Lobb & Plewe Attorneys At Law

California Source Income: How to Wrestle a Demon and Win

Tax planning for business owners in California grows increasingly more difficult every year. In addition to California's oppressive tax rates, the Tax Cuts and Jobs Act of 2017 capped the state and local tax deduction, forcing Californian's to pay even more federal tax than in the past. Fortunately, relief is available thanks to a recently decided case out of San Francisco.

For years the California Franchise Tax Board (FTB) has taken the position that trusts are subject to California state income tax on all of their California source income. With respect to non-California source income, the FTB apportions pro rata according to the number of California fiduciaries and non-contingent beneficiaries. The California Superior Court in San Francisco has rejected the FTB's approach to the taxation of trusts. In Paula Trust v. California Franchise Tax Bd., No. CGC-16-5556126 (Cal. Super.Ct. 3/7/18) the court ruled that all income, including California-source income, is subject to the apportionment formula set forth in California Revenue & Taxation Code Section 17743, et seq.

Paula Trust Creation and Partial Disposition of Assets

Paula Trust involved a trust created by Raymond Syufy for the benefit of his daughter Paula. Mr. Syufy founded Century Theatres. He was an innovator in the movie theater industry. In the legal arena, Mr. Syufy is known for taking down the likes of Paramount, MGM and Fox in a case which was decided by the Supreme Court.

In 1971, Mr. Syufy transferred a portion of his business interests to the Paula Trust. The trust agreement stated the trustees had sole and absolute discretion to make distributions of income and principal to the beneficiary. In 2007, the trust sold a portion of the business interest, creating $2.8 million of California source income. At the time of the partial sale, the trust had two trustees. One trustee was a resident of California, and the other was a resident of Maryland. The sole beneficiary of the trust was Paula Syufy Medeiros. Paula was a resident of California. Paula was considered to be a contingent beneficiary in 2007 since the trustees did not make any distributions to her in that year. The trust filed a tax return for 2007 and reported and paid tax on the entire $2.8 million from the sale of the business interest.

Now the fun starts! The trust filed a claim for refund in 2012, taking the position that only 50% of the income was subject to California income tax under the apportionment formula set forth in California Revenue & Taxation Code Section 17743. The trust apportioned the income pro rata based on the number of resident and nonresident fiduciaries as allowed for in Section 17743. Without shock or surprise, the FTB denied the claim for refund on the basis that all of the income was California source income and not subject to the apportionment method used by the trustees. The trustees then exhausted the administrative remedies and filed suit in the San Francisco Superior Court.

The Trustees and the FTB do not dispute that the proceeds from the sale of the interest in Century Theatres is California source income. However, the FTB argued California Revenue & Taxation Code Section 17951 et seq. provides that nonresidents are subject to tax on their California source income. Therefore, the California-source income is not apportionable. The trust, on the other hand, argued that California Revenue & Taxation Code Section 17743 et seq. provides the exclusive basis for taxing trust income and that the FTB's interpretation is inconsistent with the plain reading of the statutes. No California statute explicitly requires that trust income include the income from property or business activity sourced in California.

The court agreed with the trust. The court held that the trust properly apportioned its California taxable income in accordance with Section 17743. All of Paula Trust's income, including the California source income, is subject to the apportionment method set forth in Section 17743. Paula Trust will report and pay tax on one-half of the California source capital gain, and the other half of the California source capital gain will be deferred until it is distributed to the beneficiary since trust income is not taxed to a resident beneficiary until it is distributed under Section 17745(b).

The case has been appealed by the FTB. The matter has been fully briefed as of May 13, 2019. The parties to the case are currently waiting for the assignment of a hearing date. Normally, the final decision of the court is made within 90 days of the oral argument. It is likely a final decision will be made by the Courts of Appeal this year.

Planning Opportunities Abound

Forming non-grantor trusts with non-California Trustees in which all California beneficiaries are contingent will, pursuant to this ruling, defer or eliminate California tax on California source income. The non-grantor trust may also provide asset protection and estate tax planning benefits. Accordingly, income producing assets, including but not limited to intangibles, real estate, and business interests, especially those sourced in California, should be placed in such a trust.

Because the trust has the stronger argument, it is conceivable the decision of the Superior Court will be upheld. If it is and proper planning is not employed today, significant tax savings opportunities will be lost. If it's not upheld, there is no downside to having done some estate and asset protection planning. Accordingly, the potential benefits of planning vastly outweigh doing nothing.

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