New California law treats INGs as grantor trusts for state income tax

August 2023

In brief

California Governor Gavin Newsome (D) on July 10 signed legislation (Senate Bill 131) that codifies in Section 4, California’s treatment of incomplete gift non-grantor trusts (INGs) for state income tax purposes. Effective retroactive to January 1, 2023, California will treat INGs as grantor trusts for state income tax purposes. Senate Bill 131 added Section 17082 to the California Revenue and Taxation Code providing that California residents who transferred assets into an ING will be treated as owners of the ING for California income tax purposes and will be liable for California income tax on any taxable income earned by the ING.

Note: The new California law, which was modeled after a New York law that took effect in 2014, does not affect an ING’s federal income tax treatment. To the extent an ING is considered a non-grantor trust for federal income tax issues, there can be mismatch issues with California.

Action item: Taxpayers interested in forming an ING should be aware that although New York and California are the only two states with laws specifically targeting INGs, other states have statutes that make it difficult to claim the intended benefits of an ING. Before considering such a trust, taxpayers should consult with their tax advisor to evaluate potential treatment in particular states.

In detail

Federal income tax treatment

The Internal Revenue Code provides for two general types of trusts: (1) grantor trusts and (2) non-grantor trusts. Grantor trusts are disregarded for federal income tax purposes, and the income of the trust is taxable to the deemed income tax owner (usually the grantor but sometimes the beneficiary). 

Non-grantor trusts are treated as separate taxpayers. Income in a non-grantor trust is taxed either to the trust or to the beneficiaries depending on whether distributions are made and/or based on the specific type of trust.

An ING is intended to be a type of non-grantor trust where the grantor establishes the trust for the benefit of the grantor and other discretionary beneficiaries. If the grantor’s transfer of assets to the ING is treated as an incomplete gift under Section 2501, the grantor potentially could fund the trust without incurring a federal gift tax liability. 

Despite an intent for the transfer to be treated as an incomplete gift, the trust is structured in such a way to seek not to be subject to the grantor trust rules under Sections 671 through 679. A trust distribution committee controls distributions and approves distributions to the grantor. As a result, it is argued that the grantor retains sufficient control over the assets to be treated as not having made a completed gift of the assets, while at the same time being treated as having retained insufficient control over the assets to be considered the owner of the assets for income tax purposes.    

Observation: If the transfer is treated as incomplete, taxpayers could seek to transfer large sums to an ING without utilizing their federal gift tax exemption or incurring gift tax, however, if the gift is incomplete the trust would be included in the taxpayer’s estate, and any assets distributed from the trust to a non-grantor beneficiary would constitute a completed gift for gift tax purposes.

The IRS had issued a number of private letter rulings over the years concluding that INGs are not grantor trusts for federal income tax purposes, instead treating INGs in those cases as taxable trusts rather than disregarded taxable entities for federal income tax purposes. However, the IRS in 2021 issued Rev. Proc. 2021-3, adding INGs to the no-rule list for future private letter rulings.  

Observation: Because a trust has compressed tax brackets, being treated as a non-grantor trust or a grantor trust with a grantor in the top marginal rate usually has limited effect on the amount of federal tax liability. Thus, INGs primarily are utilized in seeking to reduce the state income tax impact on non-grantor trusts. 

General overview of INGs

An ING generally is set up in a state that does not subject non-grantor trusts to income tax, in order to minimize the trust’s state income tax. The grantor generally would not report the ING’s income unless the grantor received a distribution of distributable net income from the trust.

Observation: California and other states raised potential issues for their residents who wanted to set up this type of trust, so an ING did not accomplish its intended purpose for every taxpayer. 

California income tax treatment under Section 17082

California Code Section 17082 treats grantors who transfer assets into an ING in the same manner as income tax owners of grantor trusts. As a result, an ING is disregarded for California income tax purposes and the ING’s income must be included in the California resident grantor’s gross income, subject to California income tax. This means that California resident grantors cannot seek to reduce their California income tax liability by shifting the ING’s income to states with more favorable income tax treatment.

Observation: The new California law does not require grantors to terminate INGs. It only requires that all of the ING’s income, regardless of whether it is California-source, must be included in the gross income of California resident grantors for California income tax purposes for tax years 2023 and beyond. This law applies to all INGs, including those created before the law’s effective date.

California’s new law provides a limited exception for grantors who wish to contribute the vast majority of income from the trust to charitable organizations. To meet this exception, the ING must file a California Fiduciary Income Tax Return and make an irrevocable election to be treated as a resident non-grantor trust and must stipulate that 90% or more of the ING’s distributable net income is distributed (or treated as distributed) to a charitable organization. An ING meeting this exception will not be treated as a grantor trust for California income tax purposes.

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Ed Geils

Ed Geils

Global and US Tax Knowledge Management Leader, PwC US

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