California Closes State-Tax Loophole for Some Trusts

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.