Now that 2020 has passed the half-way point and is careening toward 2021, our clients are asking how to lock in today’s lofty federal gift-tax, estate-tax, and GST exemptions (currently $11.58 million), knowing that those exemptions are already scheduled to shrink to $5 million, adjusted for inflation, in 2026 and that they may well plummet to those or even lower levels as soon as early next year if November’s elections bring regime-change in Washington. 

Our California clients are also asking whether there is any way to reduce or defer the annoying California income tax. 

The answer to the second question is “yes” in many situations through the proper use of trusts. And the potential savings are nothing to sneeze at, even in the time of COVID-19. For example, incurring a $1 million long-term gain in a properly constructed trust can save over $100,000 of tax! 

If your clients are asking the same questions, read on. 

The Basics

California treats a trust as a grantor trust if the trust is classified as a grantor trust for federal purposes. But, if a client creates an irrevocable trust that does not trigger grantor-trust treatment or if grantor-trust treatment ceases, then the trust will be a nongrantor trust. In 2020, California taxes the taxable income (including accumulated ordinary income and capital gains) of nongrantor trusts at rates up to a whopping 13.3%. The tax applies to the “entire taxable income of a trust, if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor.” Note that individuals are residents of California if they are in the state for other than temporary or transitory purposes or if they are domiciled there during the year. 

The Resident Fiduciary Test

Given that taxation is based on the residences of fiduciaries not of trustees, conferring traditional trust duties on advisers, committees, or protectors probably won’t reduce tax. Nevertheless, the State Board of Equalization has ruled that California resident individual trustees who delegated their duties to nonresident corporate fiduciaries were not California resident fiduciaries. Note that “the residence of a corporate fiduciary of a trust means the place where the corporation transacts the major portion of its administration of the trust.” Tax is apportioned based on the number of California resident and nonresident fiduciaries. 

The Resident Noncontingent Beneficiary Test

Even if a Californian is a beneficiary of a trust that has a non-California trustee, the trustee should be able to defer or eliminate California taxation of accumulated ordinary income and capital gains if distribution of such income and gains is within the trustee’s discretion. This is because the State Board of Equalization has ruled that a beneficiary who could receive distributions only on a corporate trustee’s exercise of discretion was a contingent beneficiary and that a resident beneficiary of a discretionary trust has a noncontingent interest in the trust only as of the time, and to the extent of the amount of income, that the trustee actually decides to distribute. In addition, at the end of June, the Court of Appeal, First District, held that a beneficiary’s interest was contingent because “[t]he settlor intended the trustees to have absolute discretion.” Tax is apportioned based on the number of California resident and nonresident beneficiaries. 

The Throwback Tax

California resident beneficiaries are taxed on income, which was not taxed to trustees in prior years, through a “throwback tax.” Interestingly, the United States Supreme Court neither endorsed nor repudiated throwback taxes in its 2019 decision involving North Carolina’s tax system. 

Other Rules

The Franchise Tax Board’s position is that California taxes all of the California source income of the trust (i.e., income attributable to California real property, tangible personal property, or business activity), regardless of the residences of the trustees or beneficiaries. After that, the taxation of the non-California source income depends first on the residences of the trustees and then on the residences of the noncontingent beneficiaries. Trustees must make estimated tax payments. 

Source Income

As just mentioned, the Franchise Tax Board is of the view that California may tax all California source income regardless of the makeup of a trust’s fiduciaries and beneficiaries. In a 2018 decision involving the Paula trust, though, the Superior Court of the City and County of San Francisco held that tax apportionment based on the number of resident and nonresident fiduciaries extended to California source income as well as to California nonsource income. If that outcome prevailed, then California income tax could be eliminated on income attributable to farmland, rental properties, and other business activity. For example, if a trust that had one California individual trustee and one Delaware corporate trustee incurred a $1 million long-term capital gain on the sale of a parcel of California real estate, then the trustees would be taxed on only $500,000 of the $1 million gain. Unfortunately, the Court of Appeal, First District, reversed the lower court’s decision in Steuer v. Franchise Tax Board on June 29 and upheld the Franchise Tax Board’s position. At this writing, I do not know if the trustees will appeal the Court of Appeal’s decision to the Supreme Court of California or whether other taxpayers will bring similar challenges elsewhere in the state. Although the consensus among California practitioners whom I have consulted is that the superior court’s ruling was a flash-in-the-pan, one never knows. So filing of protective refund requests for certain clients might be in order. 

The DING Trust Option

Californians might use a type of Delaware asset-protection trust (“APT”) known as the Delaware incomplete gift nongrantor trust (“DING Trust”) to defer or eliminate California income tax on undistributed ordinary income and capital gains if they are willing to subject distributions to themselves to the control of adverse parties. In dozens of private letter rulings issued since 2013, the IRS has ruled that domestic APTs that followed the DING-Trust approach qualified as incomplete gifts and as nongrantor trusts. The trustor of a DING Trust might be able to receive tax-free distributions of the untaxed income in later years. In 2015 Wilmington Trust Company successfully resisted the Franchise Tax Board’s efforts to tax a DING Trust, thus saving the trustor millions of dollars of California income tax. 

Planning—Grantor Trusts

Californians who create grantor trusts often must pay all federal and California income taxes attributable to such trusts even though they do not have access to the trusts’ assets. In many grantor trusts, trustors have the all-or-nothing choice either to pay such taxes, which might become burdensome over time, or to release the powers that trigger grantor-trust treatment and thereby cause the trust funds to be depleted to pay them. Californians might consider establishing new trusts with—or moving existing trusts to—Wilmington Trust Company because, unlike California and most other states, Delaware gives trustees of grantor trusts discretion to reimburse the trustor for federal and state income taxes unless prohibited by the governing instrument. So, Wilmington Trust Company might reimburse the trustor for some taxes one year, for no taxes in a second year, and for all taxes in a third year. 

Planning—Nongrantor Trusts

As mentioned above, the potential savings from naming Wilmington Trust Company rather than a California resident fiduciary as trustee of a nongrantor trust can be substantial. For example, the potential tax reduction for the trustee of a California resident trust on a $1 million long-term capital gain incurred in 2019 was at least $107,762. 

Given that trusts get to the top federal income-tax rate so much more quickly than individuals, some trustees are considering including capital gains in distributions to beneficiaries in order to take advantage of the beneficiaries’ lower brackets. This might be a really bad idea for Californians. For example, the net tax cost of including $1 million of long-term capital gain in DNI for a California resident individual rather than taxing the gain to a California resident trust that is structured to escape tax is $73,512. 

This article, with commentary, is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.  

Wilmington Trust Company operates offices in Delaware only. Note that a few states, including Delaware, have special trust advantages that may not be available under the laws of your state of residence, including asset protection trusts and directed trusts.  

IRS CIRCULAR 230: To ensure compliance with requirements imposed by the IRS, we inform you that, while this article is not intended to provide tax advice, in the event that any information contained in this article is construed to be tax advice, the information was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any matters addressed herein.