Understanding how trust income taxability is calculated (California)

The California taxation of a trust depends on the distribution of income and the residency of trustees and beneficiaries. If income is not distributed, the trust pays tax on all California-source income and non-California-source income based on the residency of each trustee and each beneficiary.

It's important to understand how this calculation works when making decisions about who will act as trustee. To determine the taxability of income earned by trusts, five elements are considered.

1) The income taxed to the settlor

If the trust is a grantor-type trust, all of the items of income and expense, without being netted against each other, flow through to the grantor's individual tax return, usually by way of an information statement generated with the return.

2) The income taxed to the beneficiaries

If any income was distributed or required to be distributed during the year to residents of California, they report each item from the Form 541 Schedule K 1 on their California Form 540. Nonresident beneficiaries pay tax to California on distributed or distributable California-source income.

Note that income from tangible assets located in California is California source income. Intangibles held by a California trust are considered to have the same situs as the nonresident beneficiary's residence and generally are not considered California source income. However, intangible property that acquires a business situs in California will generate California-source income.

3) California source income taxed to the trust

When trust income is not distributed or required to be distributed, income from California sources is taxed to California, no matter what the trustee's or beneficiary's residence is.

4) The residency of the trustees

This determines how much non-California source income will be taxed to California.

If there are two or more trustees, some of whom are residents and some of whom are nonresidents, apportion the taxable income according to the number of trustees who are residents. If there is only one trustee and that trustee is a California resident, all of the income not distributed is taxable to California.

Conversely, if there is one trustee who is not a California resident, then this portion of the computation will not add to the California taxability of the trust's net income.

This provision of the law is creating a significant disincentive for trusts to be administered by California trustees. In a world in which banks and trust companies are multi-state, California's trust industry is suffering.

5) The residency of the beneficiaries

You can ignore the residency of contingent beneficiaries for this computation.

A contingent beneficiary will become entitled to distributions only if a condition precedent should occur, such as the death of the contingent beneficiary's parent.

After subtracting the amount of non-California source income (included because of the residency of the trustees) from the total non-California source income, the remainder is subject to California taxation in the same proportion as the number of California beneficiaries to the total number of beneficiaries.

Note that there is no provision for the possibility that the resident and nonresident beneficiaries may have significantly different proportionate interests in the trust's net income.

The California resident beneficiary may have only a 10 percent interest in the net income, while the nonresident beneficiary may have a 90 percent interest in the trust's income, or vice versa. Nevertheless, apportionment is based solely on the number of beneficiaries.

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