A Proposal Regarding the California Taxation of Non-california Resident Trusts and Their Beneficiaries

• Publication year: 2021
• Author: Richard S. Kinyon, Esq. and Kirsten Wolff, Esq.

A PROPOSAL REGARDING THE CALIFORNIA TAXATION OF NON-CALIFORNIA RESIDENT TRUSTS AND THEIR BENEFICIARIES1, 2

AUTHORS

Richard S. Kinyon, Esq.

Kirsten Wolff, Esq.

EXECUTIVE SUMMARY

When an ongoing irrevocable non-California resident, non-grantor trust distributes current net income to a California resident beneficiary, that beneficiary generally pays income tax on that income-both federal and California tax, up to the amount of the trust's distributable net income ("DNI"), and any undistributed net income more than DNI is accumulated and not currently taxable by California. However, if a beneficiary has a vested interest in that excess net income, it is taxable to the trust, not the beneficiary. If the trust later distributes the non-vested undistributed net income to a California resident beneficiary, that beneficiary will not owe federal tax on that income but will owe California tax on it if the beneficiary was also a California resident during the year the income was accumulated, provided that the income was not previously taxable by California because the resident beneficiary's interest in the trust (i.e., in the accumulated income) was contingent. This tax on distributions of accumulated net income is known as the "throwback tax," because California is effectively "throwing" the income back to the prior period in which it was accumulated, or deemed to have been accumulated, for the benefit of a California beneficiary.

This California throwback tax is not widely understood by practitioners, trustees, or beneficiaries, and the FTB regulations do not give guidance on how to determine the amount of accumulated income taxable to the beneficiary. Although the California fiduciary

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income tax Form 541 and instructions do address the throwback tax, the form and instructions do not fully determine the full application of the throwback tax law. This paper explains our interpretation of the intent and application of that law, recommends a methodology for tracking and taxing accumulated income of non-California resident trusts to implement that application, and proposes that the Franchise Tax Board adopt regulations to clarify the application and to provide guidance to taxpayers, considering our interpretation of the law and recommended methodology for applying it. We also recommend that the law be amended to provide that (1) all of a trust's entire current net income be included in its DNI for California income tax purposes, and (2) a non-contingent beneficiary's interest in any undistributed net income be taxable by California to the beneficiary rather than the trust, but maybe only if elected by that non-contingent beneficiary and the trust.

DISCUSSION

I. TAXATION OF A TRUST'S CURRENT NET INCOME

A. PROPOSAL: REVISE THE LAW TO PROVIDE THAT DNI INCLUDES A TRUST'S ENTIRE CURRENT NET INCOME

Distributions to a California resident beneficiary during the current year by an ongoing non-grantor trust (e.g., a bypass, family-pot or dynasty trust) are taxable to the beneficiary to the extent of the trust's DNI allocated to the beneficiary. The taxation of current net income of a discretionary trust that makes distributions in excess of DNI was addressed by the Franchise Tax Board ("FTB") in Technical Advice Memorandum 2006-0002. The beneficiary is taxed on the amount of the DNI distributed, and the trust is taxed on the amount of the distribution in excess of DNI up to the amount of the trust's remaining taxable net income (citing Cal. Rev. & Tax. Code § 17742(a); Frimmer, "Order Out of Chaos - Making [Half of] California's Trust Taxation System Work," Vol. 25 No. 1, California Tax Lawyer 3 (201_)), accepts that interpretation of the law.

In our view, the FTB's position in TAM 2006-0002 is incorrect in taxing a trust on the excess of a trust's taxable net income in excess of its DNI by treating a California resident beneficiary as having a non-contingent (or vested) interest in that excess amount. While we believe that a beneficiary who receives a distribution from a trust in excess of its DNI (as well as the DNI) of course results in the beneficiary having a vested interest in the amount distributed, that distribution does not result in the beneficiary having a vested interest in the trust for purposes of enabling California to tax the trust's excess net income, as provided in Cal. Rev. & Tax. Code § 17742(a). Rather, in our view, whether a beneficiary's interest in a discretionary trust is vested (i.e., non-contingent) or contingent is determined by the terms of the trust instrument and does not change from year to year based on the distributions from the trust to a beneficiary that may be made by the trustee in a particular year.

