California (Finally) Conforms to Federal Treatment of UBTI in Charitable Remainder Trusts

By David Wheeler Newman

One of the most important tax attributes of charitable remainder trusts is that they are exempt from income tax – except, that is, when it comes to unrelated business taxable income (UBTI) of these trusts. For decades the rule was that if a CRT had any UBTI at all, even an amount that was inconsequential compared to the overall net income of the trust, the trust would lose its tax exemption for the year, and become fully taxable just like any other complex trust. This rule could undo some of the best tax planning with CRTs, which often involves funding the trust with an appreciated asset and selling that asset in the tax-exempt environment of the CRT, allowing re-investment of the before-tax proceeds of the sale to generate income for the benefit of the income beneficiary and ultimately greater resources for the charitable remainder beneficiary.

After years of proposals from the advisory community to fix this unfortunate result, Congress in 2006 enacted legislation that replaced the federal rule with a new Internal Revenue Code section 664(c)(2) that instead imposed an excise tax on UBTI of a CRT equal to the amount of that UBTI. The general tax exemption of the CRT would be be preserved, while UBTI would be subject to federal excise tax of 100%. While there was some grumbling about that 100% tax rate, the preservation of the overall tax exemption of the CRT was generally applauded.

But then a curious thing happened in California. Notwithstanding a general legislative tax policy of conforming the California Revenue and Taxation Code to changes in the Internal Revenue Code, the legislature in the Golden State didn’t go along with this one. In fact, it went out of its way not to, enacting a statute in 2010 which provided that the new federal rules did not apply in California, and instead the old rule – that even a modest amount of UBTI would cause the CRT to lose its exemption – would continue in California. For the last four years, a California CRT with UBTI would be federally tax exempt, but subject to a 100% excise tax on UBTI, and fully taxable in California on all of its income.

This anomaly has happily been corrected. A few weeks ago Governor Brown signed a new law that generally conforms California treatment to federal law starting in 2014, except that instead of the excise tax imposed on UBTI under federal law, a tax will be imposed on UBTI for California purposes at the normal trust rates up to 13.3%. The result is that a California CRT with UBTI could be taxed at up to 113.3% on that UBTI (100% federal excise tax plus 13.3% California income tax), but remaining income of the CRT would remain exempt from federal and state taxation.

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