by Wendy Abkin

I. Introduction

Trustees and beneficiaries can be unpleasantly surprised to learn that their trust's income is subject to California income tax. This may happen either because the parties were unaware of the applicable law in the first place or because a trust became subject to California income tax due to changed circumstances. The problem is often not discovered until many years have passed, raising the possibility of substantial exposure for back taxes, penalties and interest as well as potential fiduciary liability for failing to make the proper tax filings.

The California Franchise Tax Board (FTB) has significantly increased enforcement efforts recently, making it all the more important for trustees to proactively evaluate the potential exposure and develop a plan to address it. In addition, the FTB has faced some of its own challenges in administering the law as written, and trustees may be baffled by the conclusions reached by auditors. By understanding these issues, trustees and their advisors will be better prepared to respond efficiently and effectively to an FTB inquiry. Finally, where a trust has exposure for unfiled tax returns, several options are available to those who are willing to voluntarily come forward and work with the FTB to resolve the matter.

II. When is a Trust's Income Subject to Tax by California?

Unlike the law in many other jurisdictions, the settlor's residence is inconsequential under California's law. Instead, the income of a trust is subject to California income tax if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor. (Revenue & Tax Code section 17742.) An individual is a resident of California if that individual is in the state for "other than temporary or transitory purposes," and if an individual is domiciled in the state but is outside the state for a temporary or transitory purpose. (Revenue & Tax Code section 17014.) An individual is presumed to be a resident in California if that individual spends, in the aggregate, more than 9 months of the taxable year in California. (Revenue & Tax Code section 17016.)

The particular terms of a trust must be examined carefully to determine the extent of a beneficiary's interest in the trust income and/or corpus, and, in particular, whether the beneficiary is contingent or non-contingent. A non-contingent beneficiary is one whose interest is not subject to a condition precedent. (Cal. Code of Regs. Section 17742(b).) The FTB auditors have at times seemed to struggle with this concept. Where a trust's terms clearly provide that distributions to a particular beneficiary are subject to the trustee's discretion, then that beneficiary's interest is contingent because it is subject to the condition that the trustee must decide to make a distribution before the beneficiary is entitled to it. (To the extent the condition is satisfied, however, the beneficiary will be considered to be non-contingent and the applicable tax consequences will follow.) The issue can become more complicated where the trust's terms provide limitations on the trustee's discretion or where an otherwise contingent beneficiary is granted certain powers over trust corpus or income. Additionally, contingencies can lapse over time as a beneficiary's rights to income or corpus "ripen" as a result of the beneficiary attaining a given age, educational status, or satisfying other conditions. Thus, a particular trust's California tax responsibilities can be a "moving target," and the fiduciary must remain sensitive to the changed circumstances that can cause a trust to become subject to tax by California.

In many cases, of course, a trust is managed by an institutional or corporate fiduciary. In such cases, California law looks to the place where the corporation transacts the major portion of its administration of the trust in order to determine the residence of the corporate fiduciary. (Revenue & Tax Code section 17742(b).) The place of administration of the trust is not necessarily the same as the corporate domicile. The key is the "major portion" of the activity; some activity not enough, and the corporate fiduciary's headquarters location or principal place of business may not be the place where the major portion of the fiduciary administration activity takes place. The FTB has sometimes grappled with the issue of what activities constitute "administration of the trust." This will depend on all the relevant facts and circumstances in a particular situation, but the exercise of discretion and legal authority to act are significant factors to be considered and evaluated. Family corporations that serve as corporate trustees are also being scrutinized by the FTB.

California law is unique in its use of the term "fiduciary" rather than "trustee." A "fiduciary" is defined to mean 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. (Revenue & Tax Code Section 17006.) A trust's terms do not always make it clear whether a person with a particular title or responsibilities (or lack thereof) qualifies as a "fiduciary" for purposes of counting up the resident and non-resident fiduciaries. These include, for example, an individual identified as a passive trustee, trust protector, trust advisor, or member of an investment committee.

The portion of a trust's income that is subject to California tax depends on the percentage of California resident fiduciaries. Where a trust has only one fiduciary who is a California resident, California will tax the entire taxable income of the trust, including accounting income and income attributable to corpus. This is based on the theory that the fiduciary is the legal owner of the trust assets, and, as a California resident, California has sufficient nexus to constitutionally tax all such income. Where there are multiple fiduciaries and not all are California residents, California taxes the trust's income in proportion to the California resident fiduciaries. For example, where one of two fiduciaries is a California resident, California will tax one-half of the trust income. (Revenue & Tax Code section 17743.)

