Minimizing California Individual & Fiduciary Income Tax

Speakers

Dan Schrauth Managing Director, J.P. Morgan Private Bank

Gigi Orta Executive Director, J.P. Morgan Private Bank

Ray Thornson Managing Director, Andersen Tax

Emerson DuBois Managing Director, Andersen Tax

Wednesday, September 4, 2019

Location: BASF Conf. Center •301 Battery st., 3rd floor • San Francisco, CA

Event Code: G190509

Minimizing California Individual & Fiduciary Income Tax

Speakers Bios

Dan Schrauth

Dan Schrauth is a Managing Director with J.P. Morgan Private Bank in San Francisco and Palo Alto, serving ultra high net worth clients in Northern California and Hawaii. As part of the Private Bank’s worldwide tax and estate planning advisory team, Dan works with individuals and families on tax-efficient wealth transfer strategies and tax minimization strategies. Dan has significant experience advising a wide range of clients including: Silicon Valley/technology entrepreneurs and executives; public company executives; principals of venture, private equity and hedge funds; cross border/international families; and multi-generational wealthy families.

Prior to joining J.P. Morgan in 2006, Dan practiced tax, trust and estate law at the San Francisco office of Morgan, Lewis & Bockius, and prior to Morgan Lewis, at the San Francisco office of Hanson Bridgett. Dan is a frequent speaker on wealth preservation and estate planning topics, and has been quoted in publications including The Wall Street Journal, The New York Times, BusinessWeek, The Financial Times and The San Francisco Chronicle. Dan lives with his wife and three children in Marin County, California.

Gigi Orta

Gigi Orta is a Wealth Advisor with J.P. Morgan Private Bank covering San Francisco and Palo Alto clients. Gigi has experience in U.S. wealth transfer and charitable giving strategies. Prior to assuming her Wealth Advisor role at J.P. Morgan, She founded Osterloh & Orta, LLP, a boutique estate planning firm in Oakland, California, in 2005. Prior to that, from 1996-2004, Gigi was an attorney at Crosby Heafey Roach & May and its successor ReedSmith. As an estate planning attorney, she provided comprehensive, personalized estate planning and wealth-transfer counseling to couples, families, and individuals, and guided clients through probate and trust administration. Gigi was named as

a Northern California estate planning "Super Lawyer" for nine consecutive years (2007-2016). She received an L.L.M. in Taxation, with honors, from Golden Gate University of Law, a J.D., magna cum laude, from the University of San Francisco, and B.S. from Syracuse University.

Gigi is a contributing author of CEB California "Decedent's Estate Practice." She was a founding member of East Bay Trusts & Estates Lawyers, and served as President of the Board of Directors in 2013. She is a member of the East Bay Estate Planning Council, the San Francisco Estate Planning Council, the Asian American Bar Association, and the California Bar Association Trusts and Estates Section. She is the current President of the Board of Directors of Camp Augusta, Inc., a non-profit summer camp. Gigi is also an adjunct professor of law at John F. Kennedy University School of Law, where she teaches Wills & Trusts, Estate Planning, and Community Property.

Ray Thornson

Ray Thornson is a Managing Director at Andersen Tax and works primarily with high net worth individuals and closely held businesses and advises on matters related to income tax planning, compliance estate planning and charitable giving. Ray also collaborates closely with clients’ attorneys and investment advisers to help optimize their financial and tax planning results. In 2019 Ray is celebrating his 20th anniversary with the firm and has over 25 years of experience in his field.

Emerson DuBois

Emerson DuBois is a Managing Director at Andersen Tax, specializing in income, gift and estate tax compliance and consulting for individuals and family groups. He has over a decade of experience helping clients accomplish their wealth transfer goals in a tax-efficient manner.

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Investment products: Not FDIC insured • No bank guarantee • May lose value

Please see important information at the end of this presentation.

