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Attachment to Legal Notice 98-12

Analysis of Trust Taxation in California and Proposed Solution to Problems Generated Due to Trend to Nationwide Trust Administration

CURRENT CALIFORNIA LAW

Current California law, Revenue and Taxation Code Section 17742, imposes California tax pursuant to a two tier system based upon the residence of the trust’s fiduciaries and the trust’s beneficiaries.

Initially, a tax is imposed if there is either a corporate fiduciary of the trust that is a California resident or an individual fiduciary of the trust that is a California resident. In determining the residence of a corporate fiduciary, Section 17742(b) provides that a corporate fiduciary is a resident of the state in which such fiduciary transacts the major portion of its administration of the trust.

The remainder of the trust’s taxable income or pro-rata portion thereof is also subject to a tax if there are one or more California resident beneficiaries (other than a beneficiary whose interest in such trust is contingent).

An example will illustrate the two-tier approach to California taxation of a Trust. Assume that a trust has three fiduciaries: one is a California corporation that performs all of the trust administration in California; the other two are individuals that are residents of the State of Oregon. There are four beneficiaries, one is a resident of California and the other three are residents of the State of Washington. The trust’s taxable income is $120,000.

The first tier imposes California tax on one-third of the trust’s taxable income since one of the three fiduciaries is a resident of California (1/3 of $120,000 is $40,000). Since $80,000 of the trust’s taxable income is not subject to California tax under tier one, the remaining $80,000 is subject to tier two. The second tier imposes California tax on one-fourth of the remainder of the trust’s taxable income since one of the four beneficiaries is a California resident (1/4 of $80,000 or $20,000). Accordingly, $60,000 of the trust’s taxable income, one-third of $120,000 plus one-fourth of the remaining $80,000, is subject to California taxation.

The tax that is imposed pursuant to the presence of a California resident corporate fiduciary or a California resident individual fiduciary rests on the theory that quantifiable events, the transactions in administering the trust, occur in California, and the fact that the California resident fiduciary owns legal title to the trust’s assets. However, in the case of the corporate fiduciary, section 17742(b), in determining the residence of the corporate fiduciary, focuses exclusively on where the transactions in administering the specific trust in question are performed.

CORPORATE FIDUCIARIES

Laws and practices relating to the administration of trusts have changed to allow administration of trusts with California grantors and beneficiaries by non-California fiduciaries and to allow California fiduciaries to administer non-California trusts. The law does not provide guidance as to what specific activities of administration will be considered in determining whether a corporate fiduciary of a trust is transacting the majority of the administration of the trust in California under section 17742(b).

Our current law was designed to subject trusts to California taxation when the legal owner, the corporate fiduciary, was present in California and transacted the majority of the activities which make up the administration of the trust in California. Until recently, the law was capable of administration because corporate fiduciaries generally separately incorporated in each state in which they administered trusts. Accordingly, they were present in California and they administered the California trusts in California. Conversely, out of state corporate fiduciaries did not administer their trusts in California.

If a California grantor created a trust and named a California corporation as the fiduciary, the fiduciary was a California entity. Since such fiduciaries were present in California they conducted most, if not all, of the administration of a California trust in California. It was possible to contract with out of state companies, parent corporations, or subsidiaries for certain trust activities to be performed outside California, but such services would be deemed to be performed in California since the California corporate trustee is the entity that had the ultimate fiduciary obligation to perform such services.

California taxation is imposed due to quantifiable activities that are transacted in California by California entities. In other words, California taxation of a trust is imposed only when the fiduciary, on behalf of the trust, has a significant relationship (transacted the majority of the administration of the trust) with California.

This focus on the activities performed in California in the administration of a trust was a reasonable solution under the laws and business practices of corporate fiduciaries which were in existence when the methodology was adopted. The corporate fiduciary generally separately incorporated in California (and in each state in which it administered trusts) and administered California trusts (those with California grantors and/or California beneficiaries) in California because state law required them to be present in California and their customers wanted immediate access to the fiduciary.

However, with more advancements in telecommunications and the liberalization of state laws to allow fiduciaries to operate nationwide, there is a move, on the part of corporate fiduciaries, to centralize as many trust administrative activities as possible in one location for all the trusts that it administers throughout the nation. Consequently, corporate fiduciaries are uncertain whether, if such activities are performed in California, those activities will subject trusts that have no other connection with California to California taxation. The cause of the uncertainty is section 17742(b)’s focus on the location where the corporate fiduciary transacts the majority of its administrative activities for a trust. Corporate fiduciaries are concerned because they do not know what activities will be considered and what weight will be applied to individual activities in determining what constitutes a majority of trust administrative activities.

