Avoiding California State Income Tax Through Irrevocable Trusts
Insights 
Scott Ross · December 11, 2013
EXECUTIVE SUMMARY:
With the maximum California state income tax rate at 13.3% for both ordinary income and capital gain, strategies to defer or eliminate California state income tax have greater importance. One strategy to consider is the creation of an irrevocable children’s trust in a state with no state income tax. If the trust is structured properly, the trust’s accumulated ordinary income and capital gain will not be subject to California state income tax until distributions are made to the trust’s beneficiaries. At that point only the distributed amount is subject to California state income tax and only if the beneficiary is a California resident when the distribution is made. Distributions to a beneficiary who has settled in another state are free of California state income tax (but may be taxable in the beneficiary’s resident state).
BENEFITS TO THE STRATEGY:
1. The trust is not taxable in California on its income if no distributions to California beneficiaries are made. Therefore the trust can serve as an accumulation trust and will enjoy many years of California tax free growth. The tax free growth compounds year over year because an additional 13.3% is preserved which will be invested for further growth. Thus, for California tax purposes the trust grows like an IRA as opposed to a regular taxable account. This works well because parents who fund irrevocable trusts for children generally don’t expect those trusts to make distributions for many years. Rather, they expect to use their own resources to pay for their children’s ongoing support and education and are funding the trust now in order to remove the future appreciation of the trust assets from their estates for estate tax purposes.
2. Such a trust can use its accumulated funds to benefit a child without a distribution being made, and thus without subjecting the accumulated income and capital gain to California tax. As an example, the trust can purchase a home as a primary residence for an adult child and continue to hold the home as a trust asset. Because the beneficiary does not own the home, this strategy has the added benefit of protecting the asset from divorce, from creditors of the child and from estate tax in the child’s estate.
3. As noted above, if the beneficiaries have settled in different states by the time distributions are made, the distributions will not be subject to California income tax. The distributions may however be subject to tax in the state where the beneficiary is a resident.
4. The total distributions to the beneficiaries over their lifetimes may end up being less than accumulated income and capital gain. The undistributed portion will therefore never be subject to California income tax, even for beneficiaries who are lifelong California residents.
DETAILS OF STRUCTURE:
The key component of this strategy is that the trust must not be taxable as a California resident trust. In order for the trust to be considered a nonresident trust, it must not have a California trustee. More details:
1. The trustee cannot be a California resident. Such a trust will typically use an institutional trust company in a state like Delaware or South Dakota (since these states do not have an income tax). If the trust has an investment committee and distribution committee to direct the institutional trustee on investments and distributions, those committee members cannot be California residents. But the investment committee can direct the trustee to use California financial advisors to invest the trust assets. This allows the family to use the same financial advisor as they use for their overall investment strategy.
2. The beneficiaries who live in California must only have “contingent interests” in the trust. This is a term of art for tax purposes. A trust clearly qualifies under this test if the trustee has sole discretion on distributions as the trustee determines to be in the best interest of the beneficiaries. A trust most likely qualifies if the trustee discretion is tied to the beneficiary’s health, education, support and maintenance. The details around the correct verbiage must be carefully watched to meet this requirement.
3. Any California source income would still be subject to California tax. However income from investments such as interest, dividend and gains from sale of stock are considered investment income from intangible assets and therefore not considered California source income. Conversely, as an example, the gain from the sale of real estate located in California would be subject to California tax even if the trust is treated as a nonresident trust.
SUMMARY:
As detailed above, the benefits of this type of trust can be significant. However, this should be considered as part of an overall estate planning strategy. We would suggest consulting with your advisors (estate planning attorney, CPA and financial advisors) to review whether this strategy makes sense for your situation and to advise on its correct implementation.
ABOUT THE AUTHORS:
Scott D. Rossis a partner at Rimon, P.C. Scott specializes in estate planning for high net worth individuals. Rimon, P.C. is a full-service law firm for entreprenuers, venture capitalists, high net worth individuals and their businesses.
Office: 650.353.3999
John T. Advaniis one of the Founders of Altum Partners LLP whose area of expertise includes minimizing income, gift and estate tax for high net worth individuals and their families, structuring closely held business structures and designing effective stock option strategies.
Office: 408.320.0252