MINIMIZING CALIFORNIA INDIVIDUAL & FIDUCIARY INCOME TAX

Dan Schrauth 415.315.5077

j.daniel.schrauth@jpmorgan.com

Gigi Orta 415.315.3924

gigi.orta@jpmorgan.com

Bar Association of San Francisco – September 4, 2019

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J.P. Morgan Chase & Co. and its affiliates and/or subsidiaries do not practice law, and do not give tax,

accounting or legal advice, including estate planning advice. The concepts discussed herein involve

complex tax and legal issues and are provided only for educational purposes. We are, however, pleased to

consult with clients and their legal and tax advisors as they move forward with planning. Please see the end of

this presentation for further important information.

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Residency, Domicile and Moving Out of California

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Resident, Part-Year Resident & Non-Resident

Resident (Cal. Rev. & Tax Code §17014(a))

A resident is any individual who meets any of the following criteria:

o Present in CA for other than a temporary or transitory purpose

o Domiciled in CA, but outside CA for a temporary or transitory purpose

Residents of CA are taxed on all income, including income from sources outside of CA

Residency is a question of facts and circumstances – it is not a question of law. The underlyingtheory of residency is that you are a resident of the place where you have the closestconnections

Nonresident (Cal. Rev. & Tax Code §17015)

A nonresident is every individual other than a resident

Nonresidents of CA are subject to CA income tax only on income from CA sources

Part-Year Resident (Cal. Rev. & Tax Code §17015.5)

Any individual who is a CA resident for part of the year and a nonresident for part of the yearis a “Part-Year Resident”

Part-year residents are subject to CA income tax on all income received while a resident, andsubject to CA income tax only on income from CA sources while a nonresident

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Determining California Residency

“Nine Month Test” - Presumption of Residency (Cal. Rev. & Tax Code §17016)

Every individual who spends in the aggregate more than nine months of the taxable year in CAshall be presumed to be a resident

The presumption may be overcome by satisfactory evidence that the individual is in the Statefor a temporary or transitory purpose

“Six Month Test” - Presumption of Non-Residency (18 Cal. Code of Reg. §17014(b))

If an individual is present in CA for less than six months within the taxable year, she or he willbe presumed to be in the state for temporary or transitory purposes provided: (1) she or he isdomiciled in another state; (2) she or he maintains a permanent abode in that state; and (3) sheor he refrains from engaging in activities beyond that of a seasonal visitor, tourist or guest

Determining Factors of CA Residency (non-exhaustive)

Appeal of Stephen D. Bragg 2003-SBE-002 (2003)

o The location of all of the taxpayer’s residential real property, and the approximate sizesand values of each of the residences

o The state wherein the taxpayer’s spouse and children reside

o The state wherein the taxpayer’s children attend school

o The taxpayer’s telephone records (e.g., the origination point of taxpayer’s calls)

o The number of days the taxpayer spends in CA versus the number of days the taxpayerspends in other states, and general purpose of such days

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Determining California Residency

Appeal of Stephen D. Bragg (cont’d)

o The location where the taxpayer files his tax returns, both federal and state, and the stateof residence claimed by the taxpayer on such returns

o The location of the taxpayer’s bank and savings accounts

o The origination point of the taxpayer’s checking account and credit card transactions

o The state wherein the taxpayer:

Maintains memberships in social, religious, and professional organizations

Registers his automobiles

Maintains a driver’s license

Maintains voter registration and the taxpayer’s voting participation history

Obtains professional services, such as doctors, dentists, accountants, and attorneys

Is employed

Maintains or owns business interests

Owns investment real property

See FTB Publication 1031, “Guidelines for Determining Resident Status”

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Domicile

Meaning of Domicile

Domicile has been defined as “the place where an individual has his true, fixed, permanenthome and principal establishment, and to which place he has, whenever he is absent, theintention of returning. It is the place in which a man has voluntarily fixed the habitation ofhimself and family, not for a mere special or limited purpose, but with the present intention ofmaking a permanent home, until some unexpected event shall occur to induce him to adoptsome other permanent home.” (18 Cal. Code Reg. §17014(c))

