California Income Tax Issues for Non-california Trusts - Part 2

• Publication year: 2014
• Author: By Matthew G. Brown, Esq., David L. Keligian, Esq., and Gregory E. Lambourne, Esq.*

CALIFORNIA INCOME TAX ISSUES FOR NON-CALIFORNIA TRUSTS - PART 2

By Matthew G. Brown, Esq., David L. Keligian, Esq., and Gregory E. Lambourne, Esq.*

I. INTRODUCTION

The blessing by the Internal Revenue Service (IRS) of irrevocable incomplete-gift nongrantor (ING Trusts) in Private Letter Rulings ("PLRs") 201310002-201310006 and others¹ potentially revives such trusts as a viable state income tax planning tool. However, planners making use of this strategy must pay careful attention to California's unparalleled statutory reach specifically designed to trap and/or claw back tax revenue on trust income.

In Part 1 of this two-part article (published in Volume 19, Issue 4), we reviewed California's broad power to tax trusts with California-source income or resident fiduciaries, including trustees, advisors, protectors, and others with power to direct the trustee or control trust property.

In Part 2, we now review California's taxation of trusts with resident beneficiaries, unique throwback rules, and related reporting requirements (see Section II), California's treatment of self-settled trusts for creditor protection purposes versus tax purposes (see Section III), and state tax limitations imposed by the U.S. Constitution (see Section IV).

II. RESIDENT BENEFICIARIES ARE TAXABLE

A. Generally

Besides imposing state income tax on trusts with California-source income or resident fiduciaries, California may also tax trust income if one or more trust beneficiaries are residents of the state. Revenue and Taxation Code section 17742, imposes current state income tax on "the entire taxable income of a trust, if the... beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor." Note that under section 17742, contingent resident beneficiaries are ignored for income tax purposes.

B. Contingent Versus Noncontingent Beneficiaries

A beneficiary's interest is "contingent" if distributions depend entirely on the trustee's discretion or the happening of another event outside the beneficiary's control.² In such cases, the beneficiary's interest is not ascertainable or even certain, so no California tax is due for non-California-source income when earned by the trust.

A trust beneficiary's interest is "noncontingent" if the beneficiary has a set, enforceable right to an ascertainable income or principal distribution. This may include vested income interests or vested remainder interests. In such cases, a resident beneficiary's interest is noncontingent, and all or part of the trust income is taxable in California when earned by the trust.

C. Multiple Resident and Nonresident Noncontingent Beneficiaries

When a trust has multiple beneficiaries, Revenue and Taxation Code section 17744, taxes trust income "according to the number and interest of beneficiaries resident in this state...." The regulations state that

the trust is taxable upon (a) all income [originating within the state]; and (b) that proportion of all net income...from all other sources which eventually is to be distributed to the noncontingent beneficiaries who are residents of this State.³

For example, if a non-California-sitused nongrantor trust has two noncontingent beneficiaries with equal income interests, one a California resident and the other a nonresident, and the trust has $100,000 of California-source income and $50,000 of non-California income, then California will tax the $100,000 of California-source income and the $25,000 non-California-source income attributable to the resident beneficiary.

Note that all income apportioned to a resident noncontingent beneficiary is taxable in California when earned by the trust, even if the income is not actually distributed to the resident beneficiary. Thus, a non-California-sitused nongrantor trust cannot entirely avoid California taxation of non-California-source income if the trust has one or more resident noncontingent beneficiaries. On the other hand, if all resident beneficiary interests are contingent, no state tax liability is triggered on non-California-source income accumulated in the trust.

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D. Tax on Contingencies, Constructive Receipt, and Throwback Rules

Even if a non-California-sitused nongrantor trust has only contingent resident beneficiaries, California law taxes all trust income when such income is distributed or becomes distributable to resident beneficiaries. Revenue and Taxation Code section section 17745(b), provides that

[i]f no taxes have been paid on the current or accumulated income of the trust because the resident beneficiary's interest in the trust was contingent, such income shall be taxable to the beneficiary when distributed or distributable to him or her.

