California Tax Trap and Residency for Trusts
“California Tax Trap and Residency for Trusts,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Natalie Perry, ACTEC Fellow from Chicago. You might be surprised to learn that if any trustee or beneficiary moves to California the entire trust could be subject to tax in California. Today you will be hearing from ACTEC Fellow Justin Miller of San Francisco, California. Welcome, Justin.
The California Tax Trap
Well thank you, Natalie. I’m going to start actually with a little tongue twister and it goes something like this: you can trust that a non-grantor trust with trust income will be subject to a California trust tax if you put your trust in a California trustee of a trust, regardless of whether the trustee can be trusted. So, try saying that five times fast. And it’s actually somewhat true. The reality is, if you have any kind of not just trustee, but fiduciary, or even potential beneficiary that moves to California, you might be somewhat unpleasantly surprised to learn that you suddenly have a trust that is subject to taxation in California.
And why is this a problem? Well, the reality is not only is there an income tax in California, but California has the highest state income tax in the country; as high as 13.3%. Now, New York was a little bit jealous, so the New York state tax is a little bit lower, but if you add in the New York City income tax, that combined tax does beat out California. But from a pure state perspective, the highest state income tax in the country is in California at 13.3%.
California Trust: California Income
So, before I talk about how we figure out whether or not we even have a fiduciary or a beneficiary in California, let’s talk about how California taxes trusts. And it’s really a three-step process. So, step number 1, if you have any California source income. That’s kind of an obvious one, it’s clearly constitutional. If you’ve got a building in California and you’re collecting rents from that building, clearly that is going to be subject to tax in California. That is California source income, so regardless of whether you’re an individual or a trust and it owns that property, collecting rents from California property, that’s going to be subject to tax in California.
California Trust: Fiduciaries
But now let’s focus down on trusts. So, two important things, so steps two and three. Step 2, we want to look at where the fiduciaries are. California law doesn’t say trustee. Trustee is certainly a fiduciary, but fiduciary is a much broader term. And unfortunately, that broad term, fiduciary, is not really defined under California law. It’s somewhat of a circular definition. A fiduciary is somebody acting in a fiduciary capacity. So, what does that mean? It’s not entirely clear. Especially when we have trusts that sometimes have these unique positions that are created such as trust protectors, trust advisors, and trust directors. You might even have a trust that specifically says that individual is not acting in a fiduciary capacity, but that’s not enough.
California Franchise Tax Board, regardless of whether it says, not acting in a fiduciary capacity, California Franchise Tax Board can still consider that person or that individual to be a fiduciary. If it looks like a fiduciary, smells like a fiduciary, sounds like a fiduciary, walks, talks, and acts like a fiduciary, then it will be determined to be having a fiduciary in California.
California Trust: Corporate Trustee
So, a very, very broad term. What about a third-party independent corporate trustee? How do you know if that corporate trustee is a fiduciary in California? And for that, the test is to look at where the major portion of the administration is done. So, if you have a corporate trustee and let’s say we can do it in Delaware or we can do it in California or some other state. We’re going to look at where the administration work is done. Where are you doing the accounting work, the distribution decisions?
Now, the investment management is a little different. If you’re doing some portfolio management work in California, that’s not typically a major portion of administration. There is a 1997 California Chief Council ruling specifically on the topic of whether investment management is enough to be considered a major portion of administration. But if you’re doing your traditional trust officer type work in California, then you could be considered what is a corporate trustee to have a California fiduciary.
California Trust: Non-Contingent Beneficiaries
Now, we’re going to talk about in a second whether or not that fiduciary is actually located in California. How do we determine that, especially for an individual? But let me then talk about the third way California taxes trust. And that is not only if you have a fiduciary in California, not only if you have source income in California, but if you have what is called a non-contingent beneficiary in California.
So, this is different than that Supreme Court case decision we had a couple of years ago. North Carolina case, the , K-A-E-S-T-N-E-R, Kaestner case. And the Kaestner case dealt with a beneficiary who didn’t have any right to income from the trust, wasn’t getting income from the trust, couldn’t demand income from the trust –hat’s what you might call a contingent beneficiary. The Supreme Court case in the Kaestner decision said you can’t tax a trust in North Carolina if you just happen to have a random beneficiary who isn’t getting anything, can’t demand anything, isn’t entitled to anything.
