California Income Taxation of Trusts and Estates

By Richard S. Kinyon, Esq.,* Kim Marois, Esq.,** and Sonja K. Johnson, Esq.***¹

Reprinted with the permission of The American College of Trust and Estate Counsel.

California's income taxation of trusts has unpleasantly surprised many trust fiduciaries and beneficiaries. Its unique method of taxation, based on the residence of the trust's fiduciaries and beneficiaries (and regardless of the residence of the settlor), may affect trustees and beneficiaries (as well as their lawyers and other advisors) far beyond the California borders.

For example, consider an irrevocable, non-grantor trust² established by an Illinois resident that is administered by two co-trustees, one of whom is an Illinois resident while the other resides in California. All beneficiaries of the trust also reside in Illinois. Despite the predominantly non-California connections, and even if the Illinois co-trustee is more actively involved in the administration of the trust, half of the trust's undistributed net income is currently taxable by California.

Alternatively, consider another irrevocable, non-grantor trust, this time with a New York settlor. In this case, the trust is administered in New York by a New York resident serving as the sole trustee. However, the trust's sole beneficiary is a California resident with a vested (i.e., non-contingent) interest in the trust property. Despite the trust's New York origin and administration, all of the trust's undistributed net income is currently taxable by California.

California acknowledges other state laws regarding taxation of trust income and will allow a credit for taxes paid to another state, but only if the trust is considered to be a resident by both states and taxes are actually payable to both states.³ The credit is effective where the taxes paid to the other state are levied on the same income and at the same rates as those of California. In the examples above, if the trusts are taxed on the same income at lower rates in Illinois or New York than in California, the additional taxes paid to California (which are not offset by the credit for taxes paid in the other states) will represent additional taxation that will deplete the trust estate.

Given that California taxes net capital gains at the same rates as ordinary income—with a maximum rate of 12.3 percent (or 13.3 percent with respect to taxable income in excess of $1,000,000)—an otherwise out-of-state trust may have significant California income tax liabilities. If the tax is not paid by the trust for the year in which the income is received and if that income is subsequently distributed to a California resident beneficiary, that beneficiary will be taxable on that income. Moreover, even where a trust has not had a prior obligation to pay California income tax, a later distribution of accumulated net income to a California beneficiary is subject to the California throwback rules, which are somewhat similar to the now largely repealed federal throwback rules (under IRC sections 666-668).⁴ Thus, even if a non-California resident establishes a trust that is always administered outside of California by non-California trustees, and even if the trust's California beneficiaries only have contingent, non-vested interests (for example, where all distributions are fully discretionary), California may still ultimately tax the trust's income when and to the extent it is later distributed to a California resident beneficiary.

The broad reach of California's fiduciary income tax laws is an important consideration for trustees, beneficiaries and advisors, where either a trustee or beneficiary resides in California or is contemplating a move to California. This article provides an in-depth analysis of the principles of California fiduciary taxation and the manner in which they are applied. Although its focus is on the treatment of irrevocable, non-grantor trusts, it includes a brief overview of California's taxation of the income of estates and administrative trusts, as well as a technical guide to complying with California income tax reporting and withholding requirements.

The California laws governing the income taxation of estates, trusts, beneficiaries and decedents are in the California Revenue and Taxation Code.⁵ (All subsequent statutory references are to the California Revenue and Taxation Code, unless specified otherwise.) Section 17731 provides that the federal rules relating to such taxation (IRC sections 641-692) apply for California purposes, except as otherwise provided.

The elections under IRC section 645(a) (treating a 'qualified revocable trust" as part of the deceased settlor's probate estate for income tax purposes), IRC section 663(b) (treating discretionary distributions in the first sixty-five days of the taxable year of an estate or trust as having been made on the last day of the preceding taxable year), and IRC section 663(c) (treating separate shares of an estate or trust as separate estates or trusts for the sole purpose of determining the amount of distributable net income taxable to the beneficiaries) are also effective for California purposes. Any of these elections not made for federal purposes cannot be made separately for California purposes.

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In considering California's unique approach to the taxation of irrevocable, non-grantor trusts, it is useful to understand and compare its treatment of other similar entities, including probate estates, administrative trusts, revocable trusts, and other grantor trusts.

The undistributed net income of a probate estate of a California decedent is taxable by California regardless of the residence of its beneficiaries, the personal representative or any other fiduciary. If part of a California decedent's estate (such as out-of-state real estate) is subject to ancillary probate administration in another state, California presumably would allow a credit for the income taxes paid to the other jurisdiction.⁶ If a California non-resident decedent owned assets (such as real estate) situated in California that produce California source income, that income will be taxed by California regardless of the residence of its beneficiaries, the personal representative or any other fiduciary.⁷

While an "administrative trust" of a California decedent (i.e., a revocable trust that has become irrevocable because of the death of the settlor) is functionally the same as a probate estate (except that it is not subject to mandatory court supervision), its undistributed net income is not taxable by California in the same manner as that of a California decedent's probate estate. Instead, it is taxed by California as an irrevocable, non-grantor trust—unless an IRC section 645(a) election is made.

An election under IRC section 645(a) to treat and tax a "qualified revocable trust" (i.e., a typical administrative trust) as part of the deceased settlor's probate estate for federal income tax purposes is treated as an election for California income tax purposes as well. If such an election is not made for federal income tax purposes, it cannot be made for California income tax purposes.⁸ Making an IRC section 645(a) election could have a substantial impact on a qualified revocable trust's income tax liability to California. For example, if the deceased settlor of a revocable trust was a California resident but all of the trustees and beneficiaries are non-residents of California, all of the trust's undistributed net income will be taxable by California if the IRC section 645(a) election is made. In comparison, none of the trust's income (except for California source income)⁹ will be taxable by California if the election is not made, because California's unique irrevocable trust taxation laws exclude the income from taxation in California. Conversely, if the deceased settlor was a non-resident of California but all of the trustees or all of the beneficiaries are residents of California, none of the trust's non-California source income will be taxable by California if an IRC section 645(a) election is made because the trust will be taxed as a non-California estate—whereas all of the income will be taxable by California if that election is not made because California's irrevocable trust rules will apply.

California treats property of a "grantor trust" (i.e., a trust subject to the grantor trust rules in IRC sections 671-679) as owned by and taxable to its settlor (or grantor) for income tax purposes. Therefore, its income, deductions and credits generally are included in computing the tax liability of the grantor, and the trust itself is disregarded for both federal and California income tax purposes.¹⁰

While many states tie the income tax liability of an irrevocable, non-grantor trust to its settlor's residence, California disregards this consideration altogether.¹² Instead, California employs a unique analysis that considers (1) the source of the trust's income, (2) the residence of its trustees,¹³ and (3) the residence of the trust's beneficiaries. Consistent with the tax laws of most states, California taxes all of a trust's income attributable to California sources (e.g., rental income from property located in California).¹⁴ What makes California unique is that it also taxes all of a trust's taxable income if all of its trustees are California residents or if all of its beneficiaries are California residents with "non-contingent" (i.e., vested) interests in the trust.¹⁵

Where some, but not all, trustees or vested beneficiaries are California residents, California taxes a fractional amount of the trust's taxable income.¹⁶ For example, where two of three trustees are California residents (and there is no California source...