If you’re using a grantor trust to hold startup equity a common strategy among founders for estate and tax planning there’s a good chance you’ve heard about the federal tax benefits. But if you’re in California, you also need to think about the Franchise Tax Board (FTB) because California may not treat that trust the same way the IRS does.
This mismatch can lead to unexpected personal income tax (PIT) liabilities even if you’ve followed all the rules federally.
Let’s break down what this means, how the IRS and FTB differ, and what you should do to stay compliant.
What Is a Grantor Trust?
A grantor trust is a type of revocable trust where the person who sets it up (the grantor) still has control. For federal tax purposes, the IRS treats the grantor as the tax owner of the trust’s income and gains. So even though the trust legally owns the startup shares, the income flows through to the grantor’s personal return.
But California isn’t always on board with this.
Why California Sees It Differently
Under federal law (IRC §§671–679), grantor trusts are generally disregarded for tax purposes.
But California has its own tax rules under Revenue & Taxation Code §17041 and may treat the trust as a separate taxpayer especially if it:
- Has California-source income
- Has a California resident trustee or beneficiary
- Files FTB Form 541
This opens the door to potential double taxation if the income is taxed to both the grantor and the trust under different views.
Real Example: A Tax Hit at Exit
Scenario:
A founder creates a grantor trust in 2023 and transfers 2% of her California-based startup’s common shares into it. The startup is acquired, and the trust receives $2 million in proceeds.
What happens?
- IRS: Treats the trust as disregarded. The founder reports the capital gain on her 1040, using Schedule D.
- FTB: If the trust is treated as a separate entity (due to improper documentation or California sourcing), it may also owe California PIT, even if the founder already paid taxes on the same gain.
This is where the trap lies: same income, two tax bills.
Key Forms to Know
| Form | Purpose |
|---|---|
| IRS Form 1041 (statement) | Shows grantor trust treatment |
| CA Form 541 | Required if the trust has CA-sourced income |
| Schedule D (Form 1040) | Reports capital gains from startup shares |
| Form 540/540NR | California resident/non-resident individual income tax return |
How to Stay Compliant: Step-by-Step
- Make the Grantor Status Explicit
Your trust agreement should clearly state that it’s a grantor trust under IRC §671, with the grantor liable for tax on all income. - Avoid Filing Form 541 Unless Required
Only file CA Form 541 if there’s California-source income or a CA-based trustee/beneficiary. - Use Grantor Statements
Attach grantor statements (per Treas. Reg. §1.671-4) to your Form 1041 filing or maintain them in your tax file. - Track Sourcing Carefully
If your income is from a California-based company, the FTB may claim it’s fully taxable in CA regardless of your residency. Use FTB Publication 1031 for sourcing guidance. - Keep Records
Keep the trust instrument, EIN letter, stock transfer documents, income allocations, and federal/state return filings for audit defense.
Conclusion: Clean Structure = Clean Taxes
Using a grantor trust to hold startup equity can be smart but it needs to be carefully planned. California’s unique trust taxation laws can turn a simple estate plan into a tax headache if you’re not careful with your filings and sourcing.
If you’re preparing for an exit, acquisition, or stock sale , review your grantor trust with a CPA who understands both IRS and California FTB rules.
Ready to Talk?
Book a free call with Anshul Goyal, CPA EA FCA a licensed U.S. Certified Public Accountant, Enrolled Agent admitted to practice before the IRS, and cross-border tax expert. He helps founders and startups across California and India handle tax planning, trust structuring, and IRS compliance.
Disclaimer
This article is for general informational purposes only and is not tax or legal advice. Always consult a licensed CPA or tax professional before acting on any of the strategies discussed. Laws referenced are current as of the tax year and may change.
FAQs: Grantor Trusts & CA PIT
- Does California recognize federal grantor trust status?
Not always. You must document it properly or California may treat the trust as a separate taxpayer. - Do I need to file CA Form 541 for a grantor trust?
Only if the trust has California-source income or has a trustee/beneficiary who is a CA resident. - Can my grantor trust hold startup stock options or SAFEs?
Yes, but you must track basis, vesting, and capital gains carefully. - What if I already filed incorrectly in the past?
You may need to amend your Form 540/541 or consider a Voluntary Disclosure through the FTB. - How can I avoid double taxation?
Coordinate both federal and state filings, and confirm sourcing rules with a qualified CPA.
About Our CPA
Anshul Goyal, CPA EA FCA is a U.S.-licensed Certified Public Accountant, Enrolled Agent, and Fellow Chartered Accountant who specializes in California tax traps, trust planning, and startup exits. He regularly represents clients before the IRS and FTB and helps Indian founders in the U.S. stay tax compliant.