California Could Say No to Nings and Don't to Dings

• Publication year: 2016
• Author: By Justin T. Miller, Esq.,* and W. Martin Behn, Esq.**

CALIFORNIA COULD SAY NO TO NINGS AND DON'T TO DINGS

By Justin T. Miller, Esq.,* and W. Martin Behn, Esq.**¹

I. INTRODUCTION

Individual taxpayers in California who own assets with significant unrealized gains or recurring ordinary income would love to find a planning strategy that allows them to retain the economic benefit of the assets while avoiding or minimizing the California state income tax arising from such assets. At first blush, an incomplete gift non-grantor trust ("ING") formed in a state such as Nevada, Delaware or Wyoming ? that is, a "NING," "DING," or "WING" ? appears to offer this solution. Arguably, an ING could eliminate California state income tax liability attributable to the sale of an asset ? up to a 13.3 percent tax savings² ? while avoiding or deferring a gift for federal gift tax purposes, thus allowing the grantor to get all of his or her money back at a later date.³ While the ING strategy might work in California, there also is a chance it might not.

The Franchise Tax Board ("FTB") is looking into ING structures.⁴ The FTB has publicly stated: "We are aware of the trust instruments. We are actively monitoring them. We will evaluate the situation to determine the best course of action."⁵ While the California Legislature and the FTB have not yet provided additional guidance, this article discusses several arguments the FTB could use to subject the net income of INGs to taxation in California ? in which case the California grantors of those INGs may face an unpleasant surprise: back taxes, interest, and penalties.⁶

II. STRUCTURING AN ING

With an ING, an individual (called the "grantor"⁷) irrevocably transfers intangible assets, such as investment securities, to a nonresident trust while remaining a contingent beneficiary of the trust. The grantor retains no ability to receive distributions from the trust without the approval or consent of one or more beneficiaries other than the grantor or the grantor's spouse⁸ ? that is, an "adverse party"⁹ ? so the trust can qualify as a non-grantor trust for federal income tax purposes.¹⁰ However, the grantor reserves a limited power to appoint the trust principal to beneficiaries other than the grantor. As a result of this retained power, the transfer is treated as an incomplete gift for gift tax purposes, meaning that there are no gift tax consequences or use of the grantor's lifetime exemption.¹¹ A multitude of Internal Revenue Service ("IRS") private letter rulings ("PLRs") acknowledge that the grantor's transfer of assets to an ING is an incomplete gift for gift tax purposes, but a completed transfer for income tax purposes, making it a non-grantor trust.¹² There are two good reasons why the IRS has no issue with INGs from a federal tax perspective: (i) the ING offers no gift and estate tax benefits, since the value of the trust's assets will be included in the grantor's estate for estate tax purposes upon the grantor's death; and (ii) as a non-grantor trust subject to compressed income tax brackets, the ING will be in the highest tax bracket at just over $12,400 in income in 2016. By comparison, a grantor trust that is taxable to the grantor would not reach the highest tax bracket in 2016 until the combined income of the trust and grantor exceeds $466,950 (if married filing jointly) or $415,050 (if single).¹³ In other words, INGs likely will result in more tax revenue for the federal government.

Hypothetical. Grant is a resident of California who owns 100 percent of the outstanding shares of a corporation he created 10 years ago, with a zero basis in the shares for tax purposes. ¹⁴ He plans to sell the shares in the near future for $200 million, and there is no currently pending transaction that could trigger the "anticipatory assignment of income doctrine." ¹⁵ Grant transfers 50 percent of his shares to an ING in a state without state income taxes ? such as Delaware, ¹⁶ Nevada, or Wyoming ? in order to avoid any California income tax on the sale of those shares. He names Independent Institutional Bank in Nevada as the trustee of the ING, and his two adult children, Amy and Bob, as members of the trust distribution committee. Amy and Bob, who both live outside of California, are also named as beneficiaries, while Grant names himself as a contingent beneficiary. In addition, Grant reserves a limited power to appoint the trust principal to Amy or Bob. Amy and Bob have the power to make distributions back to Grant ? in other words, Grant cannot get his money back without approval from his children. Grant obtains a PLR from the IRS stating that the transfer to the ING is an incomplete gift for federal gift tax purposes and that the ING is a non-grantor trust for federal income tax purposes. Six months after the transfer to the ING, a strategic buyer purchases all of the outstanding shares of Grant's company for $200 million. Grant pays California's top marginal state income tax rate of 13.3 percent ¹⁷ on the half of the shares that he retained ? that is, approximately $13.3 million in state income taxes. Arguably, the ING, as a non-grantor trust, with no California resident trustee or non-contingent beneficiary would avoid $13.3 million of California income taxes ? unless the FTB disagrees.

