To say California’s rules for taxing trusts are complex is an understatement. In any case, the rules are still there, and you the taxpayer should be aware if there are California reporting obligations. Failure to file trust tax returns may result in severe penalties in addition to prolonging statute of limitations for California Franchise Tax Board assessment.
Under California law, income produced by the trust is subject to California taxation. The trust itself will be subject to California if: (1) a trust fiduciary is a resident of California; or (2) a trust beneficiary whose interest in such trust is non-contingent is a resident of California. What if the trust settlor is not a California resident? Does not matter; the rule applies regardless of the settlor’s residence.
With regard to determining residence, an individual is deemed to be a resident of California for tax purposes when the individual is: (1) in California for other than temporary or transitory purposes; or (2) domiciled in the state but is outside of the state for temporary or transitory purposes. The determination for “residency” for corporate fiduciaries is where the corporation performs the majority of its administrative functions with respect to the trust.
California Taxation as a Result of Fiduciaries
A fiduciary that is a California resident makes the trust subject to California taxation. If there is only one fiduciary, then the entire trust income subject to California taxation; not just an apportioned amount. In the instance of multiple fiduciaries residing out-of-state, and at least one of the fiduciaries is a California resident, the income taxable to California is apportioned according to the number of fiduciaries who are California residents. For example, a trust with one California fiduciary and two Nevada fiduciaries will cause the one-third of income to be subject to California taxation.
California Taxation as a Result of Trust Beneficiaries
The residence of the trust beneficiaries also determines whether a California reporting obligation exists. Non-contingent beneficiaries and contingent beneficiaries are key in determining an existing California tax reporting obligation. Contingent beneficiaries are those beneficiaries that cannot receive trust distributions unless a certain condition is met (example: beneficiary must reach the age of 40 to receive lump sum distribution). Non-contingent beneficiaries do not hold conditions on distributions of income. It is important to note that if trustees can withhold income disbursements to beneficiaries, then those beneficiaries are said to have contingent interests.
When trust distributions are made, which makes contingent interests non-contingent, the trust with a California resident will have a California reporting obligation. If the trust has multiple beneficiaries, some of which are located out of California, the income is apportioned according to the number and respective interests of beneficiaries that are California residents. To make matters more complicated, special ordering rules apply where a trust has multiple fiduciaries and multiple beneficiaries, some of which are California residents.
Rules for California Reporting Obligation and Penalties for Non-Filing
A California trust is required to file a California income tax return if the trust: (1) has net income from all sources in excess of $100; or (2) has gross income from all sources in excess of $10,000, regardless of the amount of net income. The California Franchise Tax Board can impose failure to file penalties and interest for those non-filers. Additionally, the statute of limitations is open for collection, meaning the clock does not start on a typical four-year collection deadline.
In conclusion, be sure your tax professional is aware of the instances where an obligation for California reporting exists. The Franchise Tax Board just may sneak up on you.