Another definition of domicile consistent with the above is “the place where an individual hasfixed his habitation and has a permanent residence without any present intention ofpermanently removing therefrom.” (18 Cal. Code Reg. §17014(c))

It is the place to which, whenever you are absent, you intend to return

An individual can at any one time have but one domicile

Once you acquire a domicile, you retain that domicile until you acquire another

A change of domicile requires all of the following:

o Abandonment of your prior domicile

o Physically moving to and residing in the new locality

o Intent to remain in the new locality permanently or indefinitely as demonstrated by youractions

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Becoming a CA Non-Resident / Non-Domiciliary

Best Practices

Control the objective facts & memorialize everything

Commit to the process - stay out of state

Execute requirements of establishing a new domicile

Understand residential audit process & timeline

Separate tax years

Hot Topics, Anecdotes & Common Questions

Selling the business

o Source of income planning (asset sale vs. stock sale)

o Moving the business headquarters

o Taxation if you move, then sell, in the same tax year

o If possible, plan and act well in advance of negotiation, receipt of letter of intent, sale

Keeping your California residence after moving

o Post-Move: days of use

o Size & value of new primary residence vs. CA residence

o Overcoming presumption of “intent to return”

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Becoming a California Non-Resident / Non-Domiciliary, (cont’d)

Hot Topics, Anecdotes & Common Questions (cont’d)

Marriage / Divorce / Community Property

Employment-related departure from CA (safe harbor) - Cal. Rev. & Tax Code §17016

o Safe harbor provides that an individual domiciled in CA who is outside CA under anemployment-related contract for an uninterrupted period of at least 546 consecutivedays will be considered a nonresident unless either of the following is met:

The individual has intangible income exceeding $200,000 in any taxable year duringwhich the employment-related contract is in effect

The principal purpose of the absence from CA is to avoid personal income tax

Rules applicable to living abroad – application of “intent to return”

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Source of Income

Even after becoming a nonresident / non-domiciliary of CA, Source of Income rules must beaddressed. “Source” pertains to the place of origin

Income may be received immediately or on a deferred basis. The receipt of payment / incomeafter moving out of CA requires an assessment of its place of origin

See California Franchise Tax Board – Residency & Sourcing Technical Manual §3000

Wages and Salaries

Wages and salaries have a source where the services are performed. Neither the location of theemployer, where the payment is issued, nor taxpayer’s residency affects source of this income

Interest and Dividends

Interest and dividends generally have a source where taxpayer is a resident. Exception: Interestand dividends have a source in CA if the account or security is used in a trade or business orpledged as security for a loan, the proceeds of which are used in a CA trade or business

Trade or Business

Income from CA sources includes income from a business, trade, or profession carried on in CA.If the business, trade, or profession is carried on both within and outside CA, the incomesourced to CA may be based only on the business conducted within CA, or may be determinedby using the apportionment formula for corporations engaged in multistate businesses

Real or Tangible Personal Property

Income derived from real or tangible personal property located in CA is CA source income(includes rents and realized gain upon sale)

Sale of Stocks and Bonds

The gain or loss from the sale of stocks or bonds has a source where taxpayer is a resident atthe time of the sale

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Source of Income, (cont’d)

Installment Sales

CA taxes installment gains received by a nonresident even if sale was of an intangible (i.e.,

non-CA source asset like stock) if sale occurred while a CA resident

Non-Qualified Stock Options (NQSOs)

If taxpayer exercises NQSOs while a nonresident, the character of the stock option incomerecognized is compensation for services rendered. CA taxes wage income to the extenttaxpayer performed services in the state, whether taxpayer was always a nonresident or wasformerly a CA resident

If taxpayer performed services for a company both within and outside CA, taxpayer mustallocate to CA that portion of total compensation reasonably attributed to services performedin the state. One reasonable method is an allocation based on the time worked

Incentive Stock Options (ISOs)

