BILL ANALYSIS �
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: AB 2687 HEARING: 8/8/12
AUTHOR: Committee on Revenue and TaxationFISCAL: Yes
VERSION: 3/12/12 TAX LEVY: Yes
CONSULTANT: Grinnell
CHARITABLE REMAINDER TRUST CONFORMITY
Conforms state law to federal law treatment of charitable
remainder trusts.
Background and Existing Law
California law does not automatically conform to changes to
federal tax law, except under specified circumstances.
Instead, the Legislature must affirmatively conform to
federal changes.
Charitable remainder trusts (CRTs) are vehicles that enable
taxpayers to avoid taxes while benefitting charities. To
create a CRT, taxpayers transfer assets or cash to an
irrevocable trust on behalf of specified charitable
beneficiaries, which can be changed if the trust so
provides. Taxpayers themselves and any other designated
beneficiary can receive income from the trust within
certain limits for a specified period or until death, with
any remainder transferred to the charity or charities named
in the trust agreement. The charitable remainder must
exceed 10% of the assets' value. Generally, CRTs are
either annuity trusts, where the trust pays a fixed dollar
amount each year of at least five percent of the assets'
value to the noncharity beneficiary, or a unitrust, which
must pay a fixed percentage of the assets' value each year.
The tax benefits of creating a CRT are significant: first,
the taxpayer receives a charitable deduction against the
income tax in the year of the donation equal to the value
of the assets, less any income they allocate from the trust
to themselves. The taxpayer can carry over the deduction
to future years. Second, any appreciated assets donated to
the trust are not subject to capital gains taxes that would
normally apply had the taxpayer sold them. Third, any
AB 2687 (Committee on R&T) - 3/12/12 -- Page 2
earnings or gains from the assets in the trust are
tax-exempt. Lastly, when the taxpayer transfers the
assets, they are no longer part of his or her estate, and
therefore not subject to estate taxes.
California largely conforms to federal law for CRTs, with
one notable exception. Occasionally, CRTs generate
unrelated business taxable income (UBTI), which is income
derived from a trade or business not substantially related
to its exempt purpose. For CRTs, UBTI is usually derived
from investments made in pass-through entities, such as
limited partnerships and limited liability companies, which
produce gains from debt-financed income-producing real
estate or hedge fund investments. This rule ensured that
CRTs did not have a competitive tax advantage over other
taxable investment vehicles by enabling them to generate
UBTI tax-free.
Before 2006, any CRT generating UBTI lost its designation,
thereby revoking its tax-exempt status, and subjecting to
tax all of its income in that taxable year, not just the
UBTI. The CRT may deduct any distributions to
beneficiaries required in the trust agreement. CRTs that
may have unknowingly generated UBTI in previous taxable
years face a considerable tax bill if detected in audit.
In response, Congress enacted the Tax Relief and Health
Care Act of 2006, which provided that any UBTI generated by
a CRT is subject to a 100% excise tax payable out of the
CRT's principal, instead of disqualification and taxing all
the CRT's income less payouts. California does not conform
to this change, having specifically excluded it as part of
its last general conformity bill, SB 401 (Wolk, 2010).
Proposed Law
Assembly Bill 2687 provides that any UBTI generated by a
CRT shall be subject to the personal income tax. The
measure deletes previous law that conformed to pre-2006
federal law that revoked the CRT's tax-exempt status if it
generated UBTI. The bill additionally declares that the
measure serves a public purpose by preserving the loss of
the tax exemption for charitable remainder trusts.
AB 2687 (Committee on R&T) - 3/12/12 -- Page 3
State Revenue Impact
According to the Franchise Tax Board, AB 2687 results in
revenue losses of $400,000 in 2011-12, and $300,000 in
subsequent taxable years.
Comments
1. Purpose of the bill . According to the author, "Under
current law, a Charitable Remainder Trust (CRT) with
Unrelated Business Taxable Income (UBTI) is treated
differently under the federal and California tax laws.
Under federal law, such a CRT is subject to the 100% excise
tax on its UBTI, but it retains its tax-exempt status. The
tax-exempt status means the trust's other types of income
will be exempted from the federal income tax. In contrast,
under California law, which was the federal law prior to
2007, the CRT will lose its tax-exempt status and all of
its income, including UBTI, will be subject to income tax
in California. AB 2687 is needed to conform California law
to the federal tax treatment of CRTs that have UBTI, in
order to allow such trusts to retain their tax-exempt
status for California tax purposes."
2. Gimme a break . After the federal change, CRTs face a
different penalty for generating UBTI at the federal level
than the one currently in place for state taxes - UBTI is
subject to a 100% federal excise tax, but triggers
revocation of tax-exempt trust status at the state level.
While all taxpayers navigate different state and federal
codes when they fill out their state and federal returns
each year, trustees and taxpayers that administer CRTs are
highly sophisticated and can be reasonably expected to know
the relevant differences, as well as be aware of the
significant penalties at both levels for CRTSs that
generate UBTI. AB 2687 provides a legislative fix for
these trustees and taxpayers in the future, and applies its
provisions retroactive to taxable years beginning on or
after January 1, 2011, thereby forgiving taxpayers that
didn't comply with state law when they filed their returns
in the past. Taxpayers filed 45,000 CRT returns between
2007 and 2009 with FTB, which has not yet audited them.