The nature of the trust business is changing drastically. Federal law was recently changed allowing Federally chartered Banks and Trust Companies to operate on an interstate basis. California law, if Assembly Bill No. 2070 becomes law, will allow non-California State chartered Banks and Trust Companies to transact trust business in California. There are over thirty other states that have adopted similar laws allowing California Banks and Trust Companies to perform trust administrative activities within their borders.

Under existing Federal law and proposed state law, a corporate fiduciary can or will be able to conduct a nationwide trust administration business without separately incorporating in California. Accordingly, since a corporate fiduciary does not have to be separately incorporated in California, it can, as a nationwide fiduciary, choose to perform the administration of all trusts, including California trusts, in any state it chooses. Since the vast bulk of the administration of a trust can be performed in any location, it seems unrealistic to impose taxation based upon criteria that can be performed at any location, because there may be little realistic connection between actual activities and the incidence of taxation.

Additionally, California corporate fiduciaries are allowed to administer trusts created in other states. There are over thirty other states that have enacted laws similar to Assembly Bill 2070. The administration in California of other state trusts may subject those trusts to taxation under section 17742. Corporate fiduciaries are concerned that their administration of all trusts in one location, e.g., California, will subject trusts to California taxation that have no other connection to California. Obviously taxation based upon trust administration in California could encourage fiduciaries to move such activities to other states to avoid California taxation. This too is due to the archaic nature of existing law.

Current law providing the rules to determine when a trust’s taxable income is subject to California tax is seriously outdated and needs to be modified to conform to modern trust administration practices.

PROPOSED SOLUTION

The objectives of the solution proposed herein are to bring clarity and certainty to the law, ease administration, maintain revenue neutrality, and preserve location neutrality of trust administration by subjecting the income of trusts to California taxation only to the extent that the trust has a significant relationship to California.

First, to reduce the uncertainty as to which activities govern whether a trust is subject to California taxation, step two proposes to delete the residence of a fiduciary as a basis for imposition of California taxation in section 17742(a). In the absence of a California beneficiary, the trust would not be required to file a California return.

In keeping with the fiduciaries’ interest in reducing complexity and increasing certainty, it is further proposed that section 17742(a) be amended to delete the parenthetical phrase "other than a beneficiary whose interest in such trust is contingent." At the present time there is substantial uncertainty on the part of all fiduciaries as to which beneficiaries are contingent. By deleting the parenthetical phrase, uncertainty is eliminated and complexity is reduced because the issue of whether a beneficiary is contingent or noncontingent is eliminated.

Fiduciaries, representatives and taxpayers have a different concept on whether a beneficiary’s interest in a trust is contingent or not. The determination of whether an interest is contingent can be based upon very old English common law which distinguishes between vested interests, vested interests subject to defeasance, interests subject to a condition precedent, and even springing executory interests. These are all fairly complicated and confusing issues. The removal of the parenthetical phrase would greatly simplify the operation of the statute and bring certainty to the taxation of a trust. The only remaining determination to be made is whether a beneficiary resides in California.

Second, because of the elimination of the fiduciary as a factor, the proposal repeals section 17742(b) which currently establishes the residence of a corporate fiduciary based on the state where the majority of the fiduciary’s activities occur. By repealing section 17742(b), uncertainties that now exist as to which activities are to be considered are removed.

Third, statutory changes are proposed to add a new section 17742(b) to limit California taxation of a trust to that portion of trust income that is being accumulated for the benefit of [future distribution to] California resident beneficiaries and eliminates from taxation that portion of the trust’s taxable income that is accumulated for the benefit of [future distribution to] non-California beneficiaries.

In effect, the proposal changes the focus of taxation from the activities of the corporate fiduciary to the residence of California beneficiaries for whose benefit the trust is accumulating the income earned by the trust. This is logical since the only way a trust has taxable income that would be subject to California tax is if it does not distribute that income currently to its beneficiaries, i.e., accumulates income. This change creates certainty for the corporate fiduciary since none of the activities of the fiduciary would subject the trust’s taxable income to California taxation. The proposed amendment to section 17742(b) would provide that the trust would apportion its taxable income based upon the relative number and interest of California resident beneficiaries.

Fourth, the proposal adds new subdivision (c) to section 17742, establishing a fixed date on which the determination of residency of beneficiaries is to be made. This change eliminates any timing uncertainties and allows beneficiaries to conform their conduct to the statute.

Fifth, the proposal repeals section 17745(b) which imposes California taxation on a beneficiary for income accumulated by the trust but not taxed because the beneficiary’s interest in the trust was contingent. Section 17745(b) would not be applicable since, under this proposal, it is irrelevant whether a beneficiary’s interest in the trust is contingent or not. Moreover, section 17745(d), which provides a special rule for determining the amount of tax attributable to the inclusion of income in the gross income of a beneficiary for the year income is distributed or distributable under subdivision (b), is similarly repealed since it only operates when section 17745(b) applies.

