On July 10, 2023, California Governor Gavin Newsom signed new legislation (Senate Bill 131) that significantly impacts the taxation of incomplete gift nongrantor trusts (INGs) in California—effective retroactively to Jan. 1, 2023. Even though INGs may be treated as a separate taxpayer for federal tax purposes under subchapter J of the Internal Revenue Code, California now treats such INGs as grantor trusts for state income tax purposes. In other words, any California resident who created and funded an ING will be treated as the owner for state income tax purposes of any taxable income earned by the ING beginning in 2023.
Background on INGs
To understand the recent change, it’s helpful to first address how an ING theoretically works for federal income tax purposes. Basically, an individual—often called the grantor—irrevocably transfers assets to a trust while retaining the possibility of getting assets back from the trust at a future date. However, the grantor only can receive trust assets with the approval of one or more beneficiaries of the trust other than the grantor or the grantor’s spouse. Because those beneficiaries arguably are adverse parties under IRC Section 672(a), the trust would qualify as a nongrantor trust—meaning the grantor wouldn’t be treated as the owner of the trust for grantor trust purposes. The grantor also would reserve a limited power to appoint trust principal to the other beneficiaries, which arguably would be a retained power that results in the transfer being treated as an incomplete gift for tax purposes.
INGs have been popular income tax and asset protection planning tools. Not only have they been used to avoid state income taxation by being set up as a nongrantor trust in a state without state income taxes, but they also attempt to take advantage of state laws offering better asset protection. For instance, prior to 2023, a California taxpayer could transfer appreciated business interests to an ING in a jurisdiction such as Delaware, Nevada or Wyoming—which would be called a DING, NING or WING, respectively. If the ING sold the assets with $10 million in capital gains, the nongrantor trust wouldn’t be subject to a 13.3% California state income tax, and the taxpayer would save $1.3 million in state taxes. If the taxpayer didn’t receive any distributions back from the ING until they moved their residence outside California, then they also would avoid California throwback tax on future distributions, and the taxpayer would remain $1.3 million richer.
Prior to 2021, the IRS blessed INGs for federal income tax purposes with numerous private letter rulings (See, e.g., PLRs 201410001-201410010 (Mar. 7, 2014) and 201310002-201310006 (Mar. 8, 2013)). However, the IRS began to question whether INGs should be treated as nongrantor trusts and whether the transfers were incomplete gifts that avoided the 40% gift tax. (See Justin T. Miller and W. Martin Behn, “Adverse Enough to Be a Nongrantor Trust,” 164 Tax Notes 1019 (Aug. 12, 2019) and Grayson M.P. McCouch, “Adversity, Inconsistency, and the Incomplete Nongrantor Trust,” 39 Va. Tax Rev. 419 (Aug. 5, 2020)). In 2021, the IRS issued Revenue Procedure 2021-3, which added INGs to the no-rule list for future PLRs. While the government has yet to issue guidance that INGs don’t work for federal tax purposes, the IRS no longer will offer taxpayers the ability to get a PLR to confirm that they do work—meaning there’s a potential risk that an ING could be treated as a grantor trust or that funding an ING could be considered a completed gift for federal tax purposes.
From a state income tax perspective, New York changed its state trust taxation law back in 2014 to eliminate the possibility of taxpayers using INGs to avoid taxes. Almost 10 years later, California followed suit. Effective as of Jan. 1, 2023, INGs now will be treated as grantor trusts for state income tax purposes in California—similar to the law that was passed in New York. As a result, INGs are no longer treated as separate taxpayers in California, and a grantor who’s a resident of California will be subject to tax on the ING’s taxable income.
Options for California Grantors with INGs
For California taxpayers who previously set up INGs and already had a significant liquidity event in 2023, they likely will be personally subject to taxes on the ING’s taxable income for 2023. While a state or federal constitutional challenge is possible, such a challenge may be unsuccessful given California’s broad taxing authority. At the very least, such a taxpayer may be in a similar tax position for state income tax purposes in 2023 as if they didn’t create and fund an ING—other than the fees, expenses and hassle for setting up the structure.
California taxpayers with INGs who had large liquidity events prior to 2023 will start paying California income taxes on the ING’s taxable income beginning in 2023. While there aren’t yet any regulations for the brand-new tax law, it’s likely that California’s throwback tax will continue to apply to any distributions of pre-2023 accumulated taxable income made to any California beneficiary.
So, what can California taxpayers with existing INGs do to minimize state income taxes moving forward? The simple answer is that they can move to a state without state income taxes—provided they comply with California’s fact-based rules for determining residence and domicile. If moving is too extreme from a personal and family perspective, private placement life insurance might be an option for future federal and state tax-free growth of trust assets. In addition, it might be possible to transfer or decant the ING assets to a new completed gift nongrantor trust that isn’t subject to California’s new law. For a completed gift, a taxpayer and taxpayer’s spouse may be able to use their combined lifetime exemption amount up to $25.84 million—or $12.92 million per person in 2023—to avoid the current 40% gift tax. Taxpayers without remaining exemption amount might want to consider strategies such as a grantor retained annuity trust to transfer future appreciation to loved ones. Additional options to remove future appreciation for estate tax purposes could be selling high basis ING assets to a completed gift trust or even loaning funds from the ING to a completed gift trust.
Updated Guidance to Clients
The new legislation in California significantly alters the taxation of INGs effective retroactively to Jan. 1, 2023. As a result, tax, legal and wealth management advisors will need to update the guidance they provide to clients and use different strategies for minimizing the impact of California’s 13.3% state income tax rate. It’s also important to proactively review existing INGs to ensure appropriate state tax compliance moving forward. Because INGs are no longer a viable strategy for minimizing state income tax in California, taxpayers may want to consider completed gift nongrantor trust strategies in the future or even changing their residence outside California—especially if they may be facing a large liquidity event in the future.