If taxpayer exercises ISOs while a CA resident or a nonresident and later sells the stock in aqualifying disposition while a nonresident, the income is characterized as income from the saleor disposition of intangible personal property having a source in taxpayer’s state of residence.Accordingly, taxpayer is not subject to income tax by CA even though the services that gaverise to the grant may have been performed in this state

If taxpayer exercises an ISO while a CA resident or a nonresident and disposes of the stock in adisqualifying disposition while a nonresident, the transaction is treated as if taxpayer exerciseda NQSO

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Source of Income, (cont’d)

Restricted Stock

If a taxpayer is a nonresident of CA on the date the stock vests, the character of the incomeattributable to the vesting is compensation for services rendered. CA taxes the income to theextent the taxpayer performed services in this state during the vesting period

Qualified Retirement Income

CA does not impose tax on “retirement income” received by a nonresident after December 31,1995. Retirement income includes income from any of the following (non-exhaustive):

o Distributions from employer-sponsored and self-employment (Keogh) pension, profit-sharing, stock bonus plans, or other deferred compensation arrangements

o Lump-sum distributions from a qualified plan or annuity after December 31, 1995.However, lump-sum distributions, derived from a California source, received from mostnonqualified plans after December 31, 1995, continue to be taxable by California

o IRA, Roth IRA, SIMPLE IRA, and SEP distributions received after becoming a nonresidentare not taxable by California if received after December 31, 1995

Employee Stock Purchase Plan

If a taxpayer exercises an option under an employee stock purchase plan while a resident andlater sells the stock in a qualifying or disqualifying disposition while a nonresident, theresulting ordinary income is taxable by CA to the extent the taxpayer performed services in CAfrom the grant date to the exercise date. Any capital gain has a source in the taxpayer's stateof residence at the time the stock is sold

Nonqualified Deferred Compensation Plan

Payments to employees from performance incentive plans, long-term incentive plans, anddeferred bonus plans (including stock appreciation rights and phantom stock) are consideredcompensation for services

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Structuring Non-Grantor Irrevocable Trusts to Defer or Eliminate

California Income Tax

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Overview

If a trust is a grantor trust, all income and capital gains will be taxed to the grantor

Rules covered here are for irrevocable, non-grantor trusts

In addition to taxing CA sourced income, CA has unique method of taxation, based on residence of the trust’s fiduciaries and beneficiaries (regardless of residence of the Settlor)

State fiduciary income tax can be substantial and erode principal over time; in CA, the maximum rate is 13.3%, with no preferential treatment of LTCG

Despite state tax conventions, a trust may be taxed by more than one state

o CA allows a credit for taxes paid to another state, but only if the trust is a resident of both states and taxes are actually paid to both states

CA follows Fed tax scheme: current distributable net income (DNI) taxed to the beneficiary, while accumulated income and capital gains are taxed to the trust

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Review of California Fiduciary Income Tax Rules

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Taxation of Irrevocable Trusts (Cal. Rev. & Tax. Code §§ 17742-17745)

A non-grantor trust is taxed in CA based on any one of the following 3 factors:*

If the trust has any CA sourced income (CA taxes all CA source income**)

o Income from real or tangible personal property in CA

o Income from a business carried on in CA

• Investment-type income is generally sourced at residence of taxpayer

o Income from intangible personal property having a business or taxable situs in CA

o Mere existence of a CA entity (FLP or LLC) does not mean entity income is CA source income (look to underlying assets and activities)

If there is a non-contingent beneficiary residing in CA

o A beneficiary’s interest is non-contingent if he/she has a set, enforceable right to an ascertainable income or principal distribution

o Includes vested income

o Potentially includes vested remainder interests (Franchise Tax Board (FTB) position)

If current beneficiary has POA at death, should prevent remainder beneficiary from being considered to have a vested interest

o Beneficiaries who may receive distributions wholly in the discretion of the trustee (or a distribution committee) are considered contingent beneficiaries

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Review of CA Rules (cont’d)

* There are proportional tax rules if any of these factors are applicable.

