On July 10, 2023, California’s governor signed into law Senate Bill 131 which in essence closes a loophole under California’s state income tax law for trusts that are referred to as Incomplete Gift Non-Grantor Trusts, (“INGs”). A new section 17082 will be added to the California Revenue and Taxation Code to reflect this change. How an ING worked was that a trust was formed by a Trustor (typically a resident of a state with a state income tax) in a state that did not have a state income tax. If a state has no income tax then a taxpayer who lives in a state with income tax could place assets into an ING trust formed in a state with no income tax, which resulted in avoidance of state income tax on income generated by the ING assets or on sales of the ING assets. Additionally in states with inheritance taxes on death, the ING could also be positioned to avoid those taxes as well. The most popular states for these types of trusts were South Dakota, Nevada, Delaware and Alaska.
Some states have previously closed this loophole, like New York who enacted legislation in 2014 and which is one of the states with the highest income tax rates rivalling California. Notwithstanding the legislation closing the state income tax loophole, a resident of California may still want to maintain an ING as the state may have other benefits aside from avoidance of state income tax. These include: no rule against perpetuities (allowing trusts to avoid estate tax for multiple generations), no state inheritance tax and strong creditor protection. Under the new California law, the trust may stay in existence as the ING does not have to be terminated. All that is required is that the taxable income of the ING just needs to be reported on the Trustor’s California income tax return starting in 2023 as this legislation is retroactive to January 1, 2023. It is important to note that the new California law does not require INGs to be wound up, but only that the taxable income generated by assets held in these trusts will be reported on the California resident’s state income tax return for tax years 2023 and beyond. There may be other reasons why somebody with an ING would want to keep it in place, such as for the benefits discussed above but the cost of maintaining these trusts will need to be analyzed against the benefits.