Order Out of Chaos ̶ making [the Other Half Of] California's Trust Taxation System Work
| Publication year | 2016 |
| Author | By Paul N. Frimmer |
By Paul N. Frimmer1
The author's first article on the subject of California's income taxation of trusts was limited to a discussion of taxation based upon the California residence of the trust beneficiaries.2 This article will explore the second nexus for taxation of trusts in California - the residence of the fiduciary.3 As with the first article, the purpose of this article is to outline workable rules for applying the statutes and to suggest changes or interpretations if the statutes are difficult or impractical to apply.
In general, California imposes income tax on the accumulated income of a trust if the fiduciary is a resident of California, or in the case of a corporate fiduciary, if California is the place where the corporation transacts the major portion of its administration of the trust.4 If there is more than one fiduciary, the tax is imposed on a proportionate amount of the trust's accumulated income based on the ratio of fiduciaries resident in California to the total number of fiduciaries.5 For example, assume that a trust has no California source income and all of its beneficiaries are non-California residents or all beneficiaries' interests are contingent. If the trust has two individual trustees, one of whom is a California resident and one of whom is not, 50 percent of the trust's accumulated income will be subject to income tax in California.
Although historically it has been easy to determine who is a fiduciary and where the fiduciary resides, the mobility of individuals, the "nationalization" of corporate trustees and certain other aspects of modern trusts have made these determinations more difficult. This article demonstrates that the existing rules do not work for some of these difficulties, examines how these difficulties may be addressed under the existing statutory framework, and proposes solutions. The author believes that there are three underlying questions that must be answered to determine whether a trust is subject to tax in California based upon the residence of its fiduciaries. First, is an individual fiduciary a California resident? Second, where does a corporate trustee transact the major portion of its administration of the trust? And, third, who is a fiduciary?
California has a well-developed body of law on the issue of whether an individual is a resident of California for determining if the individual is liable for California income tax on the individual's income.6 The same criteria has been, and should continue to be, used to determine whether an individual is a resident of California for purposes of subjecting to tax a trust of which such individual is a fiduciary. Given the mobility of our society, and the fact that many individuals have homes in many states and foreign countries, the determination of an individual's residence may be difficult. But, criteria are well developed and should be the same for determining both the individual's personal income tax residence and the individual fiduciary's residence.
Most large corporate fiduciaries have offices in California and in many other states. In many cases, major decisions relating to the trust (investment decisions and distribution decisions) take place in a state other than California, but there is a contact person within the California office to facilitate communication with California beneficiaries.
The California statute provides that a corporate trustee is deemed to be a California resident fiduciary if it "transacts the major portion of its administration of the trust" in California.7 There is no useful guidance as to what "administration of the trust" means or what types of activities constitute a "major portion" of trust administration. The author believes that if distribution decisions or investment decisions are made in California, the corporate trustee should be deemed to be administering a major portion of the trust in California because those decisions are "major" decisions that are applicable to almost all trusts. If, however, the only significant contact with California is a corporate office with individuals who are charged with interfacing with California trust beneficiaries, the corporate fiduciary should not be deemed to be administering the trust in California.
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While there is no binding authority, and although additional guidance in the form of a regulation or ruling would be helpful, in the author's experience there has not been much disagreement on what the statute means and how it should be applied. The statute, however, requires a facts and circumstances inquiry that is cumbersome and expensive to audit. The corporation's activities and their locations (e.g., where records are kept, where back-office services are performed) should not have any relationship to whether the accumulated income of the trust is taxable in California. The focus should be on the location of the individuals within the corporation with the authority to make the major decisions because that analysis equates the corporate fiduciary with an individual fiduciary.
California defines "fiduciary" as 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."8 While this definition may have been adequate when the statute was enacted, modern trusts are more complex than the trusts that existed when California's income tax law was enacted. Typically, a trust had one or two trustees, and the trustees held all powers that were given to the trustees under the trust instrument. For a trust such as this, it is easy to determine that the trustees are fiduciaries, and the only issue becomes the trustee's residence and where the major portion of administration occurs in the case of a corporate trustee. Yet, the complexity of modern trusts makes implementing the statute difficult.
Modern trusts often divide trustee powers between, or among, different persons, provide that certain actions are to be taken in a non-fiduciary capacity, and have multiple persons exercising one or more specific powers.9 Modern trusts also confer the right to remove a fiduciary, and authorize (and occasionally mandate) the use of outside advisers or consultants for specific aspects of trust administration.
The primary issue with the current statute is that it does not distinguish between fiduciaries having "major powers" (investment power and distribution power) and persons having minor powers. Nor does it distinguish between fiduciaries who have certain powers and those who do not. The statute appears to require the "counting of heads" rather than examining which fiduciaries have which powers, and does not address the role of persons who act in non-fiduciary capacities or as advisers to the fiduciaries. Because the statute is deficient in many respects as it is applied to modern trusts, it should be amended, or the Franchise Tax Board should interpret it in light of modern trust provisions and administration.
A. "Major" and "Minor" PowersSome trusts may vest certain powers in an individual (or less commonly, in an entity), but limit the powers to minor aspects of trust administration. For example, an individual may have the power: (a) to move the trust administration to another jurisdiction; (b) to make certain tax elections; (c) to amend the administrative provisions or to construe certain aspects of a trust; or (d) to determine whether a receipt or disbursement is allocable to income or principal if the characterization is not clear under the Principal and Income Act. While one can have a legitimate debate as to whether these and similar powers rise to the level of powers that should cause the individual who has the power to be characterized as a fiduciary within the meaning of the California statute, these powers are relatively minor compared to the major powers of investment and distribution.
The term "major" is used in Section 17742, which is applicable to corporate fiduciaries, while Section 17006 refers to someone acting in "any" fiduciary capacity. There is no legislative history to reconcile the two sections, assuming reconciliation is needed or even appropriate.
Ifone assumes that a "major" portion of trust administration relates to investment decisions and distribution decisions, then it seems inconsistent to have a different standard...
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