When California's Tax Conformity Act of 2010 Does Not Conform: California Does Not Follow the Federal Fix for CRTs with UBTI

When California's Tax Conformity Act of 2010 Does Not Conform: California Does Not Follow the Federal Fix for CRTs with UBTI

California recently passed a bill to conform its tax law with the federal income tax law, but specifically did not accept the Federal fix for unrelated business taxable income (UBTI) of charitable remainder trusts (CRTs).  Therefore, if a CRT in California has UBTI it will be subject to California income tax on all income for the taxable year that it has UBTI.

Prior to 2006, a CRT lost its federal income tax exemption for any year in which the trust had any UBTI.  If a CRT had even one dollar of UBTI the result was that the CRT was taxable on all its income for that taxable year.  That result could be harsh for a CRT that had any UBTI in the first year, when the contributed assets are usually sold, because all of the capital gain on the sale of the contributed assets could be taxable.  

The Federal Tax Relief and Health Care Act (TRHCA) of 2006 was an attempt to fix this potentially harsh result.  TRHCA created a new Internal Revenue Code (IRC) section 664(c)(2)(A) that replaced the prior federal rule that took away the income tax exemption of a charitable remainder trust for any year in which the trust has any unrelated business taxable income.  The TRHCA rule imposed a 100% excise tax on the UBTI of a CRT, but allows the CRT to retain its tax exempt status on all other income, including capital gain on the sale of contributed assets.

IRC Section 664(c), Taxation of Charitable Trust, provides as follows:

(1) Income Tax.  A charitable remainder annuity trust and a charitable remainder unitrust shall, for any taxable year, not be subject to any tax imposed by this subtitle.

(2) Excise Tax.

(A) In general. In the case of a charitable remainder annuity trust or a charitable remainder unitrust which has unrelated business taxable income (within the meaning of section 512, determined as if part III of subchapter F applied to such trust) for a taxable year, there is hereby imposed on such trust or unitrust an excise tax equal to the amount of such unrelated business taxable income.

(B) Certain rules to apply. The tax imposed by subparagraph (A) shall be treated as imposed by chapter 42 for purposes of this title other than subchapter E of chapter 42.

(C) Tax court proceedings. For purposes of this paragraph, the references in section 6212(c)(1) to section 4940 shall be deemed to include references to this paragraph.

In April 2010, California passed the Conformity Act of 2010 (SB 401), which changed California's specified date of conformity to federal income tax law from January 1, 2005, to January 1, 2009, for taxable years beginning on or after January 1, 2010, and thereby, in general, conforms to the numerous changes that were made to federal income tax law during that four-year period, except as otherwise provided, and conforms to the February 17, 2009, federal legislation providing an exclusion from gross income in any taxable year for energy grants provided in lieu of federal energy tax credits.

However, SB 401 did not change California law to conform to IRC Section 664(c), and specifically provides otherwise.  Section 34 of SB 401 added section 17755 to the California Revenue and Taxation Code to read:

17755.  Section 664(c) of the Internal Revenue Code, relating to the taxation of trusts, shall not apply and, in lieu thereof, a charitable remainder annuity trust and a charitable remainder unitrust shall, for any taxable year, not be subject to any tax imposed under this part, unless that trust, for the taxable year, has unrelated business taxable income, within the meaning of Section 23732, determined as if Chapter 4 (commencing with Section 23701) of Part 11, applied to that trust.

Section 23732 of the California Revenue and Taxation Code conforms to IRC Section 512.

Therefore, a CRT that is taxable in California and has UBTI will pay a 100% federal excise tax on the amount of UBTI and will not lose its federal income tax exemption, but it will lose its California income tax exemption for the taxable year that it has UBTI.  By rejecting the federal fix for CRTs with UBTI, California continues to tax a CRT with even a minimal amount of UBTI on all its income for the taxable year during which the CRT has UBTI.

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Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6296 or PMcCabe@mofo.com.

© Copyright 2010 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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