Similar allocation rules apply where taxation is based on the residence of the beneficiaries. Where there is a sole resident, non-contingent beneficiary (and all fiduciaries are nonresidents), California will tax the income to the extent of that beneficiary's interest in the income. However, California has not always had this view. In reliance on Blair v. Commissioner, 300 U.S. 5 (1937), the FTB previously took the position that the trust is taxable on all income (i.e., current income and capital gains allocated to trust corpus) if the trust's income beneficiary is a California resident. The theory was that sufficient contacts exist with California because the California resident income beneficiary has an equitable interest in the corpus of the trust. There is language in McCulloch v. Franchise Tax Board, 61 Cal.2d 186 (1964) that could be argued to support a finding of sufficient nexus to support taxation by California.

In the case of multiple beneficiaries, California taxes the trust income in proportion to the California resident non-contingent beneficiaries. For example, where there are two non-contingent beneficiaries and one is a California resident and the other is not, one half of the trust's income is taxable. (Revenue & Tax Code section 17742.)

Where there are multiple beneficiaries (resident and nonresident) and multiple fiduciaries (resident and nonresident), 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 non-resident beneficiaries. For example, assume a trust has two trustees, one of whom is a California resident, and four non-contingent beneficiaries, one of whom is a California resident. If the trust has $100,000 of non-California source income, California will tax one-half of the income ($50,000) based on the residency of the California trustee and one-fourth of the remaining $50,000 based on the residency of the California non-contingent beneficiary ($12,500), for a total of $62,500 income subject to California income tax.

Finally, even where a trust's beneficiaries and fiduciaries are non-resident, the trust will still be subject to tax on its gross income from sources within California. (Revenue & Tax Code section 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 situs in California.

III. Trust Filing Obligations

Trustees may believe that a trust need not file in California where the otherwise taxable income has been distributed to a California resident and that resident beneficiary has duly reported the income on his or her personal California income tax return. However, this "no harm, no foul" approach is not necessarily consistent with the trust's filing obligations under the law. A trust must file a fiduciary income tax return (Form 541) if the trust has net income from all sources in excess of $100 (Revenue & Tax Code section 18505(e)), or if the trust has gross income from all sources in excess of $10,000, regardless of the amount of net income. (Revenue & Tax Code section 18505(f).) The consequences of failing to file and pay any taxes due include exposing the trust to interest charges, potential penalties including the penalties for failure to file and failure to pay, and the amnesty penalty for tax years prior to 2003. Less calculable are the potential costs arising from the uncertainty of unfiled tax returns and the fact that such uncertainty continues unless and until the tax returns are filed and the statute of limitations is triggered. Beneficiaries who confront these issues many years later may well expect the fiduciary, not the trust, to bear the costs of fixing the problems and bringing the trust into compliance.

Previously un-taxed income will be taxed when it is distributed to a California resident beneficiary, although the mechanics of computing the tax due differs depending on whether tax was due but not paid or whether tax was not yet due because the resident beneficiary's interest was contingent. If the trust was subject to California tax but did not pay the taxes when due, and those taxes remain unpaid when the income is distributable to the beneficiary, then the income is taxable to the beneficiary when it is distributable to him or her. In the case of a nonresident beneficiary, that income is taxable only to the extent it is derived from California sources. (Revenue & Tax Code section 17745(a).) The entire amount of the income must be reported by the beneficiary in the year it is distributable, and tax is computed accordingly. Where the trust's income was not subject to tax in prior years because the beneficiary's interest was contingent, the income is taxable to the beneficiary when it is distributed or distributable to him or her. (Revenue & Tax Code section 17745(b).) However, in those cases, the amount of tax is computed as if a the distribution had been included in the beneficiary's gross income ratably in the year it is distributed or distributable and the five immediately preceding years (or less, if the trust accumulated the income over a shorter period). The tax due is the sum total of the increases to the beneficiary's tax in each of those years. (Revenue & Tax Code section 17745(d).) The effect of this computational mechanism of spreading the distribution over several tax years is to give the recipient the benefit of the graduated tax rates. (However, if the beneficiary was already in the maximum tax rate bracket for those prior years, then this mechanism gives no advantage.)

