Source: https://www.lexisnexis.com/legalnewsroom/estate-elder/b/estate-elder-blog/posts/california-income-taxation-of-trusts-pitfalls-and-considerations-for-settlors-beneficiaries-and-trustees
Timestamp: 2018-12-13 13:59:39
Document Index: 542285928

Matched Legal Cases: ['§ 17742', '§ 17743', '§ 17745', '§ 17731', '§ 641', '§ 665', '§ 17742']

California Income Taxation of Trusts: Pitfalls and Considerations for Settlors, Beneficiaries and Trustees - Estate and Elder Law Blog - Estate and Elder Law - LexisNexis® Legal Newsroom
Practitioners have long regarded trusts as essential tools for estate planning in no small part because of the potential they offer for federal gift and estate tax savings if structured properly. With so much emphasis on federal tax issues, however, as well as on the myriad non‑tax considerations settlors must take into account when establishing a trust, state income tax considerations are often overlooked. Because state income tax regimes vary wildly,1 estate planning practitioners and their clients should be aware of the particular consequences that may follow the establishment of a trust in a particular jurisdiction. California in particular imposes substantial income taxes on trusts in a manner that many find counterintuitive, and the California Franchise Tax Board has in recent years stepped up its efforts to enforce compliance with these rules. Therefore, this article provides a basic explanation of the manner in which California taxes trust income and highlights a few issues that settlors (as well as beneficiaries of established trusts) might wish to consider in order to minimize California income tax liabilities, as well as rules with which trustees should be familiar to ensure compliance with California law.
While many states tie the income tax liability of a trust to its settlor's residence, California disregards this consideration altogether.2 Instead, it employs a unique analysis that considers (i) the source of the trust's income, (ii) the residence of the trust's beneficiaries, and (iii) the residence of its trustees. Regardless of other circumstances, California taxes all of a trust's income that is attributable to California sources (e.g., rental income from property located in California); this is not so unusual. What makes California unique is that it also taxes all of a trust's accumulated net income if all of its trustees are California residents or if all of its beneficiaries are California residents with "non-contingent" (vested) interests in the trust.3
Where some but not all of a trust's trustees or vested beneficiaries are California residents, California taxes a proportional amount of the trust's accumulated net income.4 For example, where two of a trust's three trustees are California residents (and there is no California source income and none of the beneficiaries are California residents with vested interests), California taxes two-thirds of the trust's accumulated net income. Similarly, if a California beneficiary has a vested interest in 50% of a trust and the remainder of the trust is not subject to any vested interest or is vested in non-California beneficiaries (and the trust has no California trustees or California source income), California taxes 50% of such trust's accumulated net income. Where some but not all of a trust's beneficiaries are California residents with vested interests and some but not all of its trustees are California residents, California applies a formula to determine the portion of the trust's accumulated net income that is subject to California tax.5 Trustees must be aware of these rules in order to comply with applicable reporting requirements as well as to satisfy a trust's California income tax liabilities.
California is also unique in that it imposes a "throwback" tax on California beneficiaries who receive trust distributions if (a) the trust has been non-compliant in paying California income taxes previously due or (b) the beneficiary's previously contingent (unvested) interest in the trust becomes vested by reason of the distribution.6 Under California Revenue & Taxation Code section 17745(d), the accumulated net income attributable to such a distribution is taxed as though it had been included in the income of the beneficiary receiving the distribution ratably in the year of distribution and the five preceding years (or if the income has accumulated for a shorter period, during such period). In general, the tax is calculated in accordance with the federal "throwback" rules that apply to distributions of accumulated net income from foreign trusts.7 Thus, beneficiaries are held accountable for a trust's failure to pay income tax previously owed to California and for income taxes that would have been due to California had the beneficiary previously had a vested interest in the distributed amount.8
Considerations for Trust Settlors
Clearly it would not make sense to structure many of the terms of a trust around state income tax considerations. A settlor is likely to place higher priority on the identity of a trust's beneficiaries, for example, than on whether the residence of such beneficiaries would subject the trust or the beneficiaries to California income tax liability. On the other hand, considering California's current income tax rate of approximately 10% (applicable to capital gains as well as ordinary income), it may be worthwhile for settlors to bear in mind some factors that could minimize California income tax liabilities.
As noted previously, a California beneficiary's residence only gives rise to income tax liability for the trust if such beneficiary's interest is vested. Therefore, where they feel comfortable doing so, settlors may be well advised to structure trusts such that distributions to California beneficiaries are subject to trustee discretion, or at least to an ascertainable standard, rather than being under the beneficiary's control.9 Alternatively, if a settlor anticipates a California beneficiary moving to another state at a certain point (for example, at the conclusion of an educational program), the trust could be structured such that the beneficiary's interest would become vested after such time.10
In addition, a settlor might wish to minimize a trust's California income tax liability by selecting non-California trustees to the extent reasonably possible. Again, there are many important considerations in selecting a trustee that have nothing to do with state income tax liability. However, all other things being equal, it might make sense to select a sibling residing in Nevada, for example, over one living in California to serve as a trustee. It is worth noting here that with respect to corporate trustees, the trustee's residence is deemed to be "the place where the trustee transacts the major portion of its administration of the trust."11 Thus, in some cases a settlor may elect to name as trustee a national financial institution that can administer the trust to the extent possible in a non-California jurisdiction.
