Back to Perspectives
Articles

California Moves to Crack Down on Out-of-State Trusts

By Nolan Shutler, JD
close-up-view-of-the-california-flag-waving

Executive summary

  • California Governor Newsom strives to amend the personal income tax laws to prevent wealthy taxpayers from utilizing Incomplete Gift Non-Grantor trusts.  
  • California residents use this by transferring assets into trusts held by nonresident trustees in states without income tax.  
  • If this legislation passes, taxpayers will no longer be able to take advantage of the strategy. 

If you reduce California income tax with an ING, Newsom is onto you

Californian legislators propose to amend the personal income tax laws to close a little-known-but-effective loophole for the wealthy by targeting Incomplete Gift Non-Grantor (ING) trusts set up in other states with more favorable income tax rules. To date, California residents have had the opportunity to transfer assets into these trusts held by nonresident trustees in states without income tax, utilizing the state’s sourcing rules to avoid the tax. If approved, this new legislation will put a stop to this tax planning strategy. 

Taxing the rich in California

As it stands, the ING trust is not commonly used. There are about 1,500 California residents with this trust in states without income tax — and if implemented, California would see a minimal revenue increase (about $30 million in the first year and $15 million in the following years). However, this would put an end to a tax planning strategy the wealthy have been using to their benefit for about 20 years.  

Because California is home to more billionaires than any other state at the same time as it also has the highest rate of poverty in the U.S., the concept of taxing the rich holds a certain appeal. In the past, Newsom has opposed proposals to raise taxes — but this proposal was included in the governor’s $223.6 billion budget plan for the next fiscal year, which begins in July. Whether the item survives the legislative process remains to be seen, but if New York’s passage of a similar law in 2014 is any indication, we are likely to see the end of this tax planning strategy for California’s ultra-rich.  

Moreover, this proposal has a retroactive element, differentiating it from New York’s and opening it up to potential lawsuits (New York trust holders had a five-month period to move their accounts to a different type of trust without incurring the tax). Newsom is pushing for the measure to begin the calendar year after its implementation.  

How the ING works (worked)

What is an ING, and why is Newsom trying to prevent its use? California taxpayers can transfer their assets into out-of-state, incomplete, non-grantor trusts (INGs), which constitute separate, taxable entities under state and federal tax law, and this move avoids California income tax on any appreciation or gains from those assets because it is “sourced” to another state based on the location of the trustee (i.e., the bank or whatever financial institution offers the trustee services in the other state). The non-grantor aspect comes into play when the taxpayer establishing the trust (the “grantor”) gives up control over managing investments or distributing assets to the trustee (contrast with a “grantor trust” in which the grantor continues to control how money is invested/distributed within the trust during their lifetime). For the trust to be deemed “incomplete,” the grantors specify how the money can be used. 

Some of the states where these trusts are typically established include Florida, Wyoming, Delaware, Nevada, Tennessee, and South Dakota. For example, a California resident (TP) may decide to transfer stock in their business into an ING established in South Dakota. If TP held the stock directly, then as a resident, all the dividends (or if he sold it, the gain) would be taxable by California on their personal income tax return. But since TP doesn’t hold the asset – the ING does – the ING recognizes the income relating to the stock. California’s current rules provide that the income is sourced to (and thus taxable in) the state where the trustee is domiciled, and for this ING that location is South Dakota, which, incidentally, does not tax this sort of income. 

Newsom is hoping that by eliminating this tax-free option, the state of California will be able to increase tax revenue in a way that will not alienate a large number of voters.

How MGO can help

If you are a California resident and currently use an ING as a tax strategy, there are steps to take now to avoid a negative impact. MGO’s experienced Private Client Services team can help you identify and implement an effective response. 

Related Services

Tax Services Private Client Services

Related Solutions

Tax Services Private Client Services

Tags

Taxes Financial Guidance Tax Guidance State and Local Tax California

Let’s Talk