Sixth, the proposal repeals sections 17743 and 17744. Section 17743 is no longer needed since a fiduciary does not have any impact on the taxation of a trust, and the subject matter of section 17744 is controlled by new section 17742(b).

Seventh, the proposal repeals sections 18003 and 18004. Because, under the proposal, only the portion of the trust’s taxable income that is held for the benefit of or accumulated for future distribution to a California resident is taxed, there is no need to grant a credit against California tax for taxes paid to another state. To the extent that another state imposes a tax on the trust for amounts held for the benefit of a California resident, it is the other state that is subjecting the income to a double tax.

PROPOSED STATUTORY AMENDMENTS

Amendments to Revenue and Taxation Code section 17742 to shift the taxation of California trusts to a beneficiary based system, are as follows:

Section 17742(a) is revised as follows:

[Taxability of income to estate or trust.] (a) Except as otherwise provided in this chapter, the income of an estate or trust is taxable to the estate or trust. The tax applies to the entire taxable income of an estate, if the decedent was a resident, regardless of the residence of the fiduciary or beneficiary, and to the entire taxable income of a trust, if the fiduciary or beneficiary is a resident, (other than a beneficiary whose interest in such trust is contingent), regardless of the residence of the settler.

Section 17742(b) is revised as follows:

For purposes of this article the residence of a corporate fiduciary of a trust means the place where the corporation transacts the major portion of its administration of the trust.

(b) In the case of any trust that is subject to tax under subdivision (a), the taxable income of such trust shall be apportioned according to the number and interest of beneficiaries resident in this state.

To avoid confusion concerning the date on which the determination is made as to whether a beneficiary is a resident, new section 17742(c ) is added to provide:

(c) For purposes of subdivision (b), the residence of a beneficiary shall be determined based upon the facts and circumstances existing on the last day of the trust’s taxable year for any year in which the trust has taxable income. The determination of a beneficiary’s residence shall be determined under Sections 17014 and 25120, and the regulations thereunder, whichever is appropriate.

Section 17743 would be deleted as follows:

[Apportionment to resident fiduciaries.] Where the taxability of income under this chapter depends on the residence of the fiduciary and there are two or more fiduciaries for the trust, the income taxable under Section 17742 shall be apportioned according to the number of fiduciaries resident in this state pursuant to rules and regulations prescribed by the Franchise Tax Board.

Section 17744 would also be deleted because its subject matter is governed by new section 17742(b).

[Apportionment to resident beneficiaries.] Where the taxability of income under this chapter depends on the residence of the beneficiary and there are two or more beneficiaries of the trust, the income taxable under Section 17742 shall be apportioned according to the number and interest of beneficiaries resident in this state pursuant to rules and regulations prescribed by the Franchise Tax Board.

Section 17745(b) would no longer have any relevance under this proposal and would be deleted in its entirety. Section 17745(d), which only applies to subdivision (b), is similarly repealed as being no longer relevant. Section 17745 would read as follows:

[Taxes chargeable to beneficiaries.] (a) If, for any reason, the taxes imposed on income of a trust which is taxable to the trust because the fiduciary or beneficiary is a resident of this state are not paid when due and remain unpaid when that income is distributable to the beneficiary, or in case the income is distributable to the beneficiary before the taxes are due, if the taxes are not paid when due, such income shall be taxable to the beneficiary when distributable to him except that in the case of a nonresident beneficiary such income shall be taxable only to the extent it is derived from sources within this state.

If no taxes have been paid on the current or accumulated income of the trust because the resident beneficiary’s interest in the trust was contingent such income shall be taxable to the beneficiary when distributed or distributable to him or her.

(c) (b) The tax on that income which is taxable to the beneficiary under subdivisions (a) or (b) subdivision (a) is a tax on the receipt of that income distributed or on the constructive receipt of that distributable income. For purposes of this section income accumulated by a trust continues to be income even though the trust provides that the income (ordinary or capital) shall become a part of the corpus.

The tax attributable to the inclusion of that income in the gross income of that beneficiary for the year that income is distributed or distributable under subdivision (b) shall be the aggregate of the taxes which would have been attributable to that income had it been included in the gross income of that beneficiary ratably for the year of distribution and the five receding taxable years, or for the period that the trust accumulated or acquired income for that contingent beneficiary, whichever period is the shorter.

(e) (c) In the event that a person is a resident beneficiary during the period of accumulation, and leaves this state within 12 months prior to the date of distribution of accumulated income and returns to the state within 12 months after distribution, it shall be presumed that the beneficiary continued to be a resident of this state throughout the time of distribution.

(f) (d) The Franchise Tax Board shall prescribe such regulations as it deems necessary for the application of this section.