In recent years, taxpayers across the country have taken advantage of a planning technique known as an incomplete gift non-grantor trust (ING) (a NING in Nevada, DING in Delaware, WING in Wyoming, etc.). The admiration of INGs stems from their ability to move assets from a high state income tax jurisdiction to a low state income tax jurisdiction without making a completed gift, thus deferring and potentially avoiding state income taxes in the grantor's or beneficiary's state of residence.
On Nov. 10, 2020, a legislative proposal was presented at the California Franchise Tax Board's (FTB) Stakeholders Meeting that directly attacks INGs, and arguably acts as an admission of their current viability. Legislative Proposal C suggests adding new Section 17082 to the Revenue and Tax Code to treat INGs as grantor trusts effective as of Jan. 1, 2022. The result of the proposed legislation would be that an ING established by a California resident, who is still a California resident as of Jan. 1, 2022, would become subject to California income taxation on all of its income after Jan. 1, 2022. The fact that the proposal is seeking to drastically modify current California law seems to suggest that the FTB believes INGs are a valid means of deferring state income tax.
In order to understand why an ING works, a review of how California taxes trusts is necessary. Generally, there are three scenarios that will cause some or all of a non-grantor trust's income to be subject to California income taxation: the trust has California source income, one or more of the fiduciaries is a California resident, or one or more of the non-contingent beneficiaries is a California resident.
California Taxation of Non-Grantor Trusts
California Source Income
All California source income, regardless of the residence of the fiduciaries and beneficiaries, is subject to California income taxation. Examples of California source income include rental income or any other type of income derived from the ownership, control, or management of real or tangible personal property within California, gains realized from the sale of such property, income from a trade or business conducted within California, and income from certain intangible personal property.
California Resident Fiduciaries
Residency. California taxes the income of a trust based not on the residence of the grantor, but on the residence of the fiduciaries and beneficiaries. Residence, for purposes of a corporate fiduciary of a trust, refers to the place where the corporation transacts the major portion of its administration. Although this definition may seem patently clear, the FTB will consider a myriad of facts and circumstances to make its determination as to whether a corporate fiduciary is a resident of California.
Although not defined under Section 17742 of the California Revenue and Taxation Code, presumably the residence of an individual fiduciary is determined in accordance with the rules for determining the residence of an individual taxpayer for California income taxation. If those rules do apply, then any individual who spends, in the aggregate, more than nine months in a given year in California is presumed to be a California resident. In addition, any individual who is in the state for other than a temporary purpose or who is domiciled in the state but who is outside of the state for temporary or transitory purposes is considered to be a resident of California.
Apportionment of Income Taxes Based on Residence of Fiduciaries. In the event of a trust with only one fiduciary who is a California resident, the entire income of the trust, regardless of the residence of any beneficiary, will be subject to California income taxation. If, however, there is more than one fiduciary of a trust, the portion of the trust income subject to California income taxation will be determined based on the number of fiduciaries who are California residents relative to the total number of fiduciaries. Of course, as mentioned previously, the residence of the fiduciaries is only one-half of the equation, as the residence of each non-contingent beneficiary must also be examined.
California Resident Non-Contingent Beneficiaries
Non-Contingent Beneficiaries. The second prong of California's system of trust taxation looks at the residence of every non-contingent beneficiary of the trust. A non-contingent beneficiary is a beneficiary whose interest is not subject to a condition precedent. Although the term ''condition precedent'' is not defined in either the statute or the regulations, the FTB has provided the following definition:
An act or event, other than a lapse of time, that must exist or occur before a duty to perform something promised arises. If the condition does not occur and is not excused, the promised performance need not be rendered. The most common condition contemplated by this phrase is the immediate or unconditional duty to performance by a promisor.
The FTB has determined that, in the case of a fully discretionary trust, a resident beneficiary who receives no distributions during the tax year is a contingent beneficiary. In the event a distribution is made to a resident beneficiary from a fully discretionary trust, the beneficiary becomes a non-contingent beneficiary, but only with respect to the amount so distributed.
It is less clear whether a beneficiary of a discretionary support trust, where the fiduciary has the discretion to distribute income and/or principal to a beneficiary for his or her health, maintenance, education, and support, would be considered a contingent beneficiary. The additional limitations imposed by an ascertainable standard coupled with fiduciary discretion should, in theory, render a beneficiary's interest contingent as it places a greater restriction on a fiduciaries ability to make a distribution to a beneficiary. While some commentators have suggested that a beneficiary of such a trust would indeed be considered a contingent beneficiary, others have argued that the use of an ascertainable standard would create an enforceable right in the beneficiary or his or her creditor to compel a distribution, which in turn would cause the beneficiary to be treated as non-contingent.
Apportionment of Income Taxes Based on Residence of Beneficiaries. In the event of a trust with one noncontingent beneficiary who is a California resident, the entire taxable income of the trust would be subject to California income taxation. If, however, there is more than one non-contingent beneficiary of a trust, the portion of the trust income subject to California income taxation will be determined based on the number of non-contingent beneficiaries who are California residents relative to the total number of non-contingent beneficiaries.
Finally, in the event of a trust with California resident and non-resident fiduciaries and California resident and non-resident non-contingent beneficiaries, a twostep calculation is used to determine the portion of trust income subject to California income taxation. First, the total income is multiplied by the number of California resident fiduciaries as it relates to the total number of fiduciaries. This is the first level of income subject to California income taxation. Second, the remaining amount of income not yet subject to California income tax is multiplied by the number of California resident non-contingent beneficiaries as it relates to the total number of non-contingent beneficiaries.
California's Throwback Rules
In the event income is accumulated by a trust in the year it arises but is not subject to California income taxation, such accumulated income may nevertheless become subject to California income taxation upon a later distribution to a California resident beneficiary under one of two rules.
First, if some or all of the trust income was subject to California tax in the year it was earned, due to the residency of the fiduciaries and/or non-contingent beneficiaries, but no tax was actually paid, then the accumulated income is subject to California income taxation when a distribution is made to the California resident beneficiary. If a beneficiary is a non-resident of California, only income distributed to the beneficiary that is California source income will be subject to California income taxation.
Second, and of more importance to those considering establishing an ING, if some or all of the trust income was not subject to tax in the year it arose because a California resident beneficiary's interest was contingent, then such income is subject to California income taxation when distributed to him or her. In the event this rule applies, the beneficiary must determine the California income tax due using the accumulation distribution rules (known as the throwback rules). If the period of accumulation by the trust exceeded five years, the beneficiary's tax is equal to the tax that would have been attributable to that income, had it been distributed to the beneficiary ratably over the current year and the five preceding tax years. In the event of accumulation over a period of less than five years, the beneficiary's tax is equal to the tax on the income had it been included in the beneficiary's income over the relevant number of years.
Additional consideration must be given to the residence of the beneficiary both at the time of accumulation and at the time of distribution. If a beneficiary was a California resident both at the time of accumulation and at the time of distribution, the income accumulated will be subject to California income taxation. This is of particular importance to the grantor of an ING, as if he or she intends to distribute the assets of the ING to himself or herself, while a California resident the distribution will be subject to California income tax.
To read the full article click here
Originally Published by Bloomberg Tax
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
