The California Throwback Tax Applicable to Distributions of Previously Untaxed Accumulated Trust Income to California Resident Beneficiaries

By Richard S. Kinyon, Esq.* and Kirsten Wolff, Esq.**

When an irrevocable, non-California resident, non-grantor trust distributes current net income to a California beneficiary, that beneficiary generally pays income tax on that income—both federal tax and California tax, up to the amount of the trust's distributable net income ("DNI"), and any undistributed net income in excess of DNI is accumulated and not currently taxable by California. If the trust later distributes the undistributed net income to a California resident beneficiary, that beneficiary will not owe federal tax on that income. However, the beneficiary will owe California tax on the income if: 1) the beneficiary was also a California resident during the year that the income was accumulated; and 2) the income was not previously taxable by California because the resident beneficiary had a contingent interest in the trust (i.e., in the accumulated income). This tax on distributions of accumulated 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 article focuses on the California throwback tax, which is not widely understood by practitioners or trustees and beneficiaries of trusts.¹ The Franchise Tax Board (FTB) regulations do not give guidance on how to determine the amount of accumulated income taxable to the beneficiary. Although the California Fiduciary Income Tax Return (Form 541) and instructions do address the throwback tax, the form and instructions do not fully determine the application of the throwback tax law. In this article, we explain our interpretation of the intent and application of that law, suggest a methodology for tracking accumulated income in non-California resident trusts to implement the application of the law, and explore opportunities to plan around the tax.

To understand the application of the throwback tax, we begin with a brief overview of California's system of taxation of trust income.² Unlike many other states, California taxes the current non-California source income of a trust based on the residence of the fiduciaries and the non-contingent beneficiaries. The residence of the settlor and the law governing the administration of the trust are irrelevant for California income tax purposes.

California follows the federal rules for non-grantor trusts generally, so that any of the trust's current net income that is distributed (or required to be distributed) to a beneficiary is taxable to the beneficiary and deductible by the trust. However, California's tax rate schedule applicable to the undistributed net income of trusts (as well as estates) is the same as the schedule applicable to single individuals and married individuals filing separately; there are no compressed tax-rate brackets, unlike those applicable to trusts and estates under federal law.³ California taxes both short-term and long-term net capital gains at the same rates as ordinary income, both for trusts and beneficiaries.

All the trust's undistributed net income is taxable by California: (1) if it is California-source income (e.g., rent from California real property);⁴ (2) if all the fiduciaries are California residents, in which case all the trust's non-California sourced undistributed net income is taxable; or (3) if at least one, but not all, the fiduciaries is a California resident, in which case the non-California sourced income is taxable in proportion to the number of the fiduciaries who are California residents to the total number of fiduciaries.⁵ For this purpose, a trust fiduciary generally is a person who owes a duty directly to the beneficiaries and can be sued by them for a breach of that duty, and typically includes trustees and other persons with fiduciary roles with respect to a trust.⁶

In the case of a California-resident beneficiary, all or part of the trust's remaining undistributed net income is taxable by California if one or more California resident beneficiaries have a non-contingent (i.e., vested) interest in the trust.⁷ If all the beneficiaries with non-contingent interests are California residents, all the undistributed net income is taxable by California. If at least one, but not all, the beneficiaries with a non-contingent interest is a California resident, only the portion of the undistributed net income allocable to beneficiaries who are California residents is taxable by California.

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Although there is no clear authority on the definition of contingent and non-contingent interests, in our view, a beneficiary should be treated as having a non-contingent interest in all or a portion of a trust if all or a portion of its undistributed net (accumulated) income will, sooner or later, be distributed to or for the benefit of the beneficiary or to the beneficiary's estate, or the creditors of either. We believe that beneficial interests in the remaining accumulated income should be treated as contingent. In our view, whether a beneficiary's interest in a discretionary trust is contingent or non-contingent should be determined by the nature of the beneficiary's interest as set forth in the terms of the trust instrument, and should not change from year to year based on the distributions from the trust to a beneficiary in any particular year. Therefore, although a discretionary beneficiary, of course, has a non-contingent interest in any net income distributed to him or her, that does not make him or her a non-contingent beneficiary of the trust with respect to the trust's undistributed net income. Good examples of trusts with non-contingent beneficial interests are: (1) "administrative trusts" (i.e., revocable trusts that have become irrevocable as a result of the death of the settlors) and other so-called "terminating trusts"; (2) trusts for the benefit of minors that qualify for the gift tax annual exclusion⁸; and (3) trusts for the benefit of "skip persons," structured to qualify for the GST tax annual exclusion.⁹

The residence of an individual fiduciary or beneficiary is determined in the same manner as an individual taxpayer.¹⁰ A California "resident" includes an individual who is: (1) in California for other than a temporary or transitory purpose; or (2) domiciled in California and outside the state for a temporary or transitory purpose.

An individual who spends in the aggregate more than nine months of the taxable year within California is presumed to be a resident, but this presumption can be rebutted by satisfactory evidence that he or she is in California for a temporary or transitory purpose.¹¹ However, presence within California for less than nine months of the taxable year does not create a presumption of nonresidency, unless the individual is present for less than six months as a seasonal visitor, tourist, or guest and is permanently domiciled outside of California.¹² Any person who is domiciled in California is also a resident regardless of the period of time he or she spends in the state. Domicile is the one location where an individual has his or her principal home without any present intention of permanently leaving, and to which place he or she has, whenever absent, the intention of returning.¹³

The residence of a corporate fiduciary of a trust is the place where the corporation transacts the major portion of its administration of the trust.¹⁴ Given the national presence of many corporate fiduciaries, it is often unclear where the major portion of a corporate fiduciary's administration of a trust takes place. Even the California FTB has conceded that the law does not provide guidance as to what specific administrative activities will be considered in making this determination.¹⁵

If tax is imposed on a portion of the trust's accumulated net income, but the tax is not paid when due and remains unpaid when that income is later distributed to a California-resident beneficiary, or if such income is distributable to the beneficiary before the taxes are due, such income is taxable to the beneficiary.¹⁶

The throwback tax applies when a trust that has accumulated income, all or some of which has not been taxed by California, makes a distribution of such accumulated income to a California-resident beneficiary who also was a California resident when the income was accumulated. To understand and apply the rules that tax distributions of previously untaxed accumulated income, it is helpful to review the historical origin of the throwback tax.

Consider, first, this example of the problem that the throwback tax is designed to solve: The John Smith Trust was established in Nevada¹⁷ by John's parents for the benefit of John Smith, a California resident who pays federal tax at the highest rate of 39.6% and California state tax at the highest rate of 12.3%. The trust was an irrevocable non-grantor trust with no California fiduciaries and John is a contingent beneficiary. Over a five-year period, the trust had taxable income of $100,000. If it had distributed the income currently to John, he probably would have paid federal and state income tax of about $50,000. Instead, the trust accumulated the income and paid federal tax during that period of about $35,000, but no state tax. In the sixth year, the trust terminated and distributed the trust estate, including the accumulated income of about $65,000...