By: Ted Sutton, Esq.

Sean and Scott are very successful entrepreneurs who live in San Francisco. They have had good fortunes investing in tech startups, and both have become very wealthy. Being shrewd with their money, they both decided to invest $5 million of their net worth into paper assets. Wanting to protect these holdings, Sean set up a Wyoming LLC. Because Sean is a California resident, Sean registered his Wyoming LLC in California and paid the $800 franchise tax. Scott found out that out of state trusts do not have to pay that dreaded fee, so he set up a Wyoming Statutory Trust for his portfolio. He named himself as the trustee, and he and his wife as the beneficiaries. By setting up the trust, Scott thought that he would end up paying less tax than Sean. As it turns out, he ended up paying more. A lot more.

As all our California clients know, a Wyoming holding LLC owned by a California resident must register with the California Secretary of State and pay the annual $800 franchise tax. The state’s position is that if a California resident is owning and managing a Wyoming LLC, then that entity is doing business in California. Their position infuriates a good many people, and we are frequently asked if there are any ways to avoid this fee. One potential solution, mentioned above, is the Wyoming Statutory Trust. Some use a Delaware Statutory Trust, or “DST,” but the problematic results are the same. We will use Wyoming as the example from here on out.

What exactly is a Wyoming Statutory Trust? It is a trust registered with the secretary of state that combines attributes of a standard trust and an LLC. Like a trust, a grantor puts assets into the Statutory Trust, to be held by one or more trustees, for the benefit of one or more beneficiaries. Like a Wyoming LLC, a Wyoming Statutory Trust has the same charging order protection if the beneficiary is personally sued. This trust is created by filing a Certificate of Trust with the Wyoming Secretary of State. Both the certificate and the annual report each cost $100. As a perceived bonus, California does not require these foreign trusts to pay the $800 franchise tax every year. Forming Wyoming Statutory Trusts will save our clients hundreds of dollars every year, right?

Wrong. The California Franchise Tax Board classifies out of state Statutory Trusts as “business trusts.” In two of their recent Chief Counsel Rulings, the FTB held that while these out of state “business trusts” are not subject to the franchise tax, they are subject to California’s 8.84% corporate income tax.[1] On top of this, a California Court of Appeals case recently held that trustees who are California residents are taxed at California rates on trust property located in another state.[2]

Do we really want our clients to pay this tax? As explained below, paying the $800 fee is a much better option.

Back to the example above. For simplicity’s sake, let’s say that Sean and Scott each earned $1 million in taxable income from their Wyoming entities in their first year. The diagram below shows how much each must pay to California and Wyoming.

Because Sean has an LLC now worth $6 million, he will have to pay a $1,200 license tax to Wyoming.[1] This fee arises from assets held in Wyoming. If they were held outside of the state, the fee wouldn’t apply. If he used a Nevada LLC, which has no such license tax, the annual fee would be $350. In addition to the $800 franchise tax, California also requires LLCs who make $1 million a year to pay a fee of $6,000. Sean’s total here is $8,000. However, Sean will be able to deduct the $800 California fee on his tax returns.

Scott, on the other hand, does not have to pay the license tax, the franchise tax, or the LLC fee. However, because the Wyoming Statutory Trust is a “business trust,” Scott’s income is subject to the 8.84% corporate income tax rate, even though this income came from Wyoming. On the $1 million Scott earned from his Wyoming Statutory Trust, he is footed with the California corporate tax. This means Scott must cough up $88,400. While Scott “saved” $2,000 by not paying the taxes Sean had to, Sean ended up saving $80,400 in taxes altogether. To make matters worse, this example doesn’t even account for other federal and state taxes that affects them both.

Whose situation would you rather be in: The person who paid the franchise tax, or the person who avoided it?

As it stands right now, there is a lot of inconsistency in how California chooses to tax out of state trusts. Some will argue that if the trust distributes income to the California beneficiaries, the income is taxed at the beneficiary level. But what if the income is held in the trust? What if it is reinvested? Some people will claim their DST has never been assessed an 8.84% tax. But this area is filled with unsettled law and strategy uncertainty.

A key point to remember when seeking to reduce minimum franchise taxes: The trust tax here is on the books. And California is always searching for more tax revenue. Should a favorable ruling come out, we will reconsider using Statutory Trusts for our clients. But we aren’t holding our breath. We advise our California clients to stay away from the Statutory Trust ambiguities. If you don’t, you could end up like Scott: paying costly and unnecessary taxes.

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[1] Franchise Tax Bd. Chief Counsel Ruling 2016-01 (February 17, 2016), and Franchise Tax Bd. Chief Counsel Ruling 2016-02 (February 17, 2016).

[2] Steuer v. Franchise Tax Bd., 51 Cal.App.5^th 417 (2020).

[3] For Wyoming LLCs, the Annual Report License Tax is the greater of $60, or two tenths of one mil on the dollar ($.0002).