State and federal laws impacting estate plans have been in flux for years. One of the most important changes for California residents happened in July when Governor Gavin Newsom signed a bill into law that closed loopholes for out-of-state incomplete nongrantor trusts.
This change primarily impacts high-net-worth parties who have already established significant estate plans. If you have an ING in place, it may be time to decant it into another type of trust. Let’s break down what constitutes an ING, how California’s new law affects these trusts, and your options if you decide it’s time to change your estate plan.
What Is an Incomplete Nongrantor Trust?
Trusts typically fall into one of two categories: grantor and nongrantor trusts. A grantor trust (sometimes called a revocable trust) permits the grantor, or the person who creates it, to retain some control over the entity’s rules and assets. In exchange for that control, the grantor remains responsible for paying income taxes on any revenue generated by those assets, even if the revenue stays in the trust.
In contrast, a person who establishes a nongrantor trust (sometimes known as an irrevocable trust) gives up control over the terms and assets of the entity once it is formed. The assets are entirely removed from the grantor’s estate. As a result, the entity is responsible for paying any income taxes, not the grantor.
An incomplete nongrantor (ING) trust is intended to skirt the line between these two categories. It uses a combination of careful legal wording and strategic establishment to combine the benefits of grantor and nongrantor trusts. To be considered an ING, the entity must be:
- Established in a state with minimal income taxes: Setting it up in a low-tax state protects the assets from California’s substantial income tax rates, reducing the overall tax burden on the assets.
- Funded as a nongrantor trust: This shifts the burden of income taxes to the ING and off the shoulders of the grantor.
- Structured to make the fund transfer defective: Here’s where the ING becomes “incomplete.” If handled carefully, it is possible to gift assets so that the transfer is complete enough to qualify for nongrantor status without meeting the IRS’ definition of a taxable gift. This process renders the transfer technically incomplete and protects the transferred assets from state income taxes and the federal gift tax.
The extra tax protection makes INGs particularly popular in states with high income tax rates, such as California. However, they are no longer as useful as they were due to recent legislation.
California’s New Law Ends ING Loopholes
In July, Governor Newsom signed Senate Bill (SB) 131 into law, closing the loophole that permitted INGs to function for California residents. The law added section 17082 to the state tax code, which says, “For taxable years beginning on or after January 1, 2023, the income of an incomplete gift nongrantor trust shall be included in a qualified taxpayer’s gross income to the extent the income of the trust would be taken into account in computing the qualified taxpayer’s taxable income if the trust in its entirety were treated as a grantor trust.”
In other words, the new tax code explicitly requires grantors to pay income taxes on assets placed in any trust that does not meet the definition of a grantor trust if the assets transferred are treated as an incomplete gift, according to the IRS. While the entity may still protect the included assets from gift taxes, it will not shield them from state income tax.
Furthermore, the new law is explicitly retroactive. While it went into effect in July, it applies to any income earned by an ING dating back to the start of 2023. Any California resident with an ING in place should prioritize the adjustment of their estate plan if tax reduction is a primary goal of the entity.
Should You Decant Your ING? Options for Decanting Trusts in California
If your ING can no longer serve its intended purpose due to SB 131, it may be time to decant it. In 2018, California adopted the Uniform Trust Decanting Act to permit trustees to change the terms of both revocable and irrevocable entities by transferring the assets to a new trust.
This permits grantors of INGs to alter their terms when normally it would not be possible due to their irrevocable nature. Under the law, you may work with an experienced estate planning attorney to determine the best structure for the entity into which the ING will be decanted. Depending on your goals, this may include alternatives such as:
- Asset Protection Entities: An APT is an irrevocable trust that guards the assets it contains from creditors and legal disputes and may also provide a shield against taxes and divorce.
- Generation-Skipping Entities: Careful use of a generation-skipping trust can potentially avoid triggering estate and gift taxes during probate on assets you leave to your grandchildren and later descendants.
- Qualified Terminable Interest Property Entities: A QTIP protects assets from estate taxes while optimizing tax benefits for married couples.
Your attorney will help you choose the best ING alternative to accomplish your goals and guide you through the legal process of decanting your existing ING.If you have an ING and live in California, it’s likely that it no longer supports your goal of minimizing your income tax burden. Decanting the assets can help you reclaim control over your finances and ensure your estate plan meets your needs. At the Law Offices of Denise Eaton May, P.C., we can help you update your plan under new state laws. Schedule your consultation to start the process of decanting your ING today.