California Court of Appeal Concludes That a Trust With a Non-California Trustee May Be Subject to Tax on All of Its Gain from the Sale of Stock

The California Court of Appeal recently came down with a published decision in the Paula Trust case, a case involving the taxation of trusts and limited partners—two very nettlesome issues in California. (Steuer v. Franchise Tax Board, No. A154691, 2020 BL 240383 (Cal. Ct. App. 6/29/20)). The Court of Appeal reversed the trial court and held that the trust was taxable on the entire capital gain generated from the sale of stock in various businesses. The case involves California’s unique and somewhat confusing system of taxing trusts. Generally speaking, the taxability of a trust is dependent upon the residency of fiduciaries (i.e., trustee) and beneficiaries. In this case, there were two trustees—one who was a California resident and one who was a Maryland resident, along with a contingent beneficiary who was a California resident.

The trust held a limited partnership interest in Syufy Enterprises LP, which in turn sold stock in various businesses, which generated the gain in issue. The trust argued that it should only be taxed on 50% of the gain attributable to it due to the residency of the trustees and beneficiary. The trial court agreed, but the Court of Appeal did not. The Appellate Court held that the Revenue and Taxation Code requires treating individuals and trusts similarly. Therefore, all of the income should be taxable by California since the other 50% of the gain (in the Court’s view) should be sourced to California under the personal income tax rules for taxing nonresidents.

As noted, the taxation of gains by nonresident limited partners is a hot issue in California since there is a statute (Revenue and Taxation Code Section 17952) that specifically provides that gains from the sale of intangibles (i.e., stock) should be sourced to the domicile of the nonresident. However, the Franchise Tax Board has attempted to ignore or at the very least limit its applicability. See for example, Appeal of Metropoulos, California Office of Tax Appeals, Nos. 18010012, 18010013, 2019–OTA–385P (2019), which is pending in the San Diego Superior Court, Case № 37-2020-00011877-CU-MC-CTL . The Court in Paula Trust has done a little bit of mixing apples with oranges and come up with a decision that leaves something to be desired.