California Taxes Out-of-State Trusts for Out-of-State Asset

A record number of taxpayers have moved from California to other states, such as Texas. With advance tax planning, this type of move can produce significant tax savings. The savings can be had year after year.

This type of move can also help avoid the audit and appeals process in California. This alone is worth moving out of state. Those who have been through the audit process in California know this all too well. The California tax system and the FTB audit process is based on the assumption that everything is taxable. This assumption is applied by the FTB even if the convoluted state law suggests that no tax is due. Often, the only way to overcome this assumption is to spend hours and hours trying to reason with FTB employees who are completely indifferent as to the actual facts and law and, once the inevitable tax notice arrives, waiting many-many years–if not decades–to get to a decision maker.

That brings us to the recent The 2009 Metropoulos Family Trust v. California Franchise Tax Board, No. D078790 (Cal. Ct. App. 2022) case. This court case deals with the state’s attempt to impose tax on assets held outside of the state by non-resident trusts. The case provides a stark reminder why taxpayers should avoid having any dealings with or ties to the state of California and, if they are in California now, they should start planning their exit sooner rather than later.

Facts & Procedural History

This dispute involves two family trusts. Collectively, the trusts owned a majority interest in a Delaware S corporation. The Delaware S corporation was based in Connecticut. This entity owned a subsidiary that owned another subsidiary. This bottom level subsidiary did business in California.

The Delaware S corporation sold the top level subsidiary. The sale was structured as an asset sale. The Delaware S corporation reported capital gain from the sale on its business tax return. More than 99% of the sale was attributed to goodwill. The Delaware S corporation’s return allocated 6.6% of the gain to the State of California.

The Delaware S corporation issued Schedule K-1s ito the two trusts that owned the corporation. The two trusts in turn filed fiduciary tax returns to report the flow through income from the Delaware S corporation with the income being apportioned to California. The trusts filed amended returns asking for a refund for the amounts paid to California. California wasn’t satisfied with 6.6%. It wanted 100%. The FTB denied the refunds, as did the California Office of Tax Appeals.

Litigation ensued in state court. The question was whether the out-of-state trusts were liable to pay tax in California on what appears to be out-of-state goodwill.

The Parties Positions

The California Office of Tax Appeals’ position was that:

regulation 17951-4 contained “an explicit set of instructions” requiring business income be apportioned at the S corporation level, then geographically sourced to California under regulation 17951-4(d) for multistate unitary S corporations.

A “unitary” business consists of two or more business entities that are commonly owned and integrated in a way that transfers value among the affiliated entities. They operate both in and out of California and have centralized management.

The taxpayers position was that:

none of the income at issue was taxable under California law because the trusts were nonresidents: neither had a California resident fiduciary or California resident noncontingent beneficiaries at any relevant time. Alternatively, they alleged the income was not taxable even under the theory that the trusts’ income was derived from California sources. In part, they alleged that Pabst realized capital gains from the sale of intangible personal property—goodwill—and under S corporation pass-through rules (the so-called “conduit rule”), the trusts’ pro rata share of that income was likewise realized from goodwill. They alleged that under section 17952 and this court’s decision in Valentino v. Franchise Tax Bd. (2001) 87 Cal.App.4th 1284 (Valentino), that income was sourced for California income tax purposes to the nonresident trusts’ out-of-state residence, and did not fall within the “business situs” exception to that rule so as to render it taxable [in California].

The taxpayers also argued that:

the nonresident trusts were only taxed on their California source income, and there was no dispute over 99 percent of the sale income was derived from intangible goodwill governed by section 17952, providing that income from intangible personal property is “`not income from sources within this state. . . .'” Plaintiffs argued the goodwill did not acquire a business situs within the meaning of that statute because the trusts “did not possess or control the intangibles, or employ them in California in any localized manner.”

The FTB made the following argument in court was:

that operation of the conduit rule meant that the trusts’ income from the subsidiary’s sale was business income because Pabst had characterized the income as apportionable business income on its tax return. That business income, the FTB argued, was taxed under section 17951 and corresponding regulation 17951-4. The FTB argued section 17952 did not apply to business income even if the business income was derived from intangible property, but if it did apply, the gain was taxable because the goodwill was used to do business in California. The FTB argued that the goodwill’s business situs was determined with reference to the business—the operation of subsidiaries by the S corporation Pabst—not by the actions of the trusts. Because Pabst had allocated 6.6 percent of its 2014 income to California operations, at least that much of the subsidiary’s goodwill was” `localized in connection with a business . . . in this State so that its substantial use and value attach to and become an asset of the business . . . in this State” within the meaning of regulation 17952(c).

The court had to decide which party was correct.

California’s Apportionment Rules

Business vs. Nonbusiness Income Rules

California imposes income tax on corporations based on its activities. The activities are either business activities or nonbusiness activities.

Income from business activities is apportioned to California and other states based on a formula. This usually means the state where the corporation is domiciled. Business income includes all income associated with the business operations. This even includes income from the sale of property owned by the business if the property is used in the business. There are two tests used to determine whether the sale of property produces business income.

Nonbusiness income is everything that isn’t business income.

Tax on Non-Residents’ Income

California also imposes tax on out-of-state individuals who do business in California. This requires California-sourced income.

When an individual derives income from in and outside of California, California’s regulations have to be considered. They set out a whole scheme to determine whether income is apportioned to California or other states. For S corporations and partnerships that are operating a unitary business, the regulations say that gain from the sale of property is apportioned to California if the property acquired “business situs” in California.

The regulations say that:

“intangible personal property has a business situs in this State if it is employed as capital in this State or the possession and control of the property has been localized in connection with a business, trade or profession in this State so that its substantial use and value attach to and become an asset of the business, trade or profession in this State.” (Reg. 17952(c).) Further, if a nonresident’s intangible personal property has acquired a business situs in California, “the entire income from the property including gains from the sale thereof, regardless of where the sale is consummated, is income from sources within this State, taxable to the nonresident.” (Reg. 17952(c).)

This provides the rules the court considered.

The Court’s Holding

The court agreed with the taxpayer that the income from the sale of goodwill is business income under Section 17952; however, the court concluded that the goodwill acquired a business situs in California. The result is that intangible property owned by an in-state entity that is in turn owned by out-of-state trusts is taxable in California.

The Takeaway

California has created a complex set of rules with the intent of imposing tax on just about every type of income and asset that can be tied to the state. As this case shows, even intangibles owned out of state by an out-of-state taxpayer can get pulled back into California for state tax purposes.

Luckily, the complexity of California’s tax rules often do not work in the state’s favor. The rules are sufficiently nuanced that they can usually be avoided in their entirety with basic tax planning. We help California taxpayers plan for these rules. If you are looking to avoid paying California taxes or its oppressive audit process, please give us a call.