Wealthy Californians could lose access to this lucrative tax loophole

By | September 17, 2023

This estate planning tool can help wealthy families save big on taxes, but your state may be restrictive

This estate planning tool can help wealthy families save big on taxes, but your state may be restrictive

California would like to crack down on a type of trust that allows the very wealthy to avoid state income and federal gift taxes. And the Golden State isn’t alone: ​​A number of state officials have taken aim at the loophole, known as incomplete non-grantor trusts (ING). In its 2023 budget proposal, Gov. Gavin Newsom’s administration proposed banning the trust.

New York state passed a similar law in 2014, and the idea has begun to gain traction in states that have seen many of their wealthier citizens use INGs to avoid taxes. Below we delve into the controversy and explain how an ING trust works.

You can work with a financial advisor to reduce your taxes.

California wants to ban ING trusts

This estate planning tool can help wealthy families save big on taxes, but your state may be restrictive

This estate planning tool can help wealthy families save big on taxes, but your state may be restrictive

Of course, high-income, high-tax states have a lot to lose from tax loopholes for the wealthy. These trusts have also been criticized by some tax policy analysts, who cite them – along with the carried interest loophole – as a substantial tax avoidance practice employed by the very wealthy. This criticism is exacerbated by the fact that an ING trust is particularly useful only for those seeking to avoid gift tax, which does not apply until the taxpayer has transferred approximately $13 million in total assets.

In 2014, New York State banned the use of ING trusts to avoid state taxes. They did this by redefining what New York State considers a grantor and non-grantor trust. Specifically, it updated its income tax laws to include any income generated by a non-grantor trust funded by an incomplete gift. (Although this contradicts the IRS’s interpretation of the issue, since this law only applies to taxes in New York state, it did not conflict with any supremacy clause.)

California would like to follow New York’s example. Under Newsom’s proposal, the state would update its tax laws based on the Empire State model. It would stop using the IRS definition of incomplete gifts and instead set its own definitions for when a taxpayer has made a complete transfer of assets. As proposed, this change would apply to California residents, which may leave an open question regarding nonresident taxpayers. Legislators should resolve this issue when drafting the actual law.

This proposal, “which would take effect beginning in fiscal year 2023, is expected to increase tax revenue by $30 million in 2023-24 and by $17 million annually thereafter,” according to a state news release. As of this writing, this figure is within the governor’s proposed budget. However, parliament appears to have omitted this issue from the text of the budget itself, which is expected to be voted on later this week.

What is an ING Trust?

An incomplete non-grantor trust is a specialized form of trust designed to shift the tax basis of your assets. If created correctly, it allows the creator to pay no state taxes on the entrusted assets and at the same time pay no federal gift taxes on the underlying transfer. Given the IRS’s high limit on gift taxes, an ING, which is a self-directed irrevocable trust, is typically only useful for very high net worth taxpayers.

To understand how this works, we need to look at the nature of trusts.

A trust is a legal entity established to hold, manage and distribute assets. Every trust has three (or more) main parts:

  • The Grantor – The person or persons who create the trust and place assets into it

  • The trustee – The person or company who manages and distributes the assets of the trust

  • The Beneficiary – The person or persons who obtain assets from the trust

When you create a trust, you establish its terms. This means you can identify who the trustee and beneficiaries will be, how and when its assets will be distributed, and any other rules about how the entity should function. The trust then becomes an independent third party that can legally own, control and distribute its assets.

While there are many types of trusts, there are two broad categories for tax purposes: grantor trusts and non-grantor trusts.

Grantor Trust

This estate planning tool can help wealthy families save big on taxes, but your state may be restrictive

This estate planning tool can help wealthy families save big on taxes, but your state may be restrictive

A grantor trust is one in which you, as the grantor, retain some measure of control over the trust assets. For example, you may be able to afford to withdraw assets from the trust. Or you may retain the right to change the beneficiaries or rules of the trust, to take loans from the trust, or to collect its investment income. However you do it, if you retain a significant measure of ownership or control over the trust’s assets, the entity is considered a grantor trust.

With a grantor trust, you pay trust taxes. The assets are still considered functionally yours, so any income or capital gain generated by the trust is reported on your taxes.

Non-grantor trusts

A non-grantor trust is one in which you, as the grantor, have no significant control over the trust assets. While you may maintain a de minimis connection, you have made a full gift of assets to the trust. Any trust that is not considered a grantor trust is a non-grantor trust.

With a non-grantor trust, you pay all applicable gift taxes at the time of transfer. Then, as the full owner of the underlying assets, the trust itself pays all applicable income and capital gains taxes.

Incomplete non-grantor trusts

An ING is a type of trust designed to thread the needle between these two categories. This is a non-grantor trust, which shifts the tax burden of the trust assets onto the trust itself. However, it is funded with a legally incomplete gift, which allows the grantor to avoid federal gift taxes while maintaining a measure of control over the assets.

Grantors follow three basic steps to establish an ING trust:

  1. Create a trust headquartered in a state with no income and capital gains taxes. This effectively negates the state taxes the trust would otherwise be responsible for. Please note that this will not affect the federal income tax status of the trust.

  2. Fund the trust as a non-grantor trust. This shifts the tax base of any asset to the trust itself, which pays the taxes of the state in which it is based (thanks to the first step, this will be zero). To do this, the grantor must fund the trust with a gift that effectively relinquishes control and ownership of his or her assets to the trust.

  3. Structure the gift like a defective wire transfer. This is where an ING gets tricky. By carefully wording the asset transfer, you can structure it as complete enough to qualify for non-grantor trust status, but not complete enough for the IRS to consider it a taxable gift. This is typically done by transferring nearly all ownership rights to the underlying assets, but still maintaining a narrow and specific measure of control over them. A financial advisor can help guide you.

If properly structured, you will have created a non-grantor trust that assumes all tax liability for its assets without paying gift taxes on the transferred assets. Because the trust is based in a tax haven state, it will owe the state no taxes on the income and capital gains it generates, leaving you with little control over how those assets are managed.

Bottom line

California Governor Gavin Newsom has proposed closing a tax loophole known as the non-grantor’s incomplete trust. It’s a facility used by the very wealthy to avoid paying state income taxes and federal gift taxes, and it may soon be less available than before.

Tips for estate tax planning

  • A financial advisor with experience in estate planning can help you plan for the future, including how to minimize future tax bills. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory call with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you reach your financial goals, start now.

  • There are grantor trusts and non-grantor trusts. There are also revocable and irrevocable trusts, intentionally defective grantor trusts, lifetime trusts, testamentary trusts, and many others. Let’s take a look at which, if any, are right for you.

Photo credit: ©iStock.com/rarrarorro, ©iStock.com/Andrii Yalanskyi, ©iStock.com/EXTREME-PHOTOGRAPHER

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