BILL ANALYSIS �
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: AB 1172 HEARING: 6/25/14
AUTHOR: Bocanegra FISCAL: Yes
VERSION: 6/17/14 TAX LEVY: Yes
CONSULTANT: Grinnell
CHARITABLE REMAINDER TRUST CONFORMITY
Conforms state law to federal treatment for charitable
remainder trusts generating unrelated business taxable
income.
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. 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 (SB 401,
Wolk, 2010).
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 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
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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
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, all of its income
in that taxable year subject to tax, not just the UBTI.
While 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 those tax liabilities are 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 1172 provides that any UBTI generated by a
CRT shall be subject to the personal income tax, and
deletes previous law that conformed to pre-2006 federal law
AB 1172 - 6/17/14 -- Page 3
that revoked the CRT's tax-exempt status if it generated
UBTI. The measure takes effect in the 2014 taxable year.
State Revenue Impact
Pending.
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 1172 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. Good deal . 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.
3. Options . When Congress deleted the loss of
classification penalty in 2006, it replaced it with a 100%
excise tax, thereby maintaining a very significant
deterrent for CRTs to generate UBTI. AB 1272 proposes to
treat the income like ordinary income; the CRT would pay
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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 13.3%. Combined with federal law, any CRT
with UBTI would pay tax that exceeds 100% of UBTI.
However, AB 1172'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
Not relevant to this version of the bill.
Support and Opposition (06/19/14)
Support : California Taxpayers Association, Howard Zelikow
Opposition : None received.