Incomplete Gift Non-Grantor Trusts Created by California Residents May Be Subject to California State Income Tax Beginning in 2023

2 min

Under California Governor Gavin Newsom's proposed 2023-2024 state budget, released on January 10, 2023, the income of an incomplete gift non-grantor trust (ING Trust) may now be subject to California income tax, effective on January 1, 2023, based solely on the residence of its settlor in California. Currently, the income of a non-grantor trust is subject to California income tax only if the trust has California source income, a fiduciary residing in California, or a non-contingent California resident beneficiary.

Newsom's budget legislation would modify California's historic treatment of such trusts by presumably implementing a 2020 legislative proposal by the California Franchise Tax Board (FTB), which sought to disregard ING Trusts for state tax purposes, thereby subjecting California resident settlors to tax on income of their out-of-state ING Trusts. In so doing, the FTB explicitly stated an intent to mimic New York's anti-ING legislation, which taxed ING Trusts created by New York residents as grantor trusts for state purposes. The New York statute also allowed resident taxpayers with existing ING Trusts until June 1, 2014, after the statute's effective date of January 1, 2014, to either liquidate or decant their trusts without any of the trust's net current income being included in their personal income.

The Newsom proposal appears to deviate from this aspect of the New York model, as well as the FTB's recommendations, which sought an effective date of January 1 of the tax year following enactment, as it is instead effective on January 1, 2023, prior to its potential date of enactment. It is not clear whether such legislation would withstand scrutiny under the U.S. Constitution were it to be challenged in the courts, but even if it were constitutional, tax legislation that is retroactive in effect is nonetheless controversial, as it is often perceived as prejudicial to a taxpayer's ability to plan their financial affairs. Accordingly, as proposed, the Newsom budget legislation will likely invite a fight unless it is somehow reconciled with the FTB's previous legislative proposal or otherwise fails to pass into law.

For California taxpayers with questions about the impact of the budget proposal on their particular situation, please contact us to discuss your options and other potential tax-saving strategies.