenue commissioner sought to link the trusts to Minnesota through Reid MacDonald's residency at the time of the trusts' creation and the use of a Minnesota attorney to draft the original trust documents, copies of which the commissioner pointed out were kept in Minnesota. The commissioner also argued that Faribault Foods' headquarters in Minnesota further underscored the state's authority to tax the proceeds of the stock sale.

Tax Court Judge Bradford Delapena characterized the connection upon which the state relied to tax the funds as relatively superficial.

Minnesota Supreme Court Justice Natalie Hudson, writing the court's majority opinion, agreed that the trusts' relevant contacts with Minnesota during the 2014 tax year were "either irrelevant or too attenuated to establish that Minnesota's tax on the trusts' income from all sources complies with due process requirements."

MacDonald's residence years before the stock transfer were less relevant than any links between the trustee and the state during the 2014 sale.

"These intangible assets were held outside of Minnesota, and thus do not serve as a relevant or legally significant connection with the State," Hudson wrote.

J. Patrick Coolican • 651-925-5042