In the closely watched âPaula Trustâ case, the California Court of Appeal, First Appellate District held that all of a trustâs California source income is subject to California income tax even though one of the trustees was a nonresident. Steuer v. Franchise Tax Board, No. A154691 (Cal. Ct. App. 1st Dist. June 29, 2020). The trustâs non-California source income would be apportionable.
California imposes income tax on 100% of a trustâs income if all trustees or all non-contingent beneficiaries are California residents. Cal. Rev. & Tax. Cd. § 17742(a). If the taxability of a trustâs income depends on the residence of its trustee and there are two or more trustees, the taxable income must be apportioned to California âaccording to the number of fiduciaries resident in this state pursuant to rules and regulations prescribed by the Franchise Tax Board.â Cal. Rev. & Tax. Cd. § 17743. The California Franchise Tax Boardâs (âFTBâ) regulations provide that if one or more trustees are California residents and one or more trustees are nonresidents, the trust is taxable on all income derived from California sources, but income derived from non-California sources is apportioned based on the percentage of trustees that are California residents. Cal. Code Regs. § 17743.
The âPaula Trustâ had two trustees, one who resided in California and another who did not. The trust had a sole beneficiary, Paula Syufy Medeiros, who was a California resident. The trust document authorized, but did not require, the trustees to make distributions to her. In 2007, the trust recognized capital gain on a sale of stock. The trustees took the position that only one-half of the capital gain income was subject to California income tax because one trustee was a California resident and the other was not. In support of their position, the trustees argued that Californiaâs statute, Cal. Rev. & Tax. Cd. § 17743, allowed the trust to apportion all of its income.
The trustees argued that Californiaâs regulation that taxes all California-sourced income and limiting apportionment only to income derived from non-California sources (Cal. Code Regs. § 17743) was inconsistent with the statute. The FTB disagreed. The FTB argued that Californiaâs tax law requires taxation of all California source income and, even if the taxability of the trustâs income depends on the residence of the trustee, California only allows the trust to apportion non-California source income. The FTB also argued that the trustâs sole beneficiary was a non-contingent California beneficiary, so 100% of the trustâs income would be taxable without regard to source.
In 2018, the trustees won at the trial court level. The trial court agreed with the trusteesâ reading of the statute (Cal. Rev. & Tax. Cd. § 17743) as allowing the trust to apportion all income based on the trusteesâ residence, regardless of whether the income is derived from California. The trial court also agreed that the trustâs sole beneficiary was a contingent beneficiary because the trustees were not required to make any distributions to her. The FTB appealed the trial courtâs decision. On appeal, the California Court of Appeal, First Appellate District disagreed with the trial courtâs reading of the statute. The court concluded that the plain statutory language allows trusts to apportion only their non-California source income based on the trusteesâ residence. Additionally, the statute expressly incorporates the FTB regulation that allows trusts to apportion only their non-California source income based on the trusteesâ residence. The Court of Appeal also found that the legislative history supports the FTBâs reading of the statute. Therefore, the Court of Appeal held that all of the trustâs California source income is subject to tax. However, the Court of Appeal upheld the trial courtâs holding on the second issue: that the Paula Trustâs sole beneficiary was a contingent beneficiary. Therefore, the trust would not be taxable on all of its income based on the beneficiaryâs California residence and the trustâs non-California source income is apportionable.
Contact the authors: Dmitrii Gabrielov
