In July 2023, California implemented a new law that will affect how all incomplete gift nongrantor trusts (INGs) will be taxed. Senate Bill 131 is now in effect and applies retroactively to the start of the year. Under the law, INGs that were previously treated as separate taxpayers are now treated as grantor trusts by the state.
The new law may significantly impact estate plans state-wide. INGs have long been a valuable tool for protecting assets from income taxes, so many families have established these trusts to reduce their annual tax burden. However, going forward, INGs will no longer provide the same protections on a state level. If you’ve created an ING in your estate plan, it may be time to reconsider how your finances are structured.
What Are Incomplete Gift Nongrantor Trusts?
An incomplete nongrantor trust is a specialized legal entity that is intended to shelter assets from both the federal gift tax and state income taxes. When structured correctly, INGs walk the line between standard grantor and nongrantor trusts, achieving the benefits of both. To learn how they work, it’s important to understand how the basic trust forms operate.
An ING is technically a nongrantor trust. Normally, nongrantor trusts are funded by a complete gift of assets. When you establish one, you give the property to the trust in its entirety and pay any gift taxes up front. You lose both the right to control the assets and the obligation to pay any applicable taxes for those assets. Instead, the trust itself covers those expenses.
In contrast, a grantor trust allows you to keep some control over the assets in the trust. In exchange for maintaining this control, you also retain responsibility for the assets. You need to pay any associated income or capital gains taxes on the assets within the trust, but you do not need to pay any gift taxes when you establish it.
So, what sets INGs apart? They are intended to provide all the benefits of both types of trust without the drawbacks. To accomplish this, they are structured to take advantage of a legal loophole. They are set up as nongrantor trusts, so the establishing party is no longer responsible for paying taxes on the assets they contain. However, the gift of the assets is intentionally structured to be “defective” or incomplete. If the correct language is used, the transfer will qualify to maintain the trust’s nongrantor status without triggering the IRS gift tax. As a result, you retain control over the trust’s assets but significantly reduce your tax bill each year.
Understanding the New ING Ban
INGs have been very popular estate planning tools in California due to the state’s high income tax rates. That’s why legislators took action to update its definitions of different trusts in Senate Bill 131. The new law contradicts the IRS definitions for grantor and nongrantor trusts and establishes that any trust with an incomplete gift is considered a grantor trust. As a result, anyone who has established an ING in California will likely be liable for state income taxes on its assets this year.
This law does not change the exposure to federal taxes, though. The IRS rules remain the same, so grantors will not be directly liable for federal capital gain or income taxes on ING assets in 2023.
How the New ING Rule May Impact Your Estate Plan
The ING rule makes these trusts significantly less beneficial for California estate plans going forward. If you were relying on an ING to shelter assets from taxes, it’s time to set up a new trust administration plan. Alternatives to INGs include:
- Establishing new completed gift nongrantor trusts to reduce personal exposure to income taxes
- Decanting an ING into another existing trust that provides tax protections
- Selling ING assets to gift trusts to exchange capital gains taxes for income taxes
- Purchasing private placement life insurance to combine the advantages of investments with the tax protections of insurance
However, each of these solutions comes with unique challenges. Anyone looking for an alternative to INGs in California should speak to an experienced estate planning attorney to determine the best course of action in their circumstances. You can learn more about protecting your assets and estate plan from income taxes in California by scheduling your consultation with The Dayton Law Firm P.C. Our skilled attorneys will listen to your concerns and help you understand your options for protecting your family’s financial future. Get in touch today to learn more about how we can help you now that INGs are over.