Press Room: Tax Release

September 10, 2018

Recent Case Rejects California Franchise Tax Board’s Long-Standing Approach to Taxing Trusts

In March 2018, the California Superior Court in San Francisco ruled in favor of the taxpayer in Paula Trust v. California Franchise Tax Board (Paula Trust). The California Franchise Tax Board (FTB) has long taken the position that trusts are subject to tax upon 1) all California-source income, plus 2) all other income apportioned to California based on the number of California fiduciaries and non-contingent beneficiaries. The California Superior Court found the first part of this approach contrary to the law, relegating all trust income subject to apportionment. As a result of the decision, a trust with at least some nonresident fiduciaries or nonresident non-contingent beneficiaries may be able to defer California tax on California-source income earned by the trust until the income is distributed to beneficiaries.

The Case and Its Impact

The Paula Trust reported California-source capital gain on the sale of Century Theaters in its originally filed 2006 and 2007 tax returns based upon the FTB regulations. In 2012, the trust recomputed the tax based upon statutory apportionment resulting in 50% of the trust income sourced to California because 50% of the fiduciaries were located in California. The FTB denied the refund, and prevailed at the Board of Equalization (BOE) defending its regulation. The Paula Trust filed suit in California Superior Court, and won summary judgment on the basis that the regulation is invalid. The judgment is on appeal.

To clarify the impact of this decision, consider the following example:

Taxpayer Trust has one contingent beneficiary who resides in California. Taxpayer Trust has two trustees that are located in Nevada. Taxpayer Trust owns a parcel of land in California that it sells in Year 1 for a gain of $100,000. Nothing is distributed from the trust in Years 1-4, and then in Year 5 the trustees make a discretionary distribution to the beneficiary.

The regulation would require Taxpayer Trust to report $100,000 of taxable income from the sale of land in Year 1 because such sale constitutes California-source income. However, pursuant to Paula Trust, the trust would ignore the regulation and apply statutory apportionment. The trust would therefore report $0 to California because none of the fiduciaries are in California. The California resident beneficiary would report the $100,000 of income in Year 5 when it is distributed.

The Takeaway

California taxpayer trusts should consider their own mix of income, beneficiaries, and fiduciaries to determine the impact of the Paula Trust decision. Taxpayers may file protective claims to preserve the right to a refund upon final disposition of the case.