California law is different. California uses this term which it doesn’t define very well: non-contingent beneficiary. So, if you really have a vested beneficiary, someone who’s getting money, someone who’s entitled to money, that could also subject a trust to tax in California. Now, you might say well, what if we have a trust set up in a state like Delaware, Nevada, or Wyoming, or South Dakota, or Alaska? And it’s accumulating income for 20 years? So, nobody’s getting anything in California, they’re completely contingent. And then in year 20, we make a big distribution. We distribute out $2,000,000. California also has what’s called a throwback tax.
California Throwback Tax
Now, the throwback tax is different than the federal throwback tax that applies to foreign trusts. This is a special state throwback tax that says: if you’re in California and you have a beneficiary in California, and even if it’s been 20 years you’ve been accumulating income in a different state, when that big distribution is made, California will look back over the entire term of the trust. The entire 20 years, at all of the taxable income that you’ve never paid taxes on in California. And when you make that distribution to the California beneficiary, it will be taxed then and there. The entire 20 years’ worth to the extent of that distribution. They will look back and say that is all taxable income that you’ve never paid in California.
In fact, New York was so jealous of California’s throwback tax, that a few years ago they actually copied California’s throwback tax. So, right now New York and California both have throwback taxes. The difference though is New York’s rule does not apply to capital gains, the throwback rule. Whereas in California, it does apply, not just to your traditional fiduciary retirement income, but also applies to capital gains. In case you’re wondering that’s the Pardee Erdman case. P-A-R-D-E-E, and then Erdman, E-R-D-M-A-N case. So, that’s the throwback tax.
How to Determine California Fiduciaries and Non-Contingent Beneficiaries
Last but not least, what happens if you have multiple fiduciaries and multiple non-contingent beneficiaries? There’s an apportionment rule. So, first what you do is you look at the pro-rata number of fiduciaries in California. Whatever percentages are in California, that’s the percentage that’s taxed in California. Then, you look at the non-contingent beneficiaries in California, and then you do a similar pro-rata rule for whatever remaining taxable income of the trust.
So, that’s how you tax trusts in California, but it does bring up the big question. How do we actually know if we have that fiduciary or non-contingent beneficiary? How do we know if they’re actually in California? How do we know if they are a resident of California? So, here’s the rule for California residents. And it’s sort of a two-part rule. So, the first part of the residence rule is we look at: are you in California for other than a temporary or transitory purpose? Are you in California for other than a temporary or transitory purpose?
So, if you’ve moved to California, if you’ve retired, you have no intent to leave — even if you’re ill and you’re in an indefinite recuperation period — that means your stay is other than temporary or transitory. Now look, if you’re coming to California for a vacation, if you’re simply passing through California, clearly that’s a temporary or transitory purpose. So, you’d be a non-resident, but if you’re here for other than that temporary or transitory purpose, you are considered a California resident. This is the California tax trap. So, even for people that aren’t in California, for all of those attorneys, accountants, and clients outside of California thinking, I have no ties to California, my trust will never be subject to tax in California.
Well, what if you name a trustee like Uncle Bob or Aunt Suzy and they one day move to California? Suddenly your trust might be subject to tax in California. Or what if one of your children or grandchildren one day moves to California? Little Bobby, or little Amy, whatever it is. One day they grow up and move to California as a beneficiary or non-contingent beneficiary, you could have a trust subject to tax in California.
California Residency and Safe Harbor
Now, what about sort of a safe harbor? This is the problem with people that like to do their own research, their own tax research. I get this question all the time, especially people – there’s a website you might be familiar with called Google. And people go on Google, they do their own tax research, they read some materials and they read about this nine-month rule. And they say, “Wait a minute. I read in California, aren’t I safe if I’m not subject to this nine-month rule?” And they think that, oh, as long as I spend less than nine months in California, I won’t be a resident.
Now, here’s the problem with doing your own Google research. There is a nine-month rule in California, but the nine-month rule is a presumption that says you are a California resident. If you spend more than nine months in California, you are presumed to be a California resident. Now, you theoretically could rebut that presumption, but it’s going to be very, very difficult. Most of the time if you’re spending more than nine months, you almost certainly are going to be considered a California resident. Like I said, unless you have huge facts to be able to rebut that, and the burden is going to be on you to rebut that presumption. But even if you spend nine months or less, you could still be considered a California resident.
You are not safe, which gets to the second part of California’s residency rules, and that is domicile. Even if you leave California. Even if, let’s say you move to Nevada or Florida or Washington or some state with no state income taxes, you could still be considered to be a domiciliary of California. To be domiciled. So, domicile is almost like an emotional or psychological test. Domicile is the place where even when you’re not there, you intend to return. Where do you intend to return? So, even if you’ve moved to another location, and if you’re considered to still be domiciled in California, then you are considered to be a resident of California.