The current taxation of a discretionary trust's net income up to the amount of the distribution in excess of DNI is inconsistent with the provision in Cal. Rev. & Tax. Code § 17745(a), which contemplates that the taxes imposed on a trust by Cal. Rev. & Tax. Code § 17742(a) apply to undistributed income (such as the undistributed income attributable to a vested interest in an IRC §§ 2503(c) or 2642(c)(2) trust or an administrative or other terminating trust), not the trust's net income in excess of DNI currently distributed.

Section 17745(a) provides in part that "If, for any reason, the taxes imposed on the income of a trust which is taxable to the trust [i.e., under section 17742(a)] because the fiduciary or beneficiary is a resident of this state are not paid when due [by April 15 of the following year (or the extended due date, if applicable)] and remain unpaid when that income is distributable to the beneficiary [presumably after the taxes were due], or in case the income is distributable to the beneficiary before the taxes are due [e.g., if the trust terminates later in the year during which money or other property is distributed to the beneficiary, in which case the beneficiary rather than the trust would be taxable on that

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income], if the taxes are not paid when due [again, by April 15 of the following year (or the extended due date, if applicable)], such income shall be taxable to the beneficiary when distributable to him [presumably after the due date the following year] . . . ."

Instead, we believe that the entire amount of a distribution in excess of a trust's DNI that is made to a California beneficiary with a contingent interest in the trust should be treated as accumulated income and taxed to a California resident beneficiary under the throwback rule, referred to above and discussed in Part II, below. See Kinyon, Marois, and Johnson, "California Income Taxation of Trusts and Estates," 39 ACTEC Law Journal 69 (2013), reprinted with permission in Volume 21, Issue 3, CA Trusts and Estates Quarterly 6 (2015).

In order to simplify the law and to avoid the complexity caused by the disparate treatment of the trust's DNI and distributions of its current net income in excess of DNI, we propose that California law be amended prospectively to provide that for California income tax purposes, DNI shall include a trust's entire net income. This would result in all of a trust's current net income up to the amount distributed to a California resident beneficiary being taxed by California to that beneficiary, and none of it would be taxable to the trust, which has already distributed it to the beneficiary.

B. PROPOSAL: REVISE THE LAW TO PROVIDE THAT BENEFICIARIES WITH VESTED INTERESTS IN CERTAIN TRUSTS ARE DEEMED THE OWNERS OF THOSE TRUSTS FOR INCOME TAX PURPOSES

The beneficiaries of certain ongoing vested-interest trusts, such as IRC § 2503(c) trusts for the benefit of minors that qualify for the gift tax annual exclusion, IRC § 2642(c)(2) trusts for the benefit of "skip persons" that qualify for the GST annual exclusion, and IRC §§ 2523(e) and 2056(b)(5) (life estate with [general] power of appointment in donee spouse) trusts that qualify for the gift or estate tax marital deduction, clearly should be treated as having a non-contingent interest in the trust, resulting in the undistributed net income being taxed to the trust if the beneficiary is a California resident, as provided in Cal. Rev. & Tax. Code § 17742(a).³

The California resident beneficiaries of a terminating trust (e.g., an administrative trust or a trust following the death of a beneficiary with a life estate) clearly also should be treated as having a vested interest in the trust, resulting in the undistributed net income being taxed to the trust by California, as provided in Cal. Rev. & Tax. Code § 17742(a).

We also propose that California law be amended prospectively to provide that for California income tax purposes, such ongoing trusts in which the beneficiaries have a vested interest and terminating trusts be treated as grantor trusts or separate grantor shares with respect to the vested beneficial interests, instead of the undistributed net income with respect to those vested beneficial interests being taxed to the trusts, as provide in Cal. Rev. & Tax. Code § 17742(a). Any increased tax liability with respect to the vested beneficiaries as a result of such grantor-trust treatment probably should be payable by the trusts unless otherwise agreed by the beneficiaries. This would result in the beneficiaries having vested interests in those trusts being treated as the owners of the vested portions of those trusts, and Cal. Rev. & Tax. Code § 17742(a) only would apply to a trust's net income that is neither distributed to nor vested in a beneficiary.

It might be appropriate for such an amendment to provide that grantor-trust treatment with respect to such vested-interest trusts be elective rather than mandatory. Such an election probably would be more likely if California also were to amend the law to provide that a trust's undistributed net income would be taxed pursuant to compressed tax-rate brackets as under federal law.

II. TAXATION OF A TRUST'S ACCUMULATED NET INCOME THE CALIFORNIA THROWBACK TAX

The throwback tax applies when a...