Authored by Mark Lobb
Incomplete Non-Grantor Trusts Update
Recent Lobb Reports have discussed the potential demise of the use by California residents of incomplete non-grantor trusts (INGs). The 2023-2024 California budget proposed treating INGs as grantor trusts so California could tax certain income incurred by the INGs. At the time of this writing, both the State Senate and Assembly have passed Senate Bill 131 which is not a complete death blow to the use of INGs to avoid paying California tax on certain transactions, but substantially eliminates the use of INGs for state tax planning.
Senate Bill 131 adds Section 17082 to the Revenue and Taxation Code (“RTC”). The bullet points are as follows:
- For taxable years beginning on or after January 1, 2023, the income of an incomplete gift non-grantor trust shall be included in a qualified taxpayer’s gross income to the extent the income of the trust would be included in computing the qualified taxpayer’s taxable income if the trust in its entirety were treated as a grantor trust under Section 17731.
- Section 17745 applies to distributions from an incomplete gift non-grantor trust.
- The income of an incomplete gift non-grantor trust shall not be included in a qualified taxpayer’s gross income for a taxable year if all of the following apply:
- The fiduciary of the incomplete gift non-grantor trust 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 election shall be made in the form and manner prescribed by the Franchise Tax Board.
- The incomplete gift non-grantor trust is a non-grantor trust.
- Ninety percent or more of the distributable net income of the incomplete gift non-grantor trust is distributed, or treated as being distributed pursuant to a charitable organization, as defined in Section 501(c)(3) of the Internal Revenue Code.
- The fiduciary of the incomplete gift non-grantor trust 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 election shall be made in the form and manner prescribed by the Franchise Tax Board.
- The following definitions apply to the new RTC section:
- “Incomplete gift non-grantor trust” means a trust that meets both of the following conditions:
A. The trust does not qualify as a grantor trust under Subpart E of Part I of Subchapter J of Chapter 1 of Subtitle A of the Internal Revenue Code, relating to grantors and others treated as substantial owners.
B. The qualified taxpayer’s transfer of assets to the trust is treated as an incomplete gift under Section 2511 of the Internal Revenue Code, relating to transfers in general. - “Qualified taxpayer” means a grantor of an incomplete gift non-grantor trust.
- “Resident non-grantor trust” means a trust that is not a grantor trust and where the tax applies to the entire taxable income of the trust based on the residency of the fiduciary or beneficiary.
- “Incomplete gift non-grantor trust” means a trust that meets both of the following conditions:
Elimination of INGs creates absolutely no dent in the budget deficit and likely will create a larger deficit in future years as wealthy Californians leave the state. I will provide more updates on INGs as soon as the final version of the RTC is signed into law.
Asset Protection
A comprehensive asset protection analysis needs to happen sooner than later. A top to bottom understanding of the potential weaknesses of an asset protection plan should be a top priority. Utilization of the laws of business-friendly states should be considered when scrubbing down on asset protection issues. There are ways to be in an unfriendly state and take advantage of the business-friendly laws in other states.
Many business owners are ignorant of the importance of “capitalization” in the context of corporate veil protections. In a closely held company, if shareholders do not adequately capitalize the company, the protections of having a corporation or limited liability company may be lost. The liabilities of the company become the personal liabilities of the shareholders. Each state has its own rules regarding alter ego liabilities and business owners should do a thorough analysis of those rules to make sure personal assets are not exposed to the liabilities of the company.
A first step is to identify states which have low taxes, strong asset protection laws and a business-friendly environment. For years now, Nevada has ranked as the best state in the US to fit the mold of this first step. Nevada has no state income tax, no state estate tax, some of the strongest asset protection laws in the US and an incredibly business-friendly environment.
Nevada has several tools which mitigate taxes in unfriendly tax states and provide substantial asset protection. For residents of high tax states, integration of an incomplete non-grantor trust into a tax optimization structure may eliminate state capital gains taxes on the sale of intangible assets.
One of the most effective tools to employ in utilizing the asset protection laws in Nevada is a domestic asset protection trust (DAPT) which is frequently referred to as a Nevada Asset Protection Trust or NAPT. The structure of a NAPT is normally in the form of what is referred to as a self-settled trust. Seventeen states permit self-settled trusts to have asset protection qualities. The “self-settled” nature of a trust is important to many people who want an irrevocable trust for asset protection purposes without losing complete access to the assets funded into the trust.
A NAPT is a separate entity from the grantor/beneficiary under state law; therefore, creditors cannot take assets owned by the NAPT because they are not the assets of the grantor. In California, a self-settled trust such as a NAPT would not be deemed a separate entity from the grantor/beneficiary, allowing a creditor the ability to take the assets from such a trust. However, this does not mean a California resident cannot benefit from the use of a NAPT.
For some background, NAPTs are creatures of Nevada statutory law and have been for nearly twenty years. These trusts have been tested and proven to withstand attacks from creditors under statutory law and by the Nevada Supreme Court.
A NAPT can be structured to include the same person as the grantor (creator) as a beneficiary of the trust. The grantor/beneficiary can receive discretionary distributions of income and principal from the trust. The grantor/beneficiary can also serve as the Investment Trustee of the NAPT, which allows the grantor/beneficiary to manage investment decisions for the trust assets. To add an additional layer of asset protection, the NAPT can form limited liability companies (“LLCs”) and contribute investments into the various LLCs, allowing the grantor/beneficiary to have certain management responsibilities of the business activities of the LLCs.
While the grantor/beneficiary can be involved in the operation of the NAPT as explained above, the grantor cannot be in-charge of distributions to the beneficiaries. Distributions are to be made by a Distribution Trustee. The Distribution Trustee must be an independent Nevada person or entity, such as a trust company, bank, lawyer, or CPA. A family member and/or employee should not act as the Distribution Trustee.
Although a third party controls the trust assets, distributions can only be made in compliance with the Trust Agreement. The Trust Agreement prohibits the Distribution Trustee from making distributions when the trustee knows the beneficiary will not receive a benefit from the distribution or to directly pay a judgment creditor. Otherwise, the Distribution Trustee is free to distribute as much, and as often, as the trustee deems to be in the best interest of the beneficiary. If a Distribution Trustee abuses its powers, the trustee may be removed and replaced immediately.
NAPTs are normally drafted to be tax neutral. Transfers to the NAPT do not trigger income tax nor gift tax. Furthermore, the NAPT does not pay income tax. All income tax generated by the NAPT’s investments flows to the individual tax return of the beneficiaries. Additionally, the beneficiaries are not taxed separately on the NAPT’s distribution. In essence, the tax position of the grantor/beneficiary does not change. A NAPT can be drafted to incur income tax or trigger a gift tax, but this would only be done in unique situations, normally involving the integration of intangibles which do not derive sourced income from a high tax state and have low basis.
Why would a resident from a state other than Nevada use a NAPT for asset protection? Ideally, a non-Nevada resident will employ the use of a NAPT to hold intangible assets such as ownership in a private business, ownership in an LLC which owns real estate in and out of Nevada, stocks in publicly traded companies, bonds, etc. Some assets immediately receive the full protections of a NAPT, while others require a change in form to receive complete protection from creditors. An asset-by-asset analysis is required when structuring and funding a NAPT. The Passage Trust is an example of a comprehensive NAPT structure and for more information on The Passage Trust, you can go to this link.
