THE CALIFORNIA THROWBACK TAX APPLICABLE TO DISTRIBUTIONS OF PREVIOUSLY UNTAXED ACCUMULATED TRUST INCOME TO CALIFORNIA RESIDENT BENEFICIARIES

By Richard S. Kinyon, Esq.* and Kirsten Wolff, Esq.**

I. INTRODUCTION

When an irrevocable, non-California resident, non-grantor trust distributes current net income to a California beneficiary, that beneficiary generally pays income tax on that income—both federal tax and California tax, up to the amount of the trust’s distributable net income ("DNI"), and any undistributed net income in excess of DNI is accumulated and not currently taxable by California. If the trust later distributes the undistributed net income to a California resident beneficiary, that beneficiary will not owe federal tax on that income. However, the beneficiary will owe California tax on the income if: 1) the beneficiary was also a California resident during the year that the income was accumulated; and 2) the income was not previously taxable by California because the resident beneficiary had a contingent interest in the trust (i.e., in the accumulated income). This tax on distributions of accumulated income is known as the "throwback tax," because California is effectively "throwing" the income back to the prior period in which it was accumulated, or deemed to have been accumulated, for the benefit of a California beneficiary.

This article focuses on the California throwback tax, which is not widely understood by practitioners or trustees and beneficiaries of trusts.¹ The Franchise Tax Board (FTB) regulations do not give guidance on how to determine the amount of accumulated income taxable to the beneficiary. Although the California Fiduciary Income Tax Return (Form 541) and instructions do address the throwback tax, the form and instructions do not fully determine the application of the throwback tax law. In this article, we explain our interpretation of the intent and application of that law, suggest a methodology for tracking accumulated income in non-California resident trusts to implement the application of the law, and explore opportunities to plan around the tax.