UPDATE: On October 14, 2020, the California Supreme Court denied the petition for review.
California’s Court of Appeals for the First District recently held that — consistent with Franchise Tax Board guidance and common practice since the 1930s — a trust with nonresident fiduciaries or contingent beneficiaries is taxable on all California-source income. Non-California source income is allocated based on the residence of California fiduciaries and non-contingent beneficiaries (hereafter known as 'residency apportionment').
Further, the Court held that the California resident beneficiary’s interest in the trust was contingent because the trust instrument gave the trustees absolute discretion to make distributions.
The taxpayer has asked the California Supreme Court to review the decision.
If the California Supreme Court accepts review and later reverses the Court of Appeal and adopts the taxpayer’s position, such adoption would significantly alter the taxation of trusts with California-source income to the extent trusts have nonresident fiduciaries or non-contingent beneficiaries. Such possible changes might include not only the taxation of trusts in a given tax year, but also the tracking and treatment of prior 'California source' amounts of the trust that are distributed and taxed at a later date to beneficiaries.
To the extent trusts with out-of-state fiduciaries and contingent beneficiaries have generated California-source income, they may want to consider the advisability of filing protective claims for refund pending potential consideration of the issue by the California Supreme Court.
In situations where there is 'best interests' language that may be read to limit the trustee’s discretion, that language should be reviewed to determine whether the trustee owes a duty to make allowances for the beneficiary’s support and maintenance as that may impact whether the beneficiary is considered to be a contingent or non-contingent beneficiary.
Personal Financial Services Leader, PwC US