The rules applicable to distributions of previously un-taxed income also close two potential loopholes. First, income accumulated by a trust continues to be "income" even though the trust's terms provide that accumulated income (ordinary or capital) becomes a part of the corpus. (Revenue & Tax Code section 17745(c).) Second, if a beneficiary is resident of California while the income is accumulating but leaves the state within 12 months before the distribution and returns to California within 12 months after the distribution, then the beneficiary will be presumed to be a California resident at the time of the distribution. (Revenue & Tax Code section 17745(e).).

IV. Advising Trustees and Beneficiaries

Fiduciaries, beneficiaries and their advisors should be aware of the FTB's renewed interest in ensuring that trusts comply with their tax reporting and payment obligations under California law. The FTB has increased the resources devoted to this area of tax, including a significant increase in audit personnel for these issues. Additionally, the FTB is taking advantage of new information databases and the electronic filing for Form 541. Finally, together with representatives from the private bar, the FTB is evaluating possible statutory changes in order to ease the administrative and compliance burdens for both the agency and taxpayers.

The Voluntary Disclosure Program ("VDP") is one option to be considered by trusts with California compliance challenges. Unlike the informal voluntary disclosure "policy" in the federal tax arena, the FTB is specifically authorized by statute to provide relief to those entities, including trusts, which voluntarily come forward regarding their deficiencies. If the trust is accepted into the program, the FTB and the trust execute a written Voluntary Disclosure Agreement under which the trust's exposure for prior year taxes will be limited to the six immediately preceding years (the "look back period"). (Revenue & Tax Code section 19191.) A trust must first meet certain eligibility criteria, which include the following: the trust has never filed a return with the FTB; the trust or its trustees performed no more than inconsequential administration activities in California; the trust had no California resident beneficiary or beneficiaries (other than a beneficiary whose interest in the trust is contingent), the trust has never been the subject of an inquiry by the FTB with respect to liability for franchise or income taxes; the trust voluntarily comes forward, prior to contact by the FTB; and the trust has not registered with the Secretary of State.

The VDP presents an opportunity for substantial benefits. The trust can apply to the program anonymously and obtain answers about potential VDP relief prior to disclosing its identity. The FTB has the ability to waive most penalties for the six-year look back period (this excludes the amnesty penalty). Most significantly, the FTB will waive its authority to make any assessments for years prior to the look back period. However, the VDP Agreement will be null and void if the trust misrepresents material facts relating to the agreement, fails to file any return, or 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.

For trusts that are not eligible for VDP, the FTB offers the alternative of a Filing Compliance Agreement (FCA). The authority for FCAs derives from the FTB's authority to administer tax under Revenue & Tax Code section 19501 and various other provisions that allow the FTB to abate penalties upon a showing of reasonable cause. Qualified taxpayers eligible to enter into an FCA must voluntarily disclose, file, and make full payment to the FTB for all years for which they failed to file a California return. Where reasonable cause is an available defense to penalties and the trust can show reasonable cause, the FTB will waive the penalties for the return filings identified in the agreement. 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 Voluntary Disclosure Agreement, a Filing Compliance Agreement 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. Where a trust is subject to California tax because of the California residency of a fiduciary, one option is to replace California resident fiduciaries or add nonresident fiduciaries in order to dilute the percentage of trust income that is subject to tax. The fiduciary and advisors should also evaluate the impact of future distributions and residency considerations of beneficiaries. Finally, attention must be paid to identifying future events that may impact taxation, such as a contingency lapsing for a particular resident beneficiary due to age.

V. Conclusion

California's rules regarding the income taxation of trusts can be a trap for unwary trust fiduciaries and their advisors. The FTB is clearly well-aware that there is room for improvement in the compliance rate among trusts, and it has devoted resources and personnel to pursue the matter. However, the FTB also has several very useful tools at its disposal, in the form of Voluntary Disclosure Agreements and Filing Compliance Agreements, to encourage worried trust fiduciaries to come forward. In view of the potential for substantial exposure to penalties and interest for unfiled tax returns, as well as the potential exposure to claims of beneficiaries for damages, trust fiduciaries would be well-advised to question their assumptions about California's income taxation of trusts.

If you have any questions about any of the techniques discussed above, please contact Wendy Abkin at Sideman & Bancroft.

This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.