Federal vs. California Trust Law: Who Governs Trust Distributions?

Introduction

Trustees and beneficiaries often find themselves navigating a complex legal landscape when administering or receiving distributions from a trust. One of the most common and confusing areas is determining which law governs what — particularly when federal tax law and California state trust law seem to overlap or conflict. Misunderstanding the boundaries of these legal frameworks can result in costly mistakes, penalties, or disputes.

This article breaks down the roles of federal law and California state law in governing trust distributions, taxation, and fiduciary obligations.

How is Trust Income Taxed Federally?

Under the Internal Revenue Code, federal tax law governs how trust income is reported and taxed. The IRS requires:

• Trusts to file federal income tax returns (Form 1041)
• Beneficiaries to report income distributed (or required to be distributed) to them, even if not actually received
• Trustees to allocate income vs. principal correctly for tax reporting purposes

Relevant sections of the Internal Revenue Code include:

• IRC §§ 662: Taxation of beneficiaries who receive income
• IRC §§ 666 & 667: Accumulation distributions and anti-deferral provisions

Key point: For tax purposes, federal law is supreme. Even if California allows a certain distribution structure, it must still align with federal tax obligations.

How does California Govern Distribution and Fiduciary Oversight

California trust law, found in the California Probate Code, governs how trustees are to allocate and distribute trust income and principal among beneficiaries.

Two important statutes include:

Probate Code § 16340: Defines how income is distinguished from principal

If property is specifically given to a beneficiary, by will or trust, the fiduciary of the estate or of the terminating income interest shall distribute the net income and principal receipts to the beneficiary who is to receive the property:

• The net income and principal receipts from the specifically given property are determined by including all of the amounts the fiduciary receives or pays with respect to the property,
• whether the amounts accrued or became due before, on, or after the decedent’s death or an income interest in a trust ends,
• and by making a reasonable provision for amounts the fiduciary believes the estate or terminating income interest may become obligated to pay after the property is distributed.

Probate Code § 16341: Outlines the trustee’s responsibility for fair and impartial allocation

Beneficiaries are entitled to receive a portion of the net income equal to the beneficiary’s fractional interest in undistributed principal assets, using values as of the distribution dates and without reducing the values by any unpaid principal obligations.

If a fiduciary does not distribute all of the collected but undistributed net income to each beneficiary as of a distribution date, the fiduciary shall maintain appropriate records showing the interest of each beneficiary in that net income.

In California, trustees must:

• Maintain detailed accounting records
• Follow the intent of the trust instrument
• Act impartially among beneficiaries
• Avoid favoring income beneficiaries over remainder beneficiaries or vice versa

A breach in these duties can lead to personal liability for the trustee, especially if distributions are misapplied.

When Does Federal and State Tax Laws Collide?

Conflicts arise when:

• A trustee complies with California’s rules for classification and distribution, but the IRS views the same transaction differently for tax purposes
• A distribution is allowed under California law, but triggers unintended tax consequences

Example: A trustee may allocate certain investment earnings to principal under California law, but the IRS still considers that income taxable to the trust or beneficiary.

Does Federal Law Or State Take Priority Regarding the Consequences of a Distribution or Payment to a Beneficiary?

Federal law takes priority. The Supremacy Clause of the U.S. Constitution (U.S. Const. Art. VI, Cl. 2) provides that federal law preempts state law.

Beneficiaries are taxed on the income they have the right to receive from the trust, regardless of whether they actually get it yet (Internal Revenue Code). Federal law allocates the tax liability to the beneficiary entitled under the trust to receive the income. Therefore, the Internal Revenue Code, a federal statute, preempts conflicting state law.

Specifically, Sections 662, 666 and 667 of the Internal Revenue Code require that each beneficiary include in income the amounts paid, credited, or required to be distributed to him or her in the tax year.

See Freuler v. Helvering, 291 U.S. 35, 42 (1934) (The test of taxability to the beneficiary is not receipt of income but the right to receive it.).

See Blair v. Commissioner, 300 U.S. 5 (1937) (finding phrase income currently distributable to the beneficiary merely descriptive of the one entitled to the beneficial interest and The one who is to receive the income as the owner of the beneficial interest is to pay the tax.).

Legal Precedent and Practice

Recent California case law confirms the heavy emphasis on trustee impartiality and detailed recordkeeping. Courts have ruled against trustees who fail to:

• Distinguish litigation vs. administrative expenses
• Conduct a good faith investigation before participating in beneficiary disputes
• Apply the distribution terms neutrally and in the interest of the entire trust

In Hollaway v. Edwards (1998) 68 Cal. App. 4th 94, the court reaffirmed that trustees must be able to justify distributions based on their fiduciary duties and not personal bias or informal beneficiary pressure.

How do Trustees Stay Compliant with Tax Law?

• Understand the tax consequences of distributions before making them
• Use the trust instrument as the first source of guidance
• Apply California Probate Code standards for allocation and recordkeeping
• Report and file federal tax documents accurately and timely
• Seek legal counsel when uncertainty exists between state and federal interpretations

Conclusion

Federal and California trust laws serve distinct but overlapping purposes. Federal law governs taxation, while California law governs the mechanics of distribution. Trustees must navigate both to avoid disputes and fulfill their fiduciary duties.

C. Tucker Cheadle Law advises clients throughout California, including Orange County, Los Angeles County, San Bernardino County, Riverside County, San Diego County, San Francisco County, Marin County, Santa Clara County, Santa Maria County, and Stanislas County.

Call 949.553.1066 to ensure your trust is administered correctly under both federal and state law.

This article is designed only to provide a general background and is not legal advice. If you need legal advice, please contact C. Tucker Cheadle at 949.553.1066 and after providing all the important facts and information, a legal opinion can be made. A review of any materials on this web page, any preliminary comments or an introductory meeting does not constitute legal, income tax or accounting advice upon which reliance can be placed. The attorney–client relationship can only be created by a written retainer agreement following a check of potential and actual conflicts of interest with other clients.