How Are Trusts Taxed in California? Key Rules for Trustees and Beneficiaries
Understand how California taxes trusts, including key rules on trustee residency, income distribution, and state filing requirements.
Trusts are common tools for managing assets, but they come with tax responsibilities that can be complex, particularly in California. Whether setting up a trust, serving as trustee, or receiving distributions, understanding state-level trust taxation is necessary to avoid unexpected liabilities.
California applies its own rules, distinct from federal tax treatment, governing when and how a trust owes taxes. This article outlines the factors trustees and beneficiaries should understand about California trust taxation.
Types of Trusts Subject to California Tax
California imposes an income tax on trusts similar to individuals, but the application depends on the trust’s structure. The state’s authority is detailed in the California Revenue and Taxation Code (R&TC), primarily sections 17731 through 17779, which largely align with federal rules but include specific state modifications.1Justia Law. California Revenue and Taxation Code § 17731
A key distinction exists between revocable and irrevocable trusts. Revocable trusts, or living trusts, are generally not separate taxable entities during the grantor’s lifetime. Since the grantor can alter or cancel the trust, income generated is reported on the grantor’s personal state income tax return.
Irrevocable trusts, once established, typically cannot be changed by the grantor and are usually considered separate legal entities for California tax purposes. The trust itself may owe California income tax on earnings not distributed to beneficiaries. These trusts file Form 541, the California Fiduciary Income Tax Return.
Within irrevocable trusts, California further distinguishes between grantor and non-grantor types. Grantor trusts, though irrevocable, have features causing the income to be taxed directly to the grantor under state law.
Non-grantor trusts are treated as distinct taxpayers. They pay California income tax on undistributed income. These can be simple trusts, which must distribute all income annually, or complex trusts, which may accumulate income or distribute principal. Tax liability falls either on the trust (for retained income) or beneficiaries (for distributed income). Whether a non-grantor trust owes California tax often depends on factors like fiduciary and beneficiary residency, as outlined in R&TC Section 17742.2Justia Law. California Revenue and Taxation Code § 17742 Generally, a trust’s entire taxable income is subject to California tax if the fiduciary or a non-contingent beneficiary (one whose interest is not subject to a condition precedent) is a California resident.
Trustee Residency Rules
The residency of the trustee, or fiduciary, significantly impacts whether a trust’s income faces California tax. If a trust has a fiduciary who is a California resident, the trust’s entire taxable income may be subject to state tax, regardless of where the trust was created or assets are located. Beneficiary residency can also independently trigger California taxation.
If a trust’s sole trustee resides in California, the state generally taxes all undistributed worldwide income. When multiple trustees exist, some in California and some not, the state provides for apportionment under R&TC Section 17743.3Justia Law. California Revenue and Taxation Code § 17743 Income taxable by California is apportioned based on the ratio of California resident fiduciaries to the total number. For instance, with three trustees, one being a California resident, one-third of the trust’s undistributed non-California source income would typically be allocated to California based on trustee residency.
Determining if an individual trustee is a California resident uses the same standards as for individual income tax: presence in the state for other than a temporary purpose or domicile in California while outside for a temporary purpose. For corporate trustees, R&TC Section 17742 specifies that residency is where the corporation conducts the major portion of its administration for that specific trust. If a corporate trustee manages the trust primarily from California, it is likely considered a California resident trustee.
Income Allocation and Distribution
How trust income is allocated between the trust and beneficiaries for California tax depends largely on distributions. California generally follows federal principles for determining how trust income is taxed, using the concept of Distributable Net Income (DNI).
DNI sets the maximum income taxable to beneficiaries and the maximum distribution deduction for the trust. Calculated based on the trust’s total income with specific adjustments, it ensures distributions are properly characterized. When a trust distributes income, it usually takes an income distribution deduction on Form 541, passing the tax liability for that income to the beneficiaries. The trust pays tax only on retained income.
Income distributed to beneficiaries keeps the same character (e.g., dividends, interest) it had when earned by the trust. California resident beneficiaries are generally taxed on all distributions received, up to the trust’s DNI, irrespective of the income’s source. Nonresident beneficiaries are typically taxed by California only on distributions sourced from within the state.
Income earned by the trust but not distributed remains taxable at the trust level, subject to California’s tax rate schedule for single individuals. Unlike federal law, California taxes capital gains at the same rates as ordinary income for trusts. If a trust distributes previously accumulated income that wasn’t taxed by California (perhaps due to a beneficiary’s contingent interest), the state employs a “throwback rule” under R&TC Section 17745.4FTB.ca.gov. 2023 Instructions for Schedule J (541) Accumulation Distribution This rule can subject a California resident beneficiary to state tax on this income, provided they were also a resident when the income was earned by the trust.
State Filing Obligations
Trustees connected to California must understand their state tax filing duties. The primary reporting document is Form 541, the California Fiduciary Income Tax Return, used to report trust income, distributions, and calculate tax owed by the trust.5FTB.ca.gov. Estates and Trusts
Filing Form 541 is generally required if the trust has a California resident trustee, a non-contingent California resident beneficiary, receives California-source income, or distributes income to a California resident. Filing is also mandated if the trust has gross income over $10,000 or net income over $100 for the tax year, or owes alternative minimum tax.6FTB.ca.gov. 2023 Fiduciary Income 541 Tax Booklet The fiduciary is responsible for timely filing and record-keeping.
The standard deadline for Form 541 is typically April 15th for calendar-year filers. Fiscal year filers must file by the 15th day of the fourth month after their year-end. California offers an automatic six-month filing extension (to October 15th for calendar-year filers). This extension is for filing only, not for paying tax due. Payments owed must be made by the original deadline to avoid penalties, possibly using Form FTB 3563 with the payment.7FTB.ca.gov. 2024 California Form 3563 Payment for Automatic Extension for Fiduciaries
Trusts may need to make estimated tax payments if they expect to owe at least $500 in California income tax for the year. Payments are typically made quarterly using Form 541-ES.8FTB.ca.gov. 2024 Instructions for Form 541-ES Estimated Tax for Fiduciaries The required installments are generally 30% (first), 40% (second), 0% (third), and 30% (fourth). Underpayment can lead to penalties. Trusts in their final year can allocate estimated payments to beneficiaries via Form 541-T.
When filing Form 541, the fiduciary must also provide a Schedule K-1 (541) to each beneficiary who received a distribution, detailing their share of income, deductions, and credits.9FTB.ca.gov. 2023 Instructions for Schedule K-1 (541) A copy must be attached to the trust’s Form 541 and sent to the beneficiary.