Authored by Mark Lobb
At the end of June 2023, the California Senate and Assembly passed legislation which will eliminate the use of incomplete non-grantor trusts (ING or INGs) to prevent California taxpayers from incurring California state tax under certain circumstances (SB 131). California SB 131 tracks New York legislation (Part Q of the Fiscal Year 2020 Budget Bill) made effective April 1, 2020, which allows for non-grantor trusts to be taxed as grantor trusts. The California bill has yet to be signed into law as of the drafting of this article. There appear to be no obstacles to Governor Newsom enacting this legislation.
What is an Incomplete Non-Grantor Trust?
An ING is an irrevocable trust. Uniquely, the grantor retains certain control and beneficial interests over trust assets. Unlike a traditional non-grantor trust, where the grantor surrenders control and access to trust assets, an incomplete non-grantor trust offers distinct advantages by allowing some continued access and control.
Traditionally, residents in high-tax states utilize INGs to avoid paying state tax on income generated by the sale of an intangible asset such as stock. For instance, a California resident would set up an ING in Nevada and fund the ING with stock. Later, the trust would sell the stock to a third party. When the sale happens, no state tax is realized in the high tax state (residency of the grantor) because the trust is deemed to be a taxpayer separate from the grantor and a resident of a non-tax state (Nevada in this example).
Features of an ING include:
- Flexibility and Control: Unlike traditional irrevocable trusts, INGs provide the grantor with some level of control and beneficial interests. This control can include the ability to retain access to income and principal during the grantor’s lifetime.
- State Tax Elimination: Traditionally, INGs are used to eliminate state tax on the sale of intangible assets. As mentioned, California is attempting to eliminate this benefit in line with what New York did in 2020.
- Family Business Succession: INGs can be utilized to transition ownership of a family business while maintaining control over its operation during the grantor’s lifetime. This allows for strategic planning and ensures a smooth transfer of management and ownership to the next generation.
- Charitable Planning: Individuals with philanthropic goals can establish INGs to provide ongoing support to charitable organizations while retaining some control over the trust’s assets and distributions.
- Federal Tax (Stacking): INGs can be utilized to enhance the tax-free treatment of qualified small business stock (QSBS) under Internal Revenue Code section 1202. This “enhancement” will be further discussed in a later section of this article.
- Asset Protection: By placing assets into an ING, individuals can shield those assets from creditors. As the grantor no longer owns the assets, they are protected within the trust’s legal structure.
- Generation-Skipping Transfer (GST) Tax Planning: INGs can facilitate efficient wealth transfer to future generations. By using the GST tax exemption. Assets placed in the trust can pass to grandchildren or later generations, bypassing potential estate taxes at successive generations.
- Estate Planning: INGs effectuate the estate plan desires of a grantor and are a tool used to avoid the probate of assets held by the trust.
Are INGs a Dead Planning Tool for Residents in States Like California and New York?
INGs have many benefits aside from state tax elimination. As displayed above, there are many reasons a person should consider using an ING. Two of the top items of interest include federal tax elimination and asset protection.
Federal Tax Elimination
For entrepreneurs and investors seeking to maximize tax advantages, the Internal Revenue Code (IRC) section 1202 offers a valuable opportunity. INGs provide significant tax benefits for the sale of QSBS. INGs can enhance the tax by leveraging the federal tax exclusion through a process of “stacking.”
IRC section 1202 allows eligible taxpayers to exclude a portion or all taxable gains from the sale of QSBS from federal taxation. To qualify, the stock must meet specific criteria, including being issued by a qualified small business (QSB) and held for a minimum period.
Section 1202 specifically allows for gain from the sale of stock to be reduced by $10MM or ten times the aggregate adjusted basis of QSBS. Under the concept of “stacking,” a shareholder can create additional taxpayers to benefit from additional federal tax exclusions under Section 1202. This is where the ING comes into play. A shareholder can gift shares to an ING which is a taxpayer separate from the shareholder. Once the gift is made, both the original shareholder and the ING can reduce the eligible taxable gain by $10MM or ten times the adjusted basis.
A shareholder can enhance the tax benefits under Section 1202 through avenues other than INGs by gifting stock directly to other individuals, gifting stock to a complete gift non-grantor trust or by making a trust distribution to beneficiaries of stock. However, INGs provide unique benefits which make “stacking” very attractive.
INGs set up in asset protection jurisdictions provide excellent protection from creditors. Normally domestic asset protection trusts are thought of as self-settled trusts established in certain asset protection jurisdictions such as Nevada, Alaska, Delaware, etc. INGs are in fact asset protection trusts and can provide the same protections as self-settled trusts.
For instance, in Nevada, the statute codifying asset protection trusts (Nevada Revised Statute Section 166) defines trusts falling under that Section as “spendthrift trusts.” INGs are spendthrift trusts, thus falling into the statutory scheme of asset protection trusts.
If the goal of a person setting up an ING is asset protection, setting the trust up in a state with strong asset protection laws is key. The top three states are Nevada, Wyoming, and Delaware.
If and when California SB 131 is signed into law, the use of INGs by California residents will continue. State tax elimination has not been the only reason INGs have been utilized. Likewise, if a California resident already has an ING, there is no reason to stop using the ING. Again, the trusts are estate plans which provide asset protection and other attributes as listed above.