** Maybe, but not so fast. See Paula Trust v. CA FTB, No. CGC-16-556126 (Cal. Sup. Ct. 3/7/18).

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Taxation of Irrevocable Trusts (Cal. Rev. & Tax. Code §§ 17742-17745) (cont’d)

If there is a fiduciary residing in CA

o R&T§17006 defines fiduciary to mean guardian, trustee, executor, administrator, receiver, conservator, or “any person…acting in any fiduciary capacity for any person, estate or trust”

o Includes trust administration by corporate trustee performed in CA

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Review of CA Rules (cont’d)

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Taxation of Irrevocable Trusts – Proportional Rules

Proportional rules apply if multiple fiduciaries and/or multiple non-contingent beneficiaries, some of whom are CA residents

Formula first defines the income taxable to CA on the basis of the proportion of CA trustees to total trustees; any income not allocated to CA because of one or more non-resident trustees is then allocated on the basis of the proportion of vested CA beneficiaries to total vested beneficiaries

o Example 1: Trust has 2 trustees, one of whom is a CA resident, two non-CA beneficiaries and $100k of non-CA source accumulated income. CA will tax 50% ($50k) of the trust income.

o Example 2: Trust has a non-CA resident trustee, two non-contingent beneficiaries, one of whom is a CA resident and $100k of non-CA source accumulated income. CA will tax 50% ($50k) of the trust income.

o Example 3: Trust has a non-CA resident trustee, the sole non-contingent beneficiary is a CA resident and $100k of non-CA source accumulated income. CA will tax 100% of the income ($100k).

o Example 4: Trust has two trustees, one of whom is a CA resident, two non-contingent beneficiaries, one of whom is a CA resident, and $100k of non-CA source income. Based on residency of trustees, CA will tax 50% ($50k) of the income. Based on the residency of the non-contingent beneficiaries, CA will tax another $25k of income (1/2 of the remaining $50k not taxed based on residency of the trustees). In total, CA will tax $75k.

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Review of CA Rules (cont’d)

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Taxation of Irrevocable Trusts – Throwback Rules

If CA tax is avoided because all of the CA beneficiaries’ interests are contingent, §17745 throwback rules apply when a CA beneficiary interest becomes non-contingent in a later year (e.g., upon distribution to beneficiary)

o Thus, if historical income has not previously been taxed in CA, then a beneficiary residing in CA at the time of distribution may owe taxes on distributions received from the trust

o Result is the same even if distribution is characterized as principal

o CA may treat entire distribution as income to the beneficiary

When a contingent resident beneficiary receives a trust distribution that exceeds his/her share of current income, the excess is treated as an “accumulation distribution” and “thrown back”: taxed at rates applicable to the year of accumulation

o Throwback period is shorter of (a) 5 years and (b) trust income accumulation period

o The FTB does not only look to 5 years of income; the purpose of 5-year period is for rate smoothing all prior accumulated income

Beneficiary presumed to be CA resident if he/she leaves CA within 12 months prior to receiving distribution and returns to CA within 12 months of distribution date

Important limitation: accumulated income subject to tax under §17745 must have been earned by the trust while the beneficiary was a CA resident

o Income earned in years in which the beneficiary is not a CA resident is not included in the amount taxable under the throwback rules

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Review of CA Rules (cont’d)

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Taxation of Irrevocable Trusts – Throwback Rules

Scenario: A trust with a non-CA resident trustee and a CA resident contingent beneficiary (fully discretionary distributions during trust term). Trust has been in existence 50 years, will terminate soon, and distribute on termination to sole remaining beneficiary

Question: Will the beneficiary be taxed by CA on accumulated income earned during trust term upon distribution?

o Example 1: The sole remaining beneficiary remains a CA resident through and including date of distribution

Yes, as to 100% of the distribution (to the extent trust’s income was not previously taxed by CA); 1/6 of the accumulated income will be added to beneficiary’s gross income for year of distribution and for each of preceding 5 years (hypothetical tax liability from each year added together to determine total tax to beneficiary)

o Example 2: The sole remaining beneficiary ceases to be a CA resident 2 years before distribution date

