The Issue
After years of wrangling with the issue, California has just enacted legislation to eliminate a state income tax savings strategy some California residents have pursued by establishing a non-grantor gift trust (ING). These trusts are often called WINGs, DINGs, and NINGS, a reference to the three states that first marketed them: Wyoming, Delaware, and Nevada. INGs can offer significant federal estate planning advantages. But they also allow residents of states with high income-tax rates, like California, to avoid paying state taxes on undistributed non-California-source income. The income can then grow free of state income taxes in the trust and be distributed later to the taxpayer (presumably after moving to a state with lower income taxes), or to their beneficiaries. But the new legislation has nullified the state tax benefits for California residents, leaving taxpayers who pursued the ING strategy in the lurch.
Background
INGs were designed by estate planning attorneys to protect assets and potentially reduce federal estate taxes. This means that they are primarily used by high-income and high-net-worth taxpayers. The benefit of the estate tax is derived from two characteristics of INGs (which can also play into the state residency tax planning). First, an ING is an irrevocable trust, and hence a separate taxpayer from the grantor (the person who established the trust). And second, the assets transferred to an ING by the grantor are deemed an “incomplete gift” by the IRS, because they remain under the grantor’s ultimate control. As a result, the value of the assets is not counted against the grantor’s lifetime gift tax exclusion ($12.92 million as of 2023). This can provide a substantial estate tax benefit for high-net-worth individuals. It means they can transfer more value to their beneficiaries free of the federal estate tax (though the current income is subject to federal taxation at compressed federal trust rates).
So much for the federal tax advantages. But INGs also proved to be an effective way for grantors in states with high income taxes to reduce their state tax burden. Due to a number of IRS private letter rulings stating that undistributed income from an ING is not included in a grantor’s gross earnings, and the fact that California generally conforms to federal tax treatment of trusts, California residents who set up INGs in states that didn’t tax these trusts did not have to report the income on their California tax return. This contrasts to a typical living revocable trust, whose income is included in the grantor’s gross income, whether distributed or not. If the income wasn’t California-sourced (for example, because it derived from the sale of intangible assets, such as appreciated stock), then the ING did not have to pay California income taxes as long as the trust followed the formalities that made it a non-California trust. Accordingly, INGs were marketed to California residents as a way of shielding non-California-source income from the state’s high tax rates without requiring them to change residency.
The idea was that the grantor with an ING could ultimately move to a state with lower tax rates at the taxpayer’s leisure, presumably upon retirement, and then receive the income accumulated in the trust free of California income taxes. California grantors got to have their cake and eat it too, as long as they ate the cake later.
How INGs Work
As an example, a California resident creates an ING in Wyoming (a WING!) and funds it with valuable, appreciating stock. After waiting a reasonable period of time (to avoid IRS scrutiny as an abusive tax shelter), the trust sells the stock. The result would be that neither the resident nor the trust is liable for state income taxes. Wyoming has no state income taxes, so it taxes neither the trust nor the grantor. California can’t tax the trust because it’s a separate taxpayer with no situs in California and the income is not sourced to California. California can’t tax the resident because the income wasn’t distributed, and hence, isn’t included in the resident’s gross income. Ultimately, the goal would be for the taxpayer to move from California (perhaps to retire), at which time the WING could distribute the income free from California income taxes, because upon receipt the taxpayer is no longer a California resident, nor is the income sourced to California. The taxpayer also has the alternative of distributing the income, at any time, to the trust’s beneficiaries, presumably children. The tax consequences of that depend on where the beneficiaries live. Finally, the income could remain in the ING until the grantor’s death, at which time it would be subject to federal estate tax rules (but again, free from California taxes since California doesn’t have an estate tax).
INGs’ Impact on California Tax Policy
As you can see, INGs are rather complicated to administer. And they are expensive to establish. They only make sense for taxpayers with high net worth and high income. Accordingly, only a small number of taxpayers nationwide have ever used INGs to shield their income from state taxation. The number estimated for California is negligible: about 1,500. That said, it’s also estimated that the actual undistributed income in complex trusts in the ING states in recent years is anything but small. It could be as high as $6 billion. While only a portion of those trusts are INGs, even a small portion of $6 billion is significant – a fact not lost on tax agencies from high-income states, including California.
