When Should a Trust Be Subject to State Income Tax in California?

• Jurisdiction: California,United States
• Author: By Justin T. Miller and Richard S. Kinyon
• Citation: Vol. 23 No. 3
• Publication year: 2014

When Should a Trust Be Subject to State Income Tax in California?1

By Justin T. Miller and Richard S. Kinyon²

I. INTRODUCTION

California's rules on the income taxation of trusts and beneficiaries are unique. Even if a trust holds no California situs property, no beneficiaries reside in the state, and the settlor³ of the trust has never resided in California, that trust would still be subject to taxation by California if a trustee resides in California.⁴ In fact, California law goes one large step further. If a trust has any "fiduciary" in California, then it will be subject to state income taxation.⁵ The definition of fiduciary for California tax purposes is both broad and unclear, and includes any person acting in any fiduciary capacity with respect to the trust.⁶

Sound tax policy dictates that California should tax the fees received by a trust fiduciary that resides or performs services within California. If a fiduciary is residing in California and performing services in California, then such fiduciary is justifiably subject to California income tax. The question is whether California also should tax the trust's entire net income solely based on the residence of the fiduciary, regardless of whether the settlor of the trust was a California resident, there are any trust assets located in California, or there are any beneficiaries residing in California.

The negative effect of California's law taxing trusts solely based on the residence of a fiduciary is twofold. First, it discourages the appointment of trust fiduciaries inside the state. That disincentive leads to fewer California resident fiduciaries, less business for existing California fiduciaries and, as a result, less tax revenue. Second, an individual trustee moving to the state could inadvertently subject the entire income of a trust to taxation by California despite the trust having no other contacts in California. Thus, a trustee's presence in California potentially could subject the trust's net income to a 13.3 percent California income tax even though the trust is for the benefit of a nonresident who has no connections with California that would otherwise create an income tax obligation.⁷

Removing a fiduciary's residence as a basis for taxation by California could be revenue-neutral and an easily implemented legislative change by:

• increasing the tax revenue received from trust fiduciaries within California (e.g., fiduciary fees in California would increase due to more fiduciary work being performed within the state);
• reducing the tax revenue received from trusts that have been inadvertently subjected to taxation by California (e.g., an individual trustee moving to California);
• revising the provisions of the California Revenue and Taxation Code relating to the taxation of an estate's income, a trust that is delinquent in paying its taxes, and a beneficiary who is subject to the throwback rules; and
• increasing enforcement activities and penalties for failure to timely file California income tax returns.

In sum, removing a fiduciary's residence as a basis for trust taxation by California will be a beneficial improvement that will simplify California's trust taxation regime.

II. CONSTITUTIONAL RIGHT TO STATE TAXATION OF TRUSTS BASED ON RESIDENCE OF FIDUCIARY

It is a well-settled law that California has the right to subject trusts to taxation based on the residence of a fiduciary, similar to its right to tax a resident individual for income earned from investments outside California.⁸ That law is based on the principle that a trust fiduciary is the legal owner of a trust's assets (i.e., a fiduciary holds the assets subject to an equitable interest of the beneficiary) and, as a California resident, California has sufficient nexus to constitutionally tax all that income.

Close to 100 years ago in Schaffer v. Carter, the U.S. Supreme Court held that "the power of the State as to the mode, form, and extent of taxation is unlimited, where the subjects to which it applies are within her jurisdiction."⁹ A few years after the Schaffer case, in Haavik v. Alaska Packers Ass'n, the U.S. Supreme Court found that a state has the "power to tax all persons and property actually within its jurisdiction and enjoying the benefits and protection of its Laws."¹⁰ Furthermore, in Lawrence v. State Tax Commission" the U.S. Supreme Court held that a state can tax all income (including that derived from extraterritorial sources) of residents within its borders, whom it protects in the receipt and enjoyment of that income.¹¹ Also, in Guaranty Trust Co. v. Virginia, the U.S. Supreme Court held that the entire net income of a trust, whether distributed or not, may be taxed by the state where the trustees reside, since the state provides the trustees with the protections requisite to the receipt and control of the disposition of trust income.¹²

