• California Governor Newsom strives to amend the personal income tax laws to prevent wealthy taxpayers from utilizing Incomplete Gift Non-Grantor trusts.  
• California residents use this by transferring assets into trusts held by nonresident trustees in states without income tax.  
• If this legislation passes, taxpayers will no longer be able to take advantage of the strategy. 

If you reduce California income tax with an ING, Newsom is onto you

Californian legislators propose to amend the personal income tax laws to close a little-known-but-effective loophole for the wealthy by targeting Incomplete Gift Non-Grantor (ING) trusts set up in other states with more favorable income tax rules. To date, California residents have had the opportunity to transfer assets into these trusts held by nonresident trustees in states without income tax, utilizing the state’s sourcing rules to avoid the tax. If approved, this new legislation will put a stop to this tax planning strategy. 

Taxing the rich in California

As it stands, the ING trust is not commonly used. There are about 1,500 California residents with this trust in states without income tax — and if implemented, California would see a minimal revenue increase (about $30 million in the first year and $15 million in the following years). However, this would put an end to a tax planning strategy the wealthy have been using to their benefit for about 20 years.  

Because California is home to more billionaires than any other state at the same time as it also has the highest rate of poverty in the U.S., the concept of taxing the rich holds a certain appeal. In the past, Newsom has opposed proposals to raise taxes — but this proposal was included in the governor’s $223.6 billion budget plan for the next fiscal year, which begins in July. Whether the item survives the legislative process remains to be seen, but if New York’s passage of a similar law in 2014 is any indication, we are likely to see the end of this tax planning strategy for California’s ultra-rich.  

Moreover, this proposal has a retroactive element, differentiating it from New York’s and opening it up to potential lawsuits (New York trust holders had a five-month period to move their accounts to a different type of trust without incurring the tax). Newsom is pushing for the measure to begin the calendar year after its implementation.  

How the ING works (worked)

What is an ING, and why is Newsom trying to prevent its use? California taxpayers can transfer their assets into out-of-state, incomplete, non-grantor trusts (INGs), which constitute separate, taxable entities under state and federal tax law, and this move avoids California income tax on any appreciation or gains from those assets because it is “sourced” to another state based on the location of the trustee (i.e., the bank or whatever financial institution offers the trustee services in the other state). The non-grantor aspect comes into play when the taxpayer establishing the trust (the “grantor”) gives up control over managing investments or distributing assets to the trustee (contrast with a “grantor trust” in which the grantor continues to control how money is invested/distributed within the trust during their lifetime). For the trust to be deemed “incomplete,” the grantors specify how the money can be used. 

Some of the states where these trusts are typically established include Florida, Wyoming, Delaware, Nevada, Tennessee, and South Dakota. For example, a California resident (TP) may decide to transfer stock in their business into an ING established in South Dakota. If TP held the stock directly, then as a resident, all the dividends (or if he sold it, the gain) would be taxable by California on their personal income tax return. But since TP doesn’t hold the asset – the ING does – the ING recognizes the income relating to the stock. California’s current rules provide that the income is sourced to (and thus taxable in) the state where the trustee is domiciled, and for this ING that location is South Dakota, which, incidentally, does not tax this sort of income. 

Newsom is hoping that by eliminating this tax-free option, the state of California will be able to increase tax revenue in a way that will not alienate a large number of voters.

How MGO can help

If you are a California resident and currently use an ING as a tax strategy, there are steps to take now to avoid a negative impact. MGO’s experienced Private Client Services team can help you identify and implement an effective response. 

The tax relief postpones tax filing and payment deadlines occurring between January 8, 2023, and May 15, 2023, to a new due date of October 15, 2023. 

Some of the filings and payments postponed include:  

• Individual income tax returns due on April 18 
• Business tax returns normally due on March 15 and April 18 
• 2022 contributions to IRAs and health savings accounts 
• Quarterly estimated tax payments normally due January 17 and April 18 
• Quarterly payroll and excise tax returns normally due on January 31 and April 30 

The current list of counties that qualify for this relief can be found here. 

If you qualify for this postponement, you generally do not need to contact the IRS or FTB to obtain relief. Relief is automatically granted for affected taxpayers who have an address of record located in one of the designated counties. However, if you still receive a late filing or late payment notice and the notice shows the original or extended filing, payment, or deposit due date falling within the postponement period, you should call the number on the notice to have the penalty abated.  

If you have questions or need assistance, contact MGO’s experienced State and Local Tax team. 

Specifically, under SB 113:

• Businesses will be able to fully utilize NOLs and R&D credits for the tax year 2022.
• There will be expanded eligibility and application of California’s Pass-through Entity Elective Tax (PEET) through several new provisions:
  • Qualified net income now includes guaranteed payments.
  • MGO Insight: This will significantly increase the value of the PEET for owners/operators of pass-through service providers.
  • Individual taxpayers can apply the PEET state credit against tentative minimum tax.
    • MGO Insight: By removing the 7% tentative minimum tax threshold, more of the PEET credit can be used in a given year, resulting in less carryovers and less concerns about electing into the PEET in consecutive years.
  • Passthrough entities with owners that are partnerships are now eligible to make the PEET election.
  • SMLLCs that are pass-through entity owners can now claim the PEET credit.
  • MGO Insight: By removing the limitation on partnership owners and SMLLCs, more pass-through businesses will be able to benefit from the PEET including lower-tier partnerships.
  • New credit usage ordering rules increase the benefit for taxpayers that claim the Other State Tax (OST) Credit.
    • MGO Insight: OST credits are now specifically utilized before PEET credits, which should significantly reduce credit leakage for taxpayers with income in multiple states. (Prior to this, there was ambiguity on the ordering of credits and concerns that certain OST credits would not be able to be fully utilized.)
  • The law also includes some beneficial retroactive relief:
    • California will fully conform to the federal treatment of Restaurant Revitalization grants, retroactive to the 2020 tax year, and partially conform to the federal exclusion of Shuttered Venue Operator grants, retroactive to the 2020 tax year.
    • Producers of qualified motion pictures benefit from increased flexibility to use sales & use tax credits against income taxes and sales & use tax; the prohibition period for this benefit has been shortened to only the 2020 and 2021 tax years. In addition, certain producers will have the ability to obtain an immediate refund for the 2021 tax year on sales & use tax in excess of the $5 million cap.

