Trusts are extremely useful estate planning tools. However, they are subject to the competency of the trustee, who is charged with protecting the trust and discharging various fiduciary duties.
One example of those duties is taxes. Trustees sometimes have extensive tasks related to taxes associated with the trust. If they fail to fulfill these duties, the trust could suffer financially.
Who Pays?
Trustees may have tax duties related to the administration of the trust. However, they are not personally responsible for a trust’s tax liabilities. Trust tax bills (for estate planning purposes) are paid by either the trust or the beneficiaries.
Whether the trust or the beneficiary pays taxes on the income generated by the trust depends on the trust’s language. If the beneficiary pays, they will be taxed at their personal income tax rate. Keep in mind, though, that the trust must pay taxes on any interest income that remains undistributed at the end of the year.
For taxation purposes, trusts are treated like people. As such, the IRS requires trusts to file individual income tax returns annually. The California Franchise Tax Board (FTB) also requires trusts to file income taxes. However, tricky situations arise when determining whether trust income should be taxed in California.
Out-of-State Trusts
California has established extensive jurisdiction over the taxation of trusts, more so than many other states. Trust formed and administered outside of California to beneficiaries outside of California may still be subject to California taxation.
Take a trust formed in Texas with two co-trustees for beneficiaries living in New York. If one of the co-trustees resides in California, half of the trust’s income may be subject to California’s income tax.
Trustees must be aware of the long reach of California’s tax laws in order to fulfill their tax obligations, which are more extensive there than in other states. Trustees need professional counsel and guidance from experienced estate planning attorneys whenever California is involved with a trust.
Corporate Trustees
When it comes to taxation of trusts, California rules consider a trustee’s residence to be the state where the trust is administered. For example, if a corporate trustee is incorporated in a state outside of California but administers the trust within California, the trust’s income will be subject to California income tax.
Specifically, a major portion of the trust administration must occur within California. Determining what “major portions” means has been a challenge. Different state agencies, such as the FTB and the California State Board of Equalization, have discussed and written opinions on the “major portions” question. Nonetheless, no clear legislative or judicial guidance exists as of yet.
Throwback Taxation
Throwback taxation is a complex issue that can result in extensive income tax liability. It involves the FTB collecting tax retroactively on a lump-sum payment to a beneficiary after years of accumulation.
Consider a California resident who has been the beneficiary of an irrevocable trust in Nevada for 15 years but receives no distributions during that time. They then receive a lump distribution of the money that has accumulated over the past decade and a half. California’s throwback provisions allow California to recover taxes from that distribution for unpaid trust income.
Several other tax issues arise for trustees in California or who are associated even minimally with the Golden State. Being aware of them and getting on-point guidance and service from an experienced estate planning attorney will help trustees keep trust assets and distributions safe from surprise taxation and other liabilities.
Professional Effective Estate Planning Guidance
The team at OC Wills & Trust Attorneys is ready to listen to and discuss your needs. Contact our office in Orange County for tailored guidance on matters relating to trusts and estate planning.