Now, there is a limited safe harbor. Very, very limited safe harbor. If you’re out of California for employment related reasons for at least 546 days, then you fall into the safe harbor, but it’s a limited safe harbor. If you have intangible income exceeding $200,000 then you’re not, then you can’t take advantage of that safe harbor to be considered a non-resident. Also, if your principal purpose of being outside California is to avoid personal income tax, you can’t take advantage of that safe harbor.
So, in general, if you’re domiciled in California, you will be considered a California resident. The other thing is California- I talked about the throwback tax earlier- sometimes what you might see is a beneficiary saying, “Oh, well we’ve got this trust in Delaware, Nevada, or some other state that it’s been accumulating income for many, many years. Why don’t I just leave California before I get that big distribution, so I won’t be subject to the throwback tax?”
Now, we’ve already talked about it. You’re still domiciled in California; you will still be considered a California resident. But the California code goes even further and says if you leave California twelve months before a big distribution and you come back within twelve months, you will automatically be presumed to be a California resident. So, not only do we have the domicile test, but we have this automatic presumption, that sort of two-year period that the throwback tax will apply.
California Domicile: Facts and Circumstances
So, now it leaves the final question. And that is: all right, we understand these tests, but how do you apply, how do you figure out this rule? How do you figure out if you’re in California for temporary or transitory purposes or how do you figure out what your domicile is?
So, the way it works in California is whether the Franchise Tax Board (FTB) or it goes to court, how’s the court going to determine that residency or domicile? And in California, it comes down to facts and circumstances. This goes all the way back to the Bragg case. It’s the appeal of Bragg, B-R-A-G-G. And there are a bunch of factors that the FTB and the courts will look to consider whether or not California is your place of residence or domicile. And these factors, now none of these factors, it’s not an exclusive list of factors and it’s not just the number of ties. It’s also the strength of your ties to California. And there’ll be things like how much time do you spend in California versus all the other places where you might spend time?
So, if you spend most of your time in California and the rest of the time, you’re spending in all your homes or traveling around the world, you could still be a California resident. California looks at where your driver’s license is, and where your vehicles are registered. Where your professional licenses are located, where you’re registered to vote. Your social ties even, what churches, synagogues, clubs you belong to. So, those are just a list of factors, but as I said, it’s not an exclusive list and it’s not just the number of factors. We’re going to look at the strength of each of those ties. And some factors matter more than others.
California Principal Residence
So, I’m going to leave you with the one that we see most of the time and that the courts and Franchise Tax Board really seem to focus in on. And that is going to be things like your principal residence. So, let’s put it this way, if you’ve got a huge home in California, or let’s just say a very expensive home. Let’s just say you have a $4,000,000 house in the San Francisco Bay area. Which by the way, for people not from California, a $4,000,000 house in the Bay area could be 2,200 square feet. So, it might not even be a huge home, but let’s just say you have a $4,000,000 house in California. That’s your residence and you’re trying to claim that you’re leaving California and you get a small condo somewhere, you’re renting an apartment somewhere. And all of your furniture is still in California, you still come back to California. In theory that could be a very, very bad fact for you to claim you’re not a California resident. Because you’ve kept your primary home, you keep coming back to visit, you’re not renting it out. And the other place that you purchased in the other state is not up to the same level. It doesn’t necessarily have to be the same cost. Don’t get me wrong, a $4,000,000 home in California, you could probably get a home twice as nice in other parts of the country for half the money.
So, it’s not just the cost of the home, but it’s the quality of the home. And that’s a real important factor to determine whether or not you’ve changed your residence or domicile.
And I’ll leave you with the last thing, and that is: how does the California Franchise Tax Board, how do they even figure out these factors? This is a facts and circumstances test. And the reality is the California Franchise Tax Board will do whatever they can to figure out those facts. They can interview neighbors, they can fly drones over your home, they can go through trash cans. Whatever it is, if you’re in a situation and trying to establish that you’ve officially left California, you better make sure you have the facts and circumstances in your favor.
And ultimately what it comes down to, and I’ll just repeat, even if you’re not in California and you think that you’ve drafted the perfect trust for a grantor who’s not in California. That trust could eventually be subject to California (tax) and we’ve got to look at where the fiduciaries are and where the non-contingent beneficiaries are. And that is just the rule for non-grantor trusts.
I hope this helps you and with that, thank you for your time today. And I will turn it back over to Natalie.
Thank you, Justin, for educating us on this unique provision of California law.
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