New York responded aggressively in 2014, “decoupling” the federal estate tax benefits (which the states do not control) from the state income tax treatment. The New York anti-ING legislation required grantors to include ING income receipts in their individual gross income for state income tax purposes. This nullified any state tax benefit of INGs for New York residents. The Franchise Tax Board, California’s tax enforcement agency, took note and called for the California legislature to follow suit, estimating that a proposed anti-ING law would result in an extra $20 million, more or less, in state revenues annually. The result was the new Section 17082 of California’s Revenue and Tax Code.
The Details
Section 17082 is similar to New York’s anti-ING law. Residents with INGs are required to include the taxable income of the trusts in the gross income reported in their individual California tax return, regardless of where the ING is located. It disregards the ING as a separate taxpayer, and instead treats it as a typical revocable trust, with trust income attributed to the grantor, whether it is distributed or not. Grantors who are residents of California pay income taxes on all their taxable income from whatever source. With a stroke of the governor’s pen, the ING strategy to reduce California residents’ income taxes vanished.
California residents who relied on INGs to avoid paying income taxes on non-California-source income in 2023 are left high and dry
Unlike the New York statute, however, the California law is retroactive to January 1, 2023. New York allowed taxpayers to decant or liquidate the ING during a six-month grace period after passage, in order to allow ING grantors time to adjust their asset and tax planning. Section 17082 has no such indulgence. There is no requirement that INGs be wound down under the new law, but the state tax protections of INGs are eliminated even for six months in 2023 before the law was enacted.
What This Means (and Doesn’t Mean) For California Residents with INGs.
California residents who relied on INGs to avoid paying income taxes on non-California-source income in 2023 are left high and dry. Any income receipts in 2023 – even those received before the law went into effect – will be includable in the taxpayer’s gross income for California income tax purposes. Changing residency from California at this point won’t affect the adverse tax treatment of the income receipts already on the books. It’s dollars under the bridge.
As to planning now that the law has been passed, this issue could be a particularly acute problem for residents who anticipate their INGs will experience a large liquidity event in 2023. If a receipt of large amounts of taxable capital gain occurs this year, and the taxpayer is a resident at the time of receipt, the gains will be included in the resident’s California gross income. The taxpayer needs to hit the reset button on that. The non-residency related issues for continuing the trust or liquidating it should be discussed with estate counsel and wealth advisers. As to the California income tax issue, the default strategy remains what it always has been: taxpayers can only eliminate California income taxes on non-California-source income by changing residency before the receipt of income occurs. That might require considerable, swift readjustment in their tax planning.
That doesn’t mean INGs still don’t have federal estate tax benefits. They do. If that was the main purpose of a taxpayer’s use of an ING, and changing California residency is not an option, then there may be no reason to decant or otherwise liquidate the trust. That should be discussed with estate counsel and wealth advisers. However, if state tax savings was the primary motivation, then the taxpayer has to seek another strategy, which basically comes down to changing residency.
Also, tangentially, for residents who leave California but retain a second home in California, having the property in an ING may have benefits in a residency audit if status is the issue. INGs are irrevocable trusts and remain separate taxpayers for federal purposes. If audited for residency, it’s always better not to own property in California. But be aware that the amount of control ING grantors retain over trust assets weakens this argument. There are better ways to use irrevocable trusts in residency planning. Again, a frank discussion with estate counsel and wealth managers is in order to evaluate the overall usefulness of the ING. But for California residency purposes, there is no substitute for planning to change residency status.
To summarize the bad news for California taxpayers who established INGs for residency tax purposes, it’s all for naught going forward.
Conclusion: Back to Basics
INGs have always been a complex, expensive, and uncertain way to reduce California income tax. They always had a big target on their backs. And now the target’s been hit. For California residents who established an ING to avoid California income taxes on their non-California-source income, 2023 is likely to be an annus horribilis. Any taxable ING income receipts in the year to date, even those before the passage of the new law, won’t escape California income taxes. As for the balance of the year, the only recourse this group of taxpayers may have at this point is a hasty change of residency, if the goal is to shield non-California-source ING income anticipated by the end of the year. Delaying the receipts, if possible, may buy some time (talk to your wealth and tax professionals about that). But ultimately there remains only one sure way to protect the income from California taxes: changing residency.
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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, and global citizens who are able to live, work, or retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
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