FTB stated that it won't revoke the tax-exempt status for
any CRTs that are found in audit not to comply with current
state UBTI law before first carrying out an education and
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outreach program. Given that CRTs are operated by
professionals, and FTB's decision to go easy on this class
of taxpayers, why should the Legislature act to not only
ease taxpayer compliance in the future, but absolve past
noncompliance for the mistakes of some that would normally
trigger penalties and interest for others? The rules are
different, but ignorance of the law is a poor excuse for
professional trustees and taxpayers with enough knowledge
to create a CRT in the first place, especially when
generating UBTI can only result from complex investments
made by a tax-exempt entity using tax-deferred funds. The
Committee may wish to consider the overall fairness of the
tax system for all taxpayers when considering whether to
ease the rules for some.
3. Conformity for the 1% . Charitable remainder trusts are
highly efficient and perfectly legal tax avoidance vehicles
that help persons with significant assets, such as
appreciated property and stock, defer tax until the CRT
distributes the income back to the taxpayer or the
non-charity beneficiary. CRTs also allow assets
transferred to the CRT to appreciate and produce income on
a tax-deferred basis, all the while generating charitable
deductions for those assets the taxpayer donates to
charity. As such, tax law treats CRTs like tax-exempt
entities because at least 10% of the assets must go to
charity, when they resemble investment funds in most other
respects - the taxpayer can even control the CRT's
investments instead of a trustee. In these times of fiscal
crisis and widening income inequality, when high-wealth
taxpayers have such generous tax benefits and only 10% of
the assets need be donated to charity, why would the state
further ease the UBTI rules as called for in the bill?
Additionally, both Congress and the Legislature wanted a
substantive penalty discouraging CRTs from generating
income inconsistent with its charitable purpose; taxpayers
and trustees in CRTs are sufficiently knowledgeable of the
difference between the two codes and file returns. While
federal conformity is preferable when it helps with the
Legislature's policy and fiscal priorities, the Committee
may wish to consider whether easing compliance for tax
planning for sophisticated, affluent taxpayers is merited
at this time.
4. Fitting in . Conformity helps taxpayers and tax
enforcement authorities alike by reducing differences
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between state and federal tax codes. Conformity
legislation is introduced either as individual tax bills to
conform to specific federal changes, like the Regulated
Investment Company Modernization Act (AB 1423, Perea,
2011), or as one omnibus bill that provides that state law
conforms to federal law as of a specified date, currently
January 1, 2009 - more than three years ago (SB 401, Wolk,
2010). The Legislature modifies or excludes some federal
changes due to fiscal or policy reasons during the
legislative process: the state neither conforms to federal
tax treatment of Health Savings Accounts, nor does it allow
the Franchise Tax Board to assess the erroneous claims for
refund penalty as the Internal Revenue Service can, an
important deterrent against taxpayers to making claims for
refund that lack reasonable basis.
The process for enacting conformity bills is difficult
despite its advantages and reduced tax compliance costs,
because the state may disagree with Congress's tax policy
changes, and conformity can also significantly impact state
revenues - the federal government can run large deficits
and print money if need be, but the state cannot.
Additionally, if any individual item within an omnibus
conformity bill increases a tax on any taxpayer, the
measure must be approved by 2/3 vote of each house of the
Legislature under Proposition 26 (2012). AB 2687 is a
single-issue conformity bill, which conforms state law to
federal changes for one type of tax avoidance vehicle, and
can be enacted as a majority vote bill because it results
in revenue losses, not gains. AB 2687's change was
specifically excluded from the last omnibus conformity
bill.
The Committee may wish to consider whether enacting
single-purpose conformity legislation on behalf of
taxpayers that take advantage of tax planning vehicles is
truly needed, especially given the state's lack of
conformity to the erroneous claims penalty needed to deter
aggressive refund claims, and its failure to provide
general conformity to the updated federal code.
Furthermore, does it make sense to conform only when it
benefits the taxpayer but not the state?
5. Options . When Congress deleted the loss of
classification penalty in 2006, it replaced it with a 100%
excise tax, thereby maintaining a very significant
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deterrent for CRTs to generate UBTI. AB 2687 proposes to
treat the income like ordinary income; the CRT would pay
income tax according to the marginal rate that applies to
the amount of UBTI generated. For example, a CRT with
$1,000 in UBTI would pay tax at the 1% rate, $100,000 in
UBTI would pay at the 9.3% rate, and amounts over
$1,000,000 pay 10.3%. Combined with federal law, any CRT
with UBTI would pay tax that exceeds 100% of UBTI.
However, AB 2687's treatment is simply one option for
replacing the loss of classification penalty with another
deterrent. Instead, the Committee could:
Reject the bill, and thereby retain the loss of
classification penalty,
Enact an identical 100% penalty, providing for a
combined state and federal 200% tax on UBTI, or
Enact a penalty higher than the marginal rate, but
less than 100%.
Assembly Actions
Assembly Revenue and Taxation Committee: 8-0
Assembly Appropriations Committee: 17-0
Assembly Floor: 73-0
Support and Opposition (8/2/12)
Support : California Taxpayers' Association
Opposition : Unknown