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Robert Bloink and William H. Byrnes

Financial Planning > Trusts and Estates > Trust Planning

California Closes State-Tax Loophole for Some Trusts

By Robert Bloink By William H. Byrnes

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What You Need to Know

  • Clients who have established INGs in tax-friendly states should be advised of a new California law.
  • The new law essentially subject NINGs and DINGs to the same rules that apply to grantor trusts.
  • Your clients should know that it applies retroactively as of Jan. 1, 2023.

Non-grantor trusts, such as incomplete gift non-grantor trusts (INGs), that are established in a trust-friendly state such as Nevada (NINGs) or Delaware (DINGs) are often attractive planning vehicles for high-net-worth clients.

NINGs and DINGs provide powerful asset protection tools and help clients avoid taxes at the state level. California, one of the highest-tax states in the nation, has now enacted a law that throws a wrench into the ING tax-planning strategy.

Both California residents and certain non-California residents who establish INGs in tax-friendly states like Nevada and Delaware will be affected by the new law — so those clients should be advised of it to avoid tax underpayment and a surprise tax hit when they file their 2023 returns next April.

Incomplete Gift Non-Grantor Trusts: The Basics

An incomplete gift non-grantor trust, as the name suggests, is funded by an incomplete gift to the irrevocable non-grantor trust.

Due to the “incomplete” nature of the gift to the trust, the individual who establishes the trust (called the trustor or settlor) is not required to use any of their unified credit amount. They’re similarly not required to pay gift taxes or file a federal gift tax return with respect to the gift.

The ING is a valuable planning tool because these types of non-grantor trusts are treated as a completely separate entity from the individual who establishes the trust. To the extent the trust’s income is not distributable net income, or DNI, the trust itself reports the income on its own federal income tax return. (DNI is trust income that is distributed to the trust’s beneficiary when earned by the trust’s assets.)

These trusts tend to be established in states like Nevada and Delaware that do not have an individual income tax — so that the income of irrevocable trusts is also not taxed. If formed properly, the ING will not be required to pay any income tax at the state level because of the separate nature of the trust itself. In other words, the trust is treated as a resident of the state in which it was established regardless of where the trust settlor resides for tax purposes.

However, the trust’s assets will be included in the settlor’s estate for federal estate tax purposes. Similarly, if the trust’s income is distributed to the individual in the year the income is earned by the trust, rather than allowed to accumulate within the trust, the income is taxable to the trust’s settlor or beneficiary in the year it is distributed.

California’s New Anti-NING and -DING Law

California’s new law essentially subject NINGs and DINGs to the same rules that apply to grantor trusts. Grantor trusts are treated as though the trust and its grantor are one and the same for tax purposes. In other words, all of the grantor trust’s income is treated as the grantor’s income, so the grantor reports the trust’s income on both their federal and state income tax returns. The law is similar to a New York law enacted in 2014.

For California residents, all of the trust’s income will be included in the trust settlor’s income for California state income tax purposes.

However, non-residents may also become subject to California state income tax in certain situations. If a non-California resident establishes a NING or DING that has California-source income, that non-resident may be required to pay California income taxes on that income.

It is still possible that the new California law could face constitutional challenges as it applies to California’s taxing authority over individuals who form NINGs and DINGs with California-source income. The issue of whether a state has authority to tax a non-resident with in-state trust income has been evaluated by the Supreme Court — which reached a taxpayer-friendly result. However, the precise issue presented by this law has yet to be adjudicated.

Importantly, the new California law applies retroactively as of Jan. 1, 2023.

Conclusion

Clients who have established INGs in tax-friendly states should be advised of the new California law regardless of whether they are actually California residents. It could have wide-ranging consequences and affect the valuable ING tax-planning strategy for 2023 and beyond.

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Robert Bloink

William H. Byrnes

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