California Appellate Court Rules That California Can Tax Trust Beneficiaries' Income

3 min

A California state appellate court recently overturned the trial court's decision in Paula Trust v. California Franchise Tax Board and upheld the historic position of the California Franchise Tax Board (FTB) that a trust must pay California income tax on all California source income earned by the trust, regardless of whether the trust fiduciaries or beneficiaries reside in California. The California Supreme Court declined to review the appellate court's ruling.

Under long-standing FTB regulations, a trust is taxable on (a) 100% of its California-sourced income (determined using the nonresident individual sourcing rules),1 and (b) a portion of its non‑California-sourced income based on the state of residence of the fiduciaries and the noncontingent beneficiaries of the trust. In Paula Trust, the trust sold an interest in a business that operated in California. The trust argued that only half of the income from the sale was taxable in California because one of the two trustees resided out of state. The FTB argued that the trust was taxable on all income from the sale since the sale of the business generated California-sourced income under the nonresident sourcing rules.

The trial court in Paula Trust rejected the FTB's position and ruled that the nonresident individual sourcing rules did not apply to trusts. The trial court concluded that the residence of the trust's fiduciaries and noncontingent beneficiaries is the only basis for taxing the trust's income. Thus, under the trial court's reasoning, California could only tax half of the trust's income from the sale of the business, despite all of its income being California-sourced income under the sourcing rule generally applicable to nonresident individuals.

The appellate court overturned the trial court's decision and upheld the validity of the FTB's regulations requiring taxation of all of a trust's California-sourced income and apportioning only income derived outside of California based on the residence of the fiduciaries and noncontingent beneficiaries. The trust petitioned the California Supreme Court to overturn the appellate court's decision. The California Supreme Court denied the petition, letting stand the appellate court ruling.

Given that California has the highest state income tax rate (the top rate is currently 13.3%, with state legislators proposing increases in the top rate to 16.8%), the trial court's ruling, if upheld, would have provided a favorable reporting position for non‑grantor trusts with non-California fiduciaries and noncontingent beneficiaries. The appellate court's ruling, combined with the California Supreme Court's denial of the petition for review, appears to close the door on this reporting position.

Planning to save state and local income taxes will remain an important tax and estate planning consideration, especially since the 2017 Tax Cuts and Jobs Act caps the deduction for state and local taxes at $10,000 per year. While the $10,000 cap is set to expire at the end of 2025 and Democratic legislators have proposed an earlier repeal, Democratic tax plans have also proposed a 28% cap on itemized deductions, which would limit the deductibility of state and local taxes for taxpayers subject to federal tax rates above 28%. For individuals who reside in high-tax states and hold income-generating intangible assets, establishing a properly structured non-grantor trust in a low- or no-income tax state and transferring the assets to such trust can generate significant state income tax savings.

[1] Under the nonresident sourcing rules, California-sourced income consists generally of income earned from a business carried on in California and the sale of real or tangible property located in California.