From Present to Past Tense? California Signs Bill Making "ING" Trusts Taxable
From Present to Past Tense? California Signs Bill Making "ING" Trusts Taxable
While the letters "ING" may simply resemble an ordinary English suffix to most, to others, they represent an opportunity to plan for the future. The incomplete gift non-grantor trust (ING) has been a valuable estate planning tool used by investors and founders, especially in California. Historically, when structured correctly, a taxpayer would pay no California state tax on any income from assets including qualified small business stock (QSBS) held in these trusts. However, on July 10, 2023, Gavin Newsom signed a bill into law that requires California taxpayers to pay state taxes on that ING trust income. Although this bill defeats an important planning tool for California personal income tax, taxpayers looking to take advantage of QSBS rules under Internal Revenue Code (IRC) section 1202 should not count out the value of INGs just yet.
How the Trust Works
The mechanics of an ING are fairly straightforward. First, the taxpayer creates a self-settled irrevocable trust, meaning that the taxpayer is both a grantor and a beneficiary. The taxpayer sets up this trust in a state that both allows self-settled trusts and has no state income tax, for example, Nevada (NINGs) or Delaware (DINGs). This trust is considered "incomplete" because the taxpayer still retains certain powers, such as the ability to choose a trustee. For federal gift and estate tax purposes, the taxpayer is treated as the owner of the assets held by the trust, and contributions to the trust do not count towards estate and gift tax limits. For federal income tax purposes, the trust is designed to be a non-grantor trust by careful limitations of the taxpayer's powers over the trust,1 so the trust owns the assets and is a separate taxpayer from the donor.
The ING trust files its own tax return reporting gain earned on the assets (including QSBS) it holds, and, provided the ING is domiciled in a zero state income tax jurisdiction, pays no state tax on this gain. If the trust makes a distribution out of its income to a beneficiary who is a California resident, the beneficiary pays state tax on that distribution. However, the remainder of the income stays in the trust, tax-deferred.
Effects of California's New Bill
Recently, state legislatures began to take notice of INGs. In 2014, New York amended its tax laws to include net income derived from an ING's assets in the grantor's gross income, thus requiring the grantor to pay state-level income tax. California has now followed suit, and other states may do the same. California's bill is more stringent than New York's: while the New York law gave grantors of INGs a six-month period from the bill's passage to liquidate their trusts tax-free, the California bill provides no such relief.
These bills disincentivize the creation of INGs for taxpayers hoping to reduce California state personal income tax. But the current shift in the taxation of INGs does not mean that they should be completely ignored as an estate planning tool. For founders looking to take advantage of QSBS rules, INGs may still provide significant tax savings, even if only on the federal level.
Something Worth HoldING On To
The QSBS rules under IRC section 1202 are clear that each taxpayer can exclude federal gain of up to $10 million.2 A non-grantor trust, like an ING, is considered to be a separate taxpayer that files its own return.3 If a founder transfers QSBS-eligible shares to a non-grantor trust and the trust sells those shares, the trust should be entitled to claim the $10 million exclusion.4 Thus, even without its state tax advantages, an ING can still be a valuable planning tool.
Can an ING claim a QSBS exclusion even though the founder's transfer of QSBS to the ING is "incomplete"? The answer appears to be yes. Recall that an ING is a separate taxpayer for income tax purposes, but treats the founder/grantor as the owner of the ING's assets for gift tax purposes. Accordingly, in the absence of further guidance from the IRS, transfers of QSBS are treated like any other transfer of assets to an ING.
When a founder transfers QSBS to an ING, the value of the transferred shares will not count towards a founder's lifetime gift tax exclusion.5 The ING therefore still retains a significant amount of utility for those who plan on gifting large amounts of QSBS, or have already used some (or all) of their gift tax exclusion. However, it is still in a founder's best interest to transfer QSBS when the shares are still worth relatively little. If a founder waits too long (such as until their company is acquired) to transfer the shares, those shares would likely be taxed to the founder, not the ING.6
Conclusion
Although INGs no longer allow California residents to avoid paying state tax, they can still provide massive federal tax savings. Therefore, owners of INGs or those who planned to create one may not want to change course just yet. Please contact the Hanson Bridgett Tax Group with any questions regarding this recent decision or estate planning more generally.
1 See IRC sections 671-679.
2 IRC section 1202(b).
3 Rev. Rul. 77-402.
4 Under IRC section 1202(h)(1), a QSBS transferee is treated as having acquired and held the QSBS in the same manner as the transferor.
5 As of 2023, the gift tax exclusion is $17,000 annually per donee, and $12.06 million lifetime.
6 Estate of Applestein v. C.I.R., 80 T.C. 331 (1983).
