Termination of California’s Beneficial Income Tax Loophole Pertaining to Incomplete Gift Non-Grantor Trusts

Aug 8, 2023

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.

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, the income of an ING 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 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 conditions apply:

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.

Feel free to contact any member of our International Wealth and Asset Planning Department Ed Brown ([email protected]), Andrew Bechel ([email protected]), or the author of this blog entry, Eric Kaplan ([email protected]), to discuss how to have such a trust instead qualify as a “completed gift” non-grantor trust.

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Termination of California’s Beneficial Income Tax Loophole Pertaining to Incomplete Gift Non-Grantor Trusts

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