At a Glance…

On September 25, Governor Brown signed into law Senate Bill No. 813, which updated the California Voluntary Disclosure Program (VDP) to include out-of-state trusts with California beneficiaries and non-resident partners of out-of-state partnerships, and to allow the Franchise Tax Board (FTB) to waive the S Corporation or partnership late-filing penalty for specified returns under the VDP. As the authors of this alert have argued for years, the expansion of the VDP to include out-of-state trusts with California beneficiaries was long overdue.

Trusts are subject to the California personal income tax and pay tax at the individual personal income tax rates.1 California rules differ from many other states in their determination of a trust’s taxability. California taxes the income of a trust if the trust either

  1. has income from California sources;2 or
  2. has California residency based on the California residence of a fiduciary or non-contingent beneficiary of the trust.3

Because taxing trusts based on the residency of its beneficiaries is uncommon, many administrators have overlooked reporting tax liabilities to the California Franchise Tax Board. In our experience, many trusts with a California beneficiary discover their California filing obligation many years after the obligation first arose. Often the discovery is the result of the trust hiring new administrators to manage the trust.

Voluntary disclosure agreements

California has a statutory voluntary disclosure program for out-of-state taxpayers that were not filing returns with the FTB. Cal. Rev. & Tax. Code section 19191 authorizes the FTB to enter into a voluntary disclosure agreement (VDA) with any qualified entity (including a qualified trust) to obtain voluntary compliance with the tax laws of the State of California. The FTB can waive penalties associated with the return filings, and waives its authority to assess taxes, additions to taxes, fees, or penalties for the taxable years ending prior to the six taxable years covered by the VDA.

But the FTB’s authority to enter into VDAs has long had one glaring omission. By statute, the FTB’s authority did not include trusts with non-contingent beneficiaries who are residents of California. Thus, the same oddity of California income tax law that creates the California filing obligation for trusts with California beneficiaries also operated to exclude such trusts from the FTB’s VDA program. Reed Smith brought this oversight to the attention of the FTB and legislative staff in a white paper and presentation on January 23, 2015. Our proposed solution was to simply remove language in Revenue and Taxation Code section 19192 that excluded trusts with non-contingent California resident beneficiaries from the VDP.

Senate Bill No. 813 (S.B. 813), which was signed into law this week, adopts this solution. Effective January 1, 2018, S.B. 813 expands the FTB’s authority to enter into VDAs to include out-of-state trusts with California beneficiaries (both contingent and non-contingent beneficiaries).4

As a result of the enactment of S.B. 813, out-of-state trust administrators should review the trusts they administer to determine if any have beneficiaries residing in California. If a trust has a California-resident beneficiary, and if it has not been filing income tax returns in California, this law change provides a prime opportunity for the trust to enter into a VDA with the FTB that would allow the trust to begin filing California income tax returns, and pay California income tax without exposing the trust potential liability for an unlimited lookback period and extensive non-filing penalties.