On July 10, 2023, Gov. Gavin Newsom signed into law S.B. 131, which taxes incomplete non-grantor trusts beginning in 2023 if the grantor of the trust is a California resident. Newsom included the idea in his 2023-24 budget proposal. 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.
California now follows New York as the only states targeting this tax planning strategy. The proposal is projected to raise only $30 million in revenue during the first year with a significant reduction in revenue in later years. The retroactive effective date of January 1, 2023 could bring constitutional challenges.
The proposal can be viewed as closing a tax “loophole” for wealthy taxpayers. 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.”