Considerations for Trust Beneficiaries
While a trust's beneficiaries rarely have control over the terms of the trust and therefore are not always in a position to minimize the trust's income tax liabilities, some beneficiaries of established trusts should consider the tax impact of their own state of residence. Clearly most beneficiaries will not be motivated to change residence merely to avoid state income tax on a trust distribution. However, those considering leaving the state for a brief period to collect an expected distribution must consider California Revenue & Taxation Code section 17745(e), which provides that a beneficiary is presumed to have maintained California residence if he or she leaves the state within 12 months prior to a distribution and returns within 12 months thereafter. Therefore, a beneficiary wishing to pursue this option would be required to reside outside of California for more than two years in order to avoid the throwback tax. Moreover, terminating California residency is not nearly as simple as physically leaving the state and living elsewhere, or even taking basic steps such as registering to vote and obtaining a driver's license in another state; instead, California considers a myriad of factors in determining whether an individual remains (or has become) a California resident.12 Thus, a beneficiary must be quite motivated in order to prevent having California's throwback tax imposed on an anticipated trust distribution. However, those already planning to leave the state or for whom extensive accumulated income would give rise to considerable California income tax liability may determine that it is worthwhile to consider terminating California residency prior to receiving a trust distribution.
Many individuals - including perhaps even the majority of out-of-state practitioners - are not aware of California's unique, and some might consider burdensome, imposition of taxes on trust income. While it is often impossible or at least impractical for trusts and beneficiaries to avoid these taxes, in some cases settlors and their counsel (as well beneficiaries of established trusts) should consider the suggestions discussed herein for minimizing California income tax liability to the extent reasonably possible. In addition, given the complexity of these rules, trustees of trusts with California beneficiaries and/or California trustees should seek appropriate counsel to ensure compliance with California income tax and reporting requirements.
© Copyright 2010 Morrison & Foerster LLP. The views expressed in this article are those of the author only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
[1] For a comprehensive survey of state income taxation of trusts, see, e.g., State Taxation on Income of Trusts with Multi-State Contacts, compiled by Max Gutierrez, Jr. and Frederick R. Keydel, ACTEC Studies: The American College of Trust and Estate Counsel (2001).
[2] Cal. Rev. & T. Code § 17742(a). For purposes of clarity, this article considers a typical irrevocable trust established for the benefit of individuals. Like the federal income tax regime, California treats property of a "grantor trust" as being owned by its settlor and therefore makes no income tax distinction between the settlor and the trust during such period.
[3] Note that where income is distributable to a California resident beneficiary (i.e., where income is actually distributed to the beneficiary or the beneficiary has a right to such distribution), California taxes the beneficiary rather than the trust with respect to such income. The trust itself is only taxable with respect to accumulated net income.
[4] Cal. Rev. & T. Code §§ 17743-17744.
[5] California Franchise Tax Board, Legal Ruling No. 238 (1959), available at http://www.ftb.ca.gov/law/rulings/active/lr238.shtml.
[6] Cal. Rev. & T. Code § 17745. For example, in the case of a trust where the trustee has complete discretion over any distributions to beneficiaries, a beneficiary who receives a trust distribution would only become vested in such amount upon its distribution.
[7] Cal. Rev. & T. Code § 17731. ("Subchapter J of Chapter 1 of Subtitle A of the Internal Revenue Code, relating to estates, trusts, beneficiaries, and decedents, shall apply, except as otherwise provided." Subchapter J covers I.R.C. §§ 641-692, though its most relevant parts here are §§ 665-668.)
[8] The former is limited to the tax that should have been paid with respect to the distributed amount, while the latter is limited to income that accumulated after the beneficiary reached the age of 21 and during the period in which the beneficiary was a California resident. California Form 541 Schedule J, "Trust Allocation of an Accumulation Distribution" (2006), available at http://www.ftb.ca.gov/forms/06_forms/06_541j.pdf. It is also worth noting that if anytime prior to the distribution, the trust had paid income tax on any portion of the income earned in another state, the beneficiary would likely be entitled to an income tax credit for the amount of that tax. See, e.g., California Franchise Tax Board, Legal Ruling No. 375 (1974), available at http://www.ftb.ca.gov/law/rulings/active/lr375.html. Nonetheless, in some cases these amounts are substantial.
[9] It is worth noting in this context, however, that the California Franchise Tax Board has in certain recent instances attempted to characterize a beneficiary's interest as non‑contingent - even though distributions to the beneficiary were completely discretionary - when a trustee made such regular and substantial distributions that the beneficiary was characterized as having the power in fact to access trust property as if the beneficiary had a right to it.
[10] See the following section, however, for considerations regarding the period during which a beneficiary is considered a California resident and the requirements for terminating California residency.
[11] Cal. Rev. & T. Code § 17742(b).
[12] See, e.g., Franchise Tax Board Publication 1031, "Guidelines for Determining Resident Status," available at http://www.ftb.ca.gov/forms/2009/09_1031.pdf.