No, because the beneficiary moved residency more than 12 months before distribution (also irrelevant if beneficiary returned to CA immediately after distribution)

o Example 3: The sole remaining beneficiary ceases to be a CA resident 6 months before distribution date

It depends. If the beneficiary resumes CA residency within 12 months following the distribution, he/she will be taxed on distribution as if he/she never left; if not, beneficiary may avoid CA income tax on the distribution

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Review of CA Rules (cont’d)

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Taxation of Irrevocable Trusts – Fiduciary Issues

Who is a “fiduciary” under R&T §17742(a)

Trust Protector, power holder and other decision makers: state statutes are largely silent on whether a trust protector is considered a fiduciary

o What powers do they have?

o Possible to draft around CA fiduciary income tax concerns?

o If power to remove and appoint trustees is only power, arguably not a fiduciary and no need to file in CA (not even a protective return)

Agent

o Is trustee hiring agent to perform particular task (e.g., agent is carrying out direction of trustee), or is trustee delegating effectively all fiduciary duties to agent (i.e., agent is directing trustee)? Example: trustee hiring a CA investment manager as agent should not subject trust to CA taxation

When is a corporate fiduciary “resident” in CA?

o R&T §17742(b) provides that, with respect to a particular trust, trustee is resident of place where it conducts “the major portion of the administration of the trust”

o What about corporate trustee, with respect to a specific trust, acting in multiple jurisdictions (e.g., certain administrative duties in CA, but distributions made out of Illinois?

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Review of CA Rules (cont’d)

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Taxation of Irrevocable Trusts – Fiduciary Issues Cont’d

Who is a “fiduciary” under R&T §17742(a)

Directed trusts under CA law

Is “trust advisor” a “fiduciary”?

o Trust “advisor” defined as a “fiduciary” in the DE and SD statutes (presumption against fiduciary status in AK statute)

o Possible to opt out of “fiduciary” status under DE and SD statutes. But would this work for CA purposes?

If trustee is exculpated from liability for following advisor’s direction, and advisor acts in non-fiduciary capacity, are there then no fiduciary duties on directed matter?

Certain duties seem to be inherently fiduciary in nature (e.g., investment advisor, distribution advisor); unlikely to be able to argue that a trust can have no one acting in a fiduciary capacity with respect to trust matters

What if there is a Distribution Committee, or someone has the power to veto distributions?

o Is trust advisor “advising” or “directing” trustee? Instruments drafted under the laws of states that have directed trust statutes require a trustee to follow directions of an “advisor” to exculpate the trustee from liability with respect to the actions taken (or not taken) (See e.g., 12 Del Code Section 3313).

Pressure by FTB to file in CA unless trust advisor plays very limited role in trust administration; should the trustee consider filing a protective return?

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Review of CA Rules (cont’d)

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Taxation of Irrevocable Trusts – Beneficiary Issues

What is a “non-contingent” beneficial interest under R&T §17742(a)

Reg. §17742 defines non-contingent interest as interest that is not subject to condition precedent

Beneficiary’s interest should be considered contingent if beneficiary has no legally enforceable right to demand/receive a trust distribution

o “Absolute discretion” over distributions clearly indicates contingent interest

o Ascertainable standard (e.g., health, education, maintenance and support (HEMS)) should also be indicative of contingent interest even though technically beneficiary could sue to compel distribution under extreme circumstances

“May” distribution standard provides more evidence than “shall” of an intent to create a contingent interest, even when the HEMS standard is used

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Review of CA Rules (cont’d)

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Simple trust with CA income beneficiary subjects all accumulated capital gains to taxation by CA?

o Ex: Marital trust surviving spouse is CA resident

o Planning takeaway: avoid mandatory income distribution provisions (if possible)

Testamentary general power of appointment (GPA) held by CA trust beneficiary = a non-contingent interest with respect to power holder?