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However, this article is not about whether California can tax trusts based on a fiduciary's residence in California. Instead, the focus is on whether California should tax trusts solely based on the residence of a fiduciary. Note that in addition to California, only 15 states consider whether a trustee is a resident and situs of trust administration as a basis for taxation.¹³ Further, only 8 states in addition to California subject a trust to taxation if the only state contact is the residency of the trustee within the state.¹⁴

III. OVERVIEW OF CALIFORNIA'S INCOME TAXATION OF TRUSTS

To better understand the problems with subjecting a trust to California income tax based on the trust fiduciary's residence, it is helpful to first provide a brief overview of California's income taxation of trusts.

A. Taxation Based on Residence of Settlor in California

Like most states, California taxes grantor trusts (which includes all revocable living trusts) based on the residence of the settlor (i.e., the grantor).¹⁵ That is consistent with the treatment of grantor trusts under the Internal Revenue Code of 1986, as amended (the "Code"), which treats property of a grantor trust as being owned by the settlor who created the trust and, accordingly, taxable to the grantor for federal income tax purposes.¹⁶ In short, a grantor trust is ignored for tax purposes and the property within the trust continues to be treated as the settlor's property.

The focus of this paper, however, is on California's taxation of non-grantor trusts established for the benefit of individuals other than the settlor.¹⁷ With respect to non-grantor trusts, California's approach to the income taxation of trusts is unlike any other state. While California does not look at where the settlor of the trust was resident (which many states do), it does tax trusts based on any one of the following three factors:

• if the trust has any California source income;¹⁸
• if there is a non-contingent beneficiary residing in California;¹⁹ or
• if there is a fiduciary residing in California (including any trust administration by a corporate trustee performed in California).²⁰

B. Taxation Based on California-Source Income

Similar to the taxation of individuals or business entities, trusts are subject to taxation on the following income from California sources, regardless of whether there are fiduciaries or non-contingent beneficiaries residing in California:²¹

• income from real or tangible personal property located in California;²²
• business carried on within California;²³ and
• intangible personal property having a business or taxable situs in California.²⁴

Subjecting a trust to taxation on California-source income is not controversial. It is the other factors that subject a trust to taxation by California that are a cause of concern and lead to a multitude of compliance issues (i.e., when the net income of a trust is subject to California income tax if a fiduciary or non-contingent beneficiary is a resident).²⁵

C. Taxation Based on Non-Contingent Beneficiaries Residing in California

California is one of only four states that impose an income tax on trusts based on the residence of non-contingent beneficiaries.²⁶ Georgia,²⁷ North Carolina²⁸ and North Dakota²⁹ are the only other states with a similar basis for taxation.

A non-contingent beneficiary is one whose interest is not subject to a condition precedent.³⁰ In other words, a non-contingent beneficiary has a vested interest³¹ in the trust, which means there is no event that needs to occur in order for the beneficiary, his or her estate, or his or her appointees with respect to a general power of appointment, to receive a distribution from the trust, other than the passage of time.

For instance, if a beneficiary is only entitled to a distribution pursuant to the sole and absolute discretion of the trustee, then that beneficiary would be a contingent beneficiary (i.e., until the trust fiduciary invokes its discretionary authority and distributes income to the beneficiary).³² However, a beneficiary who resides in California and is entitled to receive a portion of the trust would be considered a California non-contingent beneficiary, thus subjecting the trust to taxation regardless of other factors. Identifying a non-contingent beneficiary may become more complicated to the extent a trust agreement limits the trustee's discretion or when the contingencies lapse over time (e.g., when a beneficiary has a right to income or principal³³ upon attaining a certain age or completing a specific level of education). Accordingly, any time a named beneficiary of a trust resides in California, a trust fiduciary needs to annually address the possibility that the beneficiary is, or has become, a non-contingent beneficiary subjecting the trust to taxation by California.³⁴

The portion of a trust's income subject to California tax depends on a two-factor analysis of the percentage of non-contingent beneficiaries who are residents of California and the extent of their non-contingent interests in the trust.³⁵ If a trust has only one beneficiary who is a California resident, whose interest in the...