By: Eric R. Kaplan, Esq.
Prior to 2023, California residents were able to take advantage of a highly beneficial income tax loophole by creating what is commonly known as an “incomplete gift non-grantor trust” (hereinafter referred to as an “ING”). As a hypothetical example to demonstrate how an ING operates, assume that a California resident settles an ING that has Nevada law as the ING’s applicable law. As our California clients are already aware, California has a high state-level income tax. Nevada, on the other hand, does not have any state-level income tax. Therefore, by a California resident settling a Nevada ING, such an individual can thereafter direct some or all his or her taxable income to the Nevada ING and as a result, possibly avoid some or all of California’s state-level income tax. Additionally, when the value of the Nevada ING’s invested assets appreciates, such assets will similarly avoid California’s state-level income tax. As such, if the Nevada ING is successful, it would situs generally all income on invested intangible assets to the State of Nevada.
Until recently, an ING’s income would be subject to California’s state-level income tax only if the trust had: (i) California source income; (ii) a fiduciary residing in California; or (iii) a non-contingent California resident beneficiary.
However, on July 10, 2023, California Governor Gavin Newsom signed into law Senate Bill 131. This law added a new Section 17082 to California’s Revenue and Taxation Code to state that for taxable years beginning on or after January 1, 2023, an ING’s income shall be included in a qualified taxpayer’s gross income to the extent the ING’s income would be taken into account in computing the qualified taxpayer’s taxable income if the ING was treated as a grantor trust.
However, notwithstanding the immediately preceding paragraph, an ING’s income shall not be included in a qualified taxpayer’s gross income for a taxable year if all of the following
The fiduciary of the ING timely files an original California Fiduciary Income Tax Return and makes an irrevocable election on that return to be taxed as a resident non-grantor trust;
The ING is a non-grantor trust; and
Ninety percent or more of the distributable net income of the ING is distributed, or treated as being distributed, to a charitable organization.
There are other strategies available to our California clients to avoid California state income taxes with respect to a trust’s income. For example, the ING could instead be designed as a “completed gift” non-grantor trust.
Special issues can also arise in states such as New York in the event certain facts exist. In New York, a “resident trust” means, in part, “a trust . . . consisting of the property of a person domiciled in [New York] at the time such property was transferred to the trust, if such trust or portion of a trust was then irrevocable, or if it was then revocable and has not subsequently become irrevocable.”[1] Therefore, a New York client who creates a Nevada ING still has created a “resident trust” according to New York law. Notwithstanding its classification as a “resident trust,” the Nevada ING would not be subject to New York tax if all the following conditions are satisfied:
All trustees are domiciled in a state other than New York;
The entire corpus of the trust, including real and tangible property, is located outside New York; and
All income and gains of the trust are derived from or connected with sources outside the state of New York, determined as if the trust were a non-resident trust.[2]
In this scenario, a New York client may decide to instead: (a) transfer New York-sitused assets into a Nevada limited liability company (with such Nevada limited liability company being owned by the Nevada ING) to potentially avoid such issue (exploring whether you can navigate around the rule that the trust cannot own any New York real or tangible assets); (b) delay transferring New York-sitused assets into an ING until a date after the trust enters into a large taxable transaction with its non-New York assets; or (c) have the Nevada ING create a sub-trust to hold the New York-sitused assets, with such sub-trust being a Code Section 678 sub-trust so that its taxable income would be taxable at a beneficiary’s lower tax bracket.
Special attention may also be needed for a New York resident if the trust can be viewed as “revocable.” New York’s statute has its own definition as to when a trust is deemed “revocable.”
If you would like to further discuss potential strategies to take advantage of these facts, please feel free to contact any member of our International Wealth and Asset Planning Department (Ed Brown ([email protected] [email protected] [email protected] ))
[1] See NY Tax L § 605(b)(3)(C)(i) (2022).
[2] See NY Tax L § 605(b)(3)(D)(i)(I)(II) and (III) (2022).
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