In addition to the tax benefits signed into law by SB 113, Gov. Newsom also signed SB 114, which creates COVID leave rules for 2022 that should benefit California workers:

• Employers with more than 25 employees will be required to provide up to 80 hours of COVID-19-related paid supplemental sick and family leave for the period January 1, 2022 (retroactive) through September 30, 2022. No additional tax benefits or credits have been provided in relation to this additional requirement.

With higher-than-anticipated tax revenues during the COVID pandemic, California improved the availability of various tax benefits, resulting in significant potential tax savings for California taxpayers in 2022 and later tax years that should help boost the state’s economic recovery.

California’s workaround is in effect for the 2021 tax year and will continue to be available through the 2025 tax year (although it could expire earlier if the federal $10,000 limitation is repealed by Congress prior to its current sunset date of January 1, 2026).

The state tax credit, which is nonrefundable, can be carried over for five years. Nonresidents and part-year residents do not have to prorate the credit to account for their non-California income.

How to elect

California’s workaround is available for partnerships (including those structured as LLCs) and S corporations that only have individuals, trusts, estates, and/or corporations as owners. Publicly traded partnerships, partnerships owned by other partnerships, members of a combined reporting group, and disregarded entities do not qualify. (Disregarded Single-Member LLCs are not eligible to make the election, but will not make the entity ineligible if they are an owner of an otherwise eligible PTE).

Not all the owners of the pass-through entity need to consent to the election. Those that do not consent are not included in the calculation of the PTE Tax. To take advantage of the workaround, the pass-through entity needs to make the election annually on its state tax return. In addition, payments towards the PTE Tax need to be made by specified due dates.

• For the 2021 tax year, 100% of the PTE Tax needs to be paid by the due date for the pass-through entity’s state tax return without extensions – March 15, 2022.

• In later years, the PTE tax needs to be paid in two installments: the first installment is due by June 15 of the tax year for which the election is being made, and the second installment is due by the due date for the pass-through entity’s state tax return for that tax year without extensions (i.e., the following March 15). The minimum amount for the first installment is $1,000.

What to consider

The biggest benefit to the owners of a pass-through entity is the ability to claim a federal tax deduction for their share of the pass-through entity’s state income tax paid to California, but there is another potential benefit. In future years (starting with the 2022 tax year) PTE Tax payments may create some “float” for the owners in terms of the timing and amount of their individual estimated tax payments:

• Individuals in California need to pay 70% of their estimated tax liability through quarterly payments on April 15 and June 15, while the PTE Tax only requires that one installment of 50% of the total tax be paid in by June 15.
• Individuals in California need to pay the remaining 30% of their estimated tax liability by January 15 of the following year (i.e., the 4th quarter payment), while the PTE Tax only requires the remaining 50% be paid in by March 15.

However, despite these benefits, other factors should be considered before making the election:

• If the pass-through entity provides most of the income for an owner and that owner’s top California tax rate is less than or equal to 9.3%, the state tax credit cannot be used in full before it expires. On the other hand, since the election is made annually, you could avoid accruing too much carryover by opting not to elect in a following year.

• It’s unclear how California’s workaround will interact with pass-through entity tax regimes enacted by other states, especially their associated state tax credits. California provides credits against most other states’ taxes, but guidance has not been provided to indicate that it will afford the same treatment to other state PTE Taxes paid. Multi-state operators may not be able to reduce California taxable income by the amounts of other states’ similar taxes.
• The 9.3% flat rate may not be sufficient to cover the full tax liability for higher income owners.
• The PTE tax credit does not reduce the amount of tax due below California’s Tentative Minimum Tax (TMT), and thus may not be as beneficial for taxpayers subject to the TMT.
• There are considerations pertaining to cash management, since the pass-through entity would be paying the PTE Tax, not the owners.
• Non-resident withholding (7% for individuals) is not offset by the withholding requirements for the PTE Election. Non-resident taxpayers making the election would therefore be required to pay in tax at 16.3% among the quarterly and bi-annual installments, then claim a refund up to the amount of the 7% withholding. But because the 9.3% PTE Tax is non-refundable, to the extent that withholding exceeds tax due, it would need to be claimed in a later year.

How we can help

This PTE Election is a little complicated, but it is worth the effort to explore. MGO’s state and local tax professionals can advise you on the numerous pass-through entity tax regimes being passed by states to counter the federal limitation on deducting state taxes. Our cumulative experience as SALT specialists can help you determine if you are able to benefit from pass-through entity taxes and how to appropriately use them. Reach out to our team of experienced practitioners for your state and local tax needs.