Estate Planning: Taxing Trusts
California CPA September 2009
Navigating the Waters of California’s Income Taxation of Trusts
By Wendy Abkin, Esq.
Unlike the law regarding the income taxation of trusts in many other jurisdictions, the grantor residence is inconsequential under California’s law. Rather, the income of a trust is taxed by California if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident (Revenue and Taxation Code Sec. 17742).
A trust’s terms determine the extent of a beneficiary’s interest in the trust income or corpus, and whether the beneficiary is contingent or noncontingent. For example, when a trust’s terms state that distributions to a particular beneficiary are subject to the trustee’s discretion, then that beneficiary’s interest is contingent because it’s subject to the trustee’s decision to make a distribution. To the extent the condition is satisfied, however, the beneficiary will be considered to be noncontingent and the applicable tax consequences will follow.
The issue can become more complicated when the trust’s terms limit the trustee’s discretion or when an otherwise contingent beneficiary is granted powers over trust corpus or income. Additionally, contingencies can lapse over time, as a beneficiary’s rights to income or corpus “ripen” if the beneficiary attains a given age, educational status or satisfies other conditions of the trust. Thus, a particular trust’s California tax responsibilities can be a moving target, forcing the fiduciary to constantly monitor circumstances.
Fiduciary and Trustee Defined
California law is unique in its use of the term “fiduciary” rather than “trustee.” A fiduciary includes a guardian, trustee, executor, administrator, receiver, conservator or any person, whether individual or corporate, acting in any fiduciary capacity for any person, estate or trust (RTC Sec. 17006). However, it’s unclear whether a person with a particular title (e.g., a trust protector or trust adviser), responsibilities (e.g., a member of an investment committee) or lack of responsibilities (e.g., a passive trustee) qualifies as a fiduciary.
If a trust is managed by an institutional or corporate fiduciary, the residence is the place where the corporation transacts the major portion of its administration of the trust [Sec. 17742(b)]—not necessarily the corporation’s domicile, headquarters or principal place of business.
The portion of a trust’s undistributed income that is taxed by California depends on the percentage of California resident fiduciaries. When a trust has a sole fiduciary that is a California resident, California will tax the entire taxable income of the trust—including accounting income and income attributable to corpus. When there are multiple fiduciaries and not all are California residents, California taxes the trust’s income in proportion to the California resident fiduciaries (Sec. 17743).
Similar allocation rules apply when taxation is based on the residence of the beneficiaries. When there is a sole resident, noncontingent beneficiary (and all fiduciaries are nonresidents), California taxes the undistributed income to the extent of that beneficiary’s interest in the income. In the case of multiple beneficiaries, California taxes the trust income in proportion to the California resident noncontingent beneficiaries (Sec. 17742).
When there are multiple resident and nonresident beneficiaries and multiple resident and nonresident fiduciaries, income is first allocated according to the proportion of resident to nonresident fiduciaries. The remaining income is then allocated according to the proportion of resident to nonresident beneficiaries.
For example, assume a trust has two trustees, one of which is a California resident; and four noncontingent beneficiaries, one of which is a California resident. Thus, half of the trustees are California residents and one-fourth of the noncontingent beneficiaries are California residents. If the trust has $100,000 of non-California source undistributed income, California will tax half of the income based on the residency of the California trustee, and will also tax one-fourth of the remaining $50,000 of undistributed income based on the residency of the one California noncontingent beneficiary, for a total of $62,500 of income subject to California income tax.
Finally, even when a trust’s beneficiaries and fiduciaries are all nonresidents, the trust will still be subject to tax on its gross income from sources within California (Sec. 17951). This includes income from real or personal property located in California, business carried on within California, and intangible personal property having a business or taxable location in California.
Trust Filing Obligations
A trust must file a fiduciary income tax return (Form 541) if it has net income from all sources in excess of $100 [Sec. 18505(e)], or if it has gross income from all sources in excess of $10,000 [Sec. 18505(f)], regardless of the amount of net income. Failing to file and pay any taxes due may result in penalties and interest. The uncertainty about potential exposure from unfiled tax returns continues until those returns are filed and the statute of limitations expires. The amnesty penalty will apply for tax years prior to 2003 (Sec. 19777.5).
The Voluntary Disclosure Program is one option to be considered by “compliance-challenged” trusts. The FTB is authorized by statute to provide relief to entities—including trusts—that voluntarily come forward regarding their deficiencies. If the trust is accepted into the program, then the FTB and the trust execute a written
VDP agreement under which the trust’s exposure for prior year taxes will be limited to the six immediately preceding years (the look-back period) (Sec. 19191).
The program is limited to trusts that have not registered with the California Secretary of State and who voluntarily come forward prior to contact by the FTB.
Additionally, the trust cannot have ever filed a return with the FTB, any administrative activities within California must have been “inconsequential” and the trust cannot have any noncontingent California resident beneficiaries.
The initial application and exchange of information can be undertaken anonymously, so the trust can get an indication of whether relief will be granted before it is required to disclose its identity. Most significantly, the FTB will waive its authority to make any assessments for years prior to the six-year look-back period. The FTB can also waive most penalties for that period.
The VDP agreement, however, will be voided if the trust misrepresents material facts; fails to file any return; pay in full any tax, penalty or interest for the periods covered by the agreement; or understates the tax liability for any year covered by the agreement and cannot show a good faith effort to accurately compute the tax liability.
Trusts not eligible for VDP should consider a Filing Compliance Agreement. The FTB’s authority for FCAs derives from Sec. 19501 and various other provisions that allow it to abate penalties upon a showing of reasonable cause.
Qualified taxpayers must voluntarily disclose, file and make full payment to the FTB for all years for which they failed to file a California return. The FTB will waive the penalties for the return filings identified in the agreement when reasonable cause is an available defense to penalties and the trust can show reasonable cause. Most commonly these are the failure to file and failure to pay penalties. The failure to pay estimated tax and the amnesty penalties cannot be waived. Unlike a VDP, an FCA is not limited to a six-year look-back period.
In addition to dealing proactively with the problems from prior years, trust fiduciaries must consider whether the trust can or should mitigate its California tax exposure for future years. When a trust is taxed by California because of a fiduciary’s California residency, one option is to replace California resident fiduciaries or add nonresident fiduciaries to dilute the percentage of trust income that is subject to tax. The fiduciary and CPA advisers should also evaluate the impact of future distributions and residency considerations of beneficiaries. Finally, trust fiduciaries must pay attention to future events that may impact taxation, such as a contingency lapsing for a particular resident beneficiary due to age.
California’s rules regarding the income taxation of trusts can be challenging to navigate. However, careful planning and monitoring of trust contingencies can help trust fiduciaries and their advisers minimize the potential tax exposure of beneficiaries.
Wendy Abkin, Esq. is a partner at Sideman & Bancroft LLP.