Recent Federal and California Laws Significantly Hinder Tax Benefits of Intentionally Defective Grantor Trusts and Incomplete Non-Grantor Trusts

We recently highlighted the tax advantages of establishing an Intentionally Defective Grantor Trust (IDGT) and how selling assets into the trust opened the door to significant tax savings for high-net-worth individuals. Now, an IRS ruling and a bill signed into law by California Governor Gavin Newsom are rolling back many of these tax advantages.

California Senate Bill 131 was passed into law on July 10, 2023, ending the ability of taxpayers to obtain certain tax benefits from these trusts along with Incomplete Non-Grantor Trusts established as separate taxpaying entities for income tax purposes. Additionally, the IRS issued Revenue Ruling 2023-2 that says completed gifts to irrevocable grantor trusts will not receive a step-up basis upon the death of the grantor. This removes the tax relief received by placing assets into these trusts.

Revenue Ruling 2023-2 Clarifies Uncertainty for Intentionally Defective Grantor Trusts

In the case of IDGTs, the IRS had previously avoided directly answering questions about whether or not these trusts afforded the grantor the ability to take advantage of the Code 1014 step-up basis on assets held within the trust at the time of their death. Now, the government is directly addressing the issue at the cost of taxpayers who have already implemented this into their estate plan and tax strategy.

Intentionally defective trusts establish the grantor as the owner of the trust for income tax purposes which means the grantor is responsible for the income taxes incurred by the trust. However, this is a small cost compared to the savings and additional tax-free gifts able to be made to the grantor trust.

Revenue Ruling 2023-2 adds clarity to completed gifts to grantor trusts are not eligible for a basis step-up under Section 1014 of the Code upon the death of the grantor. Therefore, assets transferred to an IDGT will not receive a step-up in tax basis upon the death of the grantor – the trust creator. 

Senate Bill 131 Addresses Incomplete Non-Grantor Trusts

In California, taxpayers were able to utilize more advantageous laws from other states such as Nevada to establish an Incomplete Non-Grantor Trust (ING) that would, legally speaking, be treated as a separate taxpayer. This allowed the taxpayer to establish a trust and not pay California income taxes on those assets through the trust – rather the income taxes would be assessed in Nevada since the trust is formed under Nevada law with a Nevada resident trustee and it is irrevocable, which means there would be no California state income taxes assessed on income from the trust assets. 

The resident would be able to avoid up to a 13.3% California state income tax bill while still benefiting from the assets held within the trust. Senate Bill 131 rips away this benefit starting in 2023 and for all tax periods moving forward. The law will require grantors of INGs to report income to the California Franchise Tax Board, which will assess income taxes on the income of the trust assets. 

Utilize Alternative Beneficial Tax Strategies

It’s important to note that this does not mean you are automatically on the hook for these taxes if you are already utilizing an IDGT or ING. It just means you will need to work with your attorney to come up with a more effective tax strategy that reflects these changes.At the Law Offices of Tyler Q. Dahl, we are always keeping up with changes to the law to ensure our clients have the most up-to-date and effective tax strategy. If you are using these currently and need to look at alternatives, contact our team to get started.

The following two tabs change content below.

Dahl Law Group

At Dahl Law Group, we’re not just a law firm. We’re your trusted advisor for your business and family from beginning to end. As your family and business grow, we will be there by your side. Our passion is providing you with peace of mind and protection through personalized estate and business planning.