FWR talks to a wealth advisor in the Golden State about proposed changes to the taxation of out-of-state trusts. The change could, the advisor says, drive even more affluent citizens from California and shrink the total tax base.

California governor Gavin Newsom’s proposal to impose state income tax on what are called incomplete gift non-grantor trusts could drive even more affluent citizens, and their businesses, from the state, causing long-term damage far beyond the short-term revenue benefits of such legislation, an advisor warns.

The changes, if enacted, will take effect retroactively from January 1, 2023. Such a move would follow in the footsteps of a similar adjustment made by New York state in 2014.

The proposal is part of Newsom’s 2023-2024 state budget, with details released about a month ago. At present, the income of a non-grantor trust is subject to California income tax only if the trust has California source income, a fiduciary residing in California, or a non-contingent California resident beneficiary. Under the proposal, however, any out-of-state ING Trust, for example one in a state such as Nevada or South Dakota, would be in the firing line. 

“Every trust that is set up has its tax and non-tax features and that is something that is often lost [in political debates],” Kevin Ghassomian, partner at Venable LLP, told Family Wealth Report. In almost all cases, trusts are created with a non-tax goal in mind, such as wealth transfer, businesses succession, and adherence to certain values of a settlor, he said. “I have never had a client set up a trust for exclusively for tax purposes.”

The possibility of a crackdown on the use of out-of-state non-grantor trusts by the government in Sacramento also sheds light on how the state, which levies some the highest taxes in the US, is seeking to stem outflows of revenue and, patch budget deficits. Private wealth advisors, like Ghassomian, warn that such moves may accelerate a recent trend of net migration from California to states such as Texas, Florida, Tennessee, and Nevada. According to the US Census Bureau (report: San Francisco Chronicle, December 22, 2022), California’s population fell by 114,000 people from about 39,143,000 in 2021 to 39,029,000 in 2022. Firms such as Charles Schwab, Hewlett Packard and Tesla have relocated their HQs from the state. The plight of the state – still  home to many HNW individuals – has become a trope of American political debate.

Though Newsom’s proposal may raise additional revenue, it prevents Californians from having such trusts for non-tax reasons, Ghassomian said. 

By Newsom's own estimates, the damage that such a change would do seems to be out of proportion to the likely amount – only $30 million – of revenue it would raise in 2023, he said.

“The problem is obvious. The tax on individuals and businesses being driven from California create a short-term revenue benefit for the state but the long-term consequences will likely be devastating,” he said.

The story also highlights the role that specific states – Nevada, New Hampshire, Delaware, South Dakota, Alaska – play as trust jurisdictions. (See another article here.) They act almost as “offshore” jurisdictions for Americans, and with standards of privacy that match those of traditional hubs such as Switzerland. (Ironically, Swiss bank secrecy laws are a dead letter, while privacy protections in states such as Delaware are relatively powerful – a fact that can make Swiss bankers seethe, as the author of this article will attest.)

According to a note from Ghassomian: “The Newsom proposal appears to deviate from this aspect of the New York model, as well as the [California Franchise Tax Board’s] recommendations, which sought an effective date of January 1 of the tax year following enactment, as it is instead effective on January 1, 2023, prior to its potential date of enactment.”

“It is not clear whether such legislation would withstand scrutiny under the US Constitution were it to be challenged in the courts, but even if it were constitutional, tax legislation that is retroactive in effect is nonetheless controversial, as it is often perceived as prejudicial to a taxpayer's ability to plan their financial affairs. Accordingly, as proposed, the Newsom budget legislation will likely invite a fight unless it is somehow reconciled with the FTB's previous legislative proposal or otherwise fails to pass into law.

Taxes, taxes and more taxes
The threat of tax hikes, particularly in the aftermath of the big spending rises caused by pandemic lockdowns, and by ever increasing entitlement spending, remains. It is not just trusts that are in the firing line. In January, the Ninth US Circuit Court of Appeals upheld a form of wealth tax, according to some interpretations. In this case, Moore versus US, stemmed from a provision of the 2017 Tax Cuts and Jobs Act, which imposed a one-time retroactive tax applicable to individual US shareholders of foreign corporations. Under previous law, US taxpayers had to pay taxes on overseas corporate income when that income was repatriated to the US in the form of dividends. 

The 2017 act abolished the tax on overseas income, bringing the US tax system into line with those of most other developed countries. But it also created a “mandatory repatriation tax” on the corporation’s undistributed income since 1986, payable not by the corporation but its shareholders. The result, claimed two authors in the Wall Street Journal on January 25, was that without selling their stock or receiving a dividend, US investors were deemed to have received “income” and suddenly became liable for the new tax.

Christopher Cox and Hank Adler in the WSJ argued that this was unconstitutional and created an unlimited tax power. (Cox served as chairman of the Securities and Exchange Commission, from 2005 to 2009, and as a US representative from California, from 1989 to 2005. Adler is a professor of accounting at Chapman University.)

For more of our content on trusts and the issues around the world, see commentaries here and here.