Newsom Proposes Taxing Some Non-grantor Trusts

Gov. Gavin Newsom’s 2023-24 budget includes a proposal to tax incomplete non-grantor trusts beginning in 2023 if the grantor of the trust is a California resident. According to the governor’s budget summary, the proposal “mitigates a tax strategy which allows California residents to transfer assets into out-of-state incomplete non-grantor trusts and potentially avoid state taxation.” The California Franchise Tax Board made the same proposal in 2020.

An incomplete non-grantor trust is a tax strategy in which an individual transfers funds to a state that does not have a state income tax. A trust is “incomplete” if the grantor retains some power over the gift. A non-grantor trust is one in which the trust is its own taxable entity and that taxation occurs at the trust level rather than at the level of the individual grantor. With a non-grantor trust, the tax laws in the state in which the trust is established apply. To use this tax strategy, a California resident would establish an incomplete non-grantor trust with an out-of-state trustee and transfer assets to that trust. The taxable income of the trust would then be taxed by the state that is the trustee’s commercial domicile rather than by California.

If approved, California would follow New York in ending this tax planning strategy. The retroactive effective date of January 1, 2023 of the proposed legislation would be controversial and would most likely bring constitutional challenges. The proposal is projected to raise only $30 million in revenue during the first year with a significant reduction in revenue in later years.

While the proposal can be viewed as closing a tax “loophole” for wealthy taxpayers, Newsom has opposed other proposals to increases taxes on the wealthy, including a wealth tax and a surtax on high incomes.

California legislators have made efforts in the past few years to increase taxes on the wealth, including proposed legislation in 2023 to impose a 1.5% state tax on the worldwide wealth of California residents. (California Legislators Reintroduce Wealth Tax for 2023 Legislative Session.)