Does California’s New Law Ending the State Income Tax Benefits Associated with Incomplete Gift Non-Grantor Trusts Violate the U.S. Constitution?
Published in Delaware Banker Magazine.
ON JULY 10, 2023, CALIFORNIA FOLLOWED IN THE FOOTSTEPS of the State of New York by adding Section 17082 to the California State Tax and Revenue Code (hereafter, “Section 17082”) which establishes that income generated from Incomplete Gift Non-Grantor Trusts (“ING Trust” or “ING Trusts”) created by California taxpayers will be includable in a grantor’s income for California state income tax purposes.1 ING Trusts are unique tax saving vehicles utilized by individuals residing in states with high income tax rates to eliminate or defer state income tax liabilities on the sale of low-basis, highly-appreciated assets. For federal taxation purposes, an ING Trust is treated as a non-grantor trust, however, the assets contributed to an ING Trust do not count against the grantor’s federal lifetime gift tax exemption because the grantor retains certain powers over the ING Trust to cause the transfer into the ING Trust to be wholly incomplete for federal gift tax purposes.
To qualify for this favorable tax treatment, an ING Trust must be created in a jurisdiction like Delaware that authorizes self-settled asset protection trusts and does not impose state income tax on trust income when none of the trust’s beneficiaries reside in Delaware. Additionally, the grantor must avoid making a completed gift when funding the ING Trust and the ING Trust must avoid being classified as a grantor trust for federal taxation purposes. The IRS has issued a series of Private Letter Rulings establishing that a grantor can accomplish both of these objectives if the following requirements are met: (1) the ING Trust is a self-settled asset protection trust; (2) the grantor retains a limited power of appointment over the ING Trust’s assets; (3) the grantor retains the power to consent to distributions directed by a majority of the distribution committee members; and (4) the ING Trust has a distribution committee that has the discretion to determine whether the grantor is entitled to distributions from the ING Trust’s income and principal….