All income and capital gain accumulated by the trust continues to be treated as income for tax purposes, even if the trust states the accumulated income and capital gain become part of the principal.⁴

Generally speaking, income is "distributed" to a beneficiary when the beneficiary actually receives a distribution from the trust. Income is "distributable" to a beneficiary when the beneficiary's interest becomes a set, enforceable right to an ascertainable distribution, such as when the beneficiary reaches a required age or survives another beneficiary's life interest.

1. Constructive Receipt

Tax is also due upon "constructive receipt" of trust income or principal by an otherwise contingent beneficiary.⁵ The authors are unaware of any California cases or rulings detailing constructive receipt in this context, but state statutes and tax rulings generally appear to track and defer to federal tax law on constructive receipt.⁶

Trust property under a resident beneficiary's control should trigger state income tax liability unless such control remains subject to significant constraints.⁷ Until recently, federal law did not treat mere use of trust-owned property (such as real estate) as a constructive distribution to the beneficiary. In fact, there was contrary authority providing for tax-free distributions for maintenance of trust property used by a beneficiary free of rent.⁸ However, federal law now treats any use of trust property (including real estate) as a taxable constructive distribution.⁹

Bona fide market-rate loans are generally not considered taxable income under the doctrine of constructive receipt.¹⁰ However, below-market or no-interest loans to beneficiaries, and direct or indirect payments on behalf of beneficiaries, constitute constructive distributions, triggering income tax liability for the beneficiary.¹¹

2. Throwback Rules

California applies certain "throwback rules" to any distributions of accumulated income. Revenue and Taxation Code section 17745, subdivision (d), provides that the taxes due

shall be the aggregate of the taxes which would have been attributable to that income had it been included in the gross income of that beneficiary ratably for the year of distribution and the five preceding taxable years, or for the period that the trust accumulated or acquired income for that contingent beneficiary, whichever period is shorter.

Thus, when an otherwise contingent resident beneficiary receives a trust distribution that exceeds his or her share of the trust's current income (taxable currently), the excess is treated as an "accumulation distribution" and "thrown back" to be taxed in the accumulation years at rates applicable to the year of accumulation. The calculations (discussed below) are challenging. The intent is to prevent taxpayers from shifting income from years when income tax rates are higher to years when income tax rates are lower.

California gives a credit for any income taxes the trust paid in another state.¹² And, the throwback rules generally allow beneficiaries to exclude income accumulated before they reached age 21 when calculating the taxable portion.¹³

California's throwback rules are rooted in the federal throwback rules under IRC sections 665-668 for distributions from foreign trusts. These state rules have been challenged on federal constitutionality grounds and have been upheld.¹⁴

3. Accounting and Reporting Compliance with the Throwback Rules

While the accounting and reporting requirements for California's throwback rules are complex and their details are beyond the scope of this article, we provide a brief summary to highlight the key issues:

a. Federal Form 1041 Required, California Form 541 May Be Required

A nongrantor trust will normally file an annual federal Form 1041 to calculate and pay its federal income tax.¹⁵ The trust need only file a California Form 541 (including Schedule J throwback calculations) if the trust has resident fiduciaries, resident noncontingent beneficiaries, or California-source income. If the trust has none of these things, the trust does not file Form 541 (or any other California state tax filings).¹⁶

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b. If the Trust Files California Form 541, Full Throwback Calculations

If the trust files California Form 541, when the trust makes a distribution exceeding the current year's distributable income, the excess is treated as an "accumulation distribution" and is "thrown back" and allocated to the earliest taxable year for which there is prior undistributed net income (UNI). The trust's prior federal and non-California income taxes are also added back to each year's UNI. These distributions are transferred to each beneficiary's California Form 5870A, part 1. There the beneficiary adds the average accumulation distribution for all prior years to the beneficiary's taxable income for the current year and prior five years (dropping the highest and lowest taxable income years). The beneficiary then recalculates what the beneficiary's tax liability would have been for each those years (with the tax rates then in effect). The beneficiary totals the recalculated tax liabilities for those years and, after applying a credit for any trust taxes paid, adds the remaining tax liability to the beneficiary's...