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In order to subject some or all of an ING's net income to taxation in California ? plus potential interest and penalties ? the FTB could argue that: (i) the ING actually is a grantor trust for California state income tax purposes; (ii) the ING is a tax shelter; (iii) the grantor is a fiduciary who is a resident of California; or (iv) the grantor is a non-contingent beneficiary who is a resident of California. Even if the FTB is unsuccessful with any such claim, all of the ING's previously untaxed accumulated income will be subject to taxation in California pursuant to California's throwback rules when it is distributed to the grantor ? assuming the grantor has not changed his or her residence to another state ? albeit without any interest or penalties.¹⁸

III. GRANTOR TRUSTS IN CALIFORNIA

A. Grantor Trusts Under Federal Tax Rules

Like most states, California taxes grantor trusts ? such as revocable living trusts ? based on the residence of the grantor who created the trust.¹⁹ This result is consistent with the treatment of grantor trusts under the federal grantor trust rules (the "Grantor Trust Rules") of subpart E of subchapter J of the Internal Revenue Code of 1986, as amended (the "Code"). The Grantor Trust Rules treat property of a grantor trust as being owned by the grantor and, accordingly, taxable to the grantor for federal income tax purposes.²⁰ No California statute specifically applies the Grantor Trust Rules to California resident grantors. However, absent a specific provision to the contrary, the California Revenue & Taxation Code (the "Rev. & Tax. Code") generally conforms California law to subchapter J of the Code ? that is, the federal fiduciary income tax rules under sections 641-692 of the Code, which include the Grantor Trust Rules.²¹ Thus, a grantor trust generally is ignored for income tax purposes and the property within the trust continues to be treated as the grantor's property.

Unfortunately, there is a lack of legal authority in California addressing whether or not a trust is a grantor or non-grantor trust. According to section 17731 of the Rev. & Tax. Code, a trust that qualifies as a non-grantor trust under the federal Grantor Trust Rules also should be a non-grantor trust under California's laws.²² This lack of definitive legal authority allows the FTB to argue that a trust that is a non-grantor trust for federal income tax purposes may be a grantor trust for state income tax purposes. Regulations are needed in California for determining whether a trust is a grantor trust or a non-grantor trust. Such regulations would provide the FTB with clear authority to apply in conducting examinations and enforcing the law. Such regulations also would give taxpayers the necessary guidance to prudently plan their affairs. Without any authoritative guidance, taxpayers will continue to be subject to costly disputes with the FTB involving INGs and other types of trusts.

Thus, even if an ING qualifies by its terms as a non-grantor trust under the Code, the FTB can, and will, scrutinize these structures to determine whether or not the trust should be taxed in California as a grantor trust.

B. Adverse Parties

In order for the grantor to get his or her money back from an ING and achieve non-grantor trust status under the Grantor Trust Rules, distributions back to the grantor must be made with the consent or approval of individuals or members of a distribution committee whose members qualify as "adverse parties" under section 672(a) of the Code.²³ (Neither the grantor nor the grantor's spouse qualify as an "adverse party."²⁴) In other words, a trust will not be treated as a grantor trust if the grantor only may receive a distribution with an adverse party's approval or consent.²⁵ According to the Code, an adverse party is:

[A]ny person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. ²⁶

The adverse party rule assumes that adverse parties would be acting against their self-interest as trust beneficiaries by allowing the trustee to distribute to the grantor assets that they potentially could receive.²⁷ Since the grantor arguably cannot get assets out of the trust without other beneficiaries acting against their self-interest, the Code does not treat the grantor as the owner of the trust and, instead, treats the trust as a non-grantor trust.²⁸

Whether an individual has an interest that is substantial enough to qualify as an adverse party requires an analysis of all the facts.²⁹ The Treasury Regulations provide that an adverse party's interest is substantial "if its value in relation to the total value of the property subject to the...