In the closely watched “Paula Trust” case, the California Court of Appeal, First Appellate District held that all of a trust’s 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 trust’s non-California source income would be apportionable.

California imposes income tax on 100% of a trust’s income if all trustees or all non-contingent beneficiaries are California residents.  Cal. Rev. & Tax. Cd. § 17742(a).  If the taxability of a trust’s income depends on the residence of its trustee and there are two or more trustees, the taxable income must be apportioned to California “according to the number of fiduciaries resident in this state pursuant to rules and regulations prescribed by the Franchise Tax Board.”  Cal. Rev. & Tax. Cd. § 17743.  The California Franchise Tax Board’s (“FTB”) 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 “Paula Trust” 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 California’s statute, Cal. Rev. & Tax. Cd. § 17743, allowed the trust to apportion all of its income.

The trustees argued that California’s 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 California’s tax law requires taxation of all California source income and, even if the taxability of the trust’s 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 trust’s sole beneficiary was a non-contingent California beneficiary, so 100% of the trust’s income would be taxable without regard to source.

In 2018, the trustees won at the trial court level.  The trial court agreed with the trustees’ reading of the statute (Cal. Rev. & Tax. Cd. § 17743) as allowing the trust to apportion all income based on the trustees’ residence, regardless of whether the income is derived from California.  The trial court also agreed that the trust’s sole beneficiary was a contingent beneficiary because the trustees were not required to make any distributions to her.  The FTB appealed the trial court’s decision. On appeal, the California Court of Appeal, First Appellate District disagreed with the trial court’s 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 trustees’ residence.  Additionally, the statute expressly incorporates the FTB regulation that allows trusts to apportion only their non-California source income based on the trustees’ residence.  The Court of Appeal also found that the legislative history supports the FTB’s reading of the statute.  Therefore, the Court of Appeal held that all of the trust’s California source income is subject to tax.  However, the Court of Appeal upheld the trial court’s holding on the second issue: that the Paula Trust’s sole beneficiary was a contingent beneficiary.  Therefore, the trust would not be taxable on all of its income based on the beneficiary’s California residence and the trust’s non-California source income is apportionable.

Contact the authors: Mike Shaikh and Dmitrii Gabrielov

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