o FTB reasoning: beneficiary could monetize his GPA by going to insurance company and getting a lump sum in exchange for a pledge/agreement to exercise GPA in favor of insurance company upon holder’s death

o Testamentary GPA issue has come up on audit; however, dropped when holder of power died during audit and his Will had exercised GPA in favor of out-of-state person

o Planning/drafting takeaway: if sole purpose of GPA is to avoid potential GST tax or to get step-up for estates under exemption amount, by including trust assets in beneficiary’s estate, limit GPA just to “creditors of the estate” and not “estate”, or give Trust Protector power to grant GPOA

Incomplete Non-Grantor (ING) Trust Risks

California does not have specific legislation addressing INGs. However, the FTB could target INGs by arguing that:

o The ING is actually a grantor trust for CA state income tax purposes

o The ING is a tax shelter

o The grantor is a fiduciary who is a CA resident; the grantor is a non-contingent beneficiary who is a CA resident

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FTB Potential Audit Positions

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LCA Source Income

Recent taxpayer “win” - Paula Trust v. CA FTB, No. CGC-16-556126 (Cal. Sup. Ct. 3/7/18); but, FTB has appealed

Facts: settlor created irrevocable trust for daughter in 1971 and transferred CA business interests to trust; trustee had absolute discretion to distribute income and principal. In 2007, trust sold some business interests (CA source income) for $2.8M; at time, trust had 2 trustees, one of whom was a CA resident; Paula, sole beneficiary, was a CA resident. No distributions were made in 2007 and Paula was a contingent beneficiary.

o Trust originally filed tax return and reported and paid tax on entire $2.8M of CG.

o In 2012, trustees filed a claim for refund and took position only 50% of income was subject to CA tax under apportionment (based on ½ trustees being CA residents); CA FTB denied claim, taking the position that 100% of the income was CA source income

o Trustee argued FTB regulation is inconsistent with plain language of §17743 because statute does not say trust taxable income includes CA source income; FTB relied on §§17041 and 17951 (regarding taxation of non-residents on CA source income)

o CA Superior Court agreed with trustee that sections relied upon by FTB do not apply to trusts because they apply only to nonresidents and trust’s CA taxable income should be determined by apportioning its income pursuant to R&T §17743

o Takeaway: If trust has potentially apportionable CA source income, consider filing a protective claim for refund to preserve rights

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FTB Potential Audit Positions (cont’d)

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Best answer is usually simplest – draft provisions to avoid nexus to CA for income tax purposes

Consider carefully current and potential future residences of trustees, other fiduciaries and beneficiaries

o Avoid mandatory income and principal distribution provisions

o Use caution in setting HEMS standard and at a minimum, use fully discretionary (or “may”) standard

o Provide flexibility to change situs without court involvement

o Provide broad capability for trustee or trust protector to appoint successor, non-CA resident trustees and other fiduciaries

Include language recommending an incumbent or nominated trustee consider state income tax implications when deciding whether to act, or who to appoint as successor

o Consider administration location and capabilities of corporate fiduciary

Ex: JPM has CA specific trust charter, DE trust company, and the ability to serve in many other states

Specifically define Trust Protector as a non-fiduciary

o For directed, non-CA trusts, don’t assign traditional fiduciary roles (e.g., investment advisor or distribution advisor) to CA residents

Consider creating separate trusts and/or governing law for CA and non-CA source income

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Best Practices When Creating New Trusts

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Moving Trust Before Liquidity Event

Example 1:

o Non-grantor trust holds highly appreciated position; trustee would like to sell (or position may be involuntarily liquidated) and avoid paying CA tax on gain

o Solution: Move trust to tax-friendly jurisdiction, such as Delaware, before gain is realized

o Procedure: For example, CA trustee resigns in favor of DE trustee in accordance with trust instrument; no legal proceeding required in DE

Example 2:

o Grantor trust owns interest in company likely to be sold in next year; settlor is CA resident; one CA resident trustee and one FL trustee; sole contingent beneficiary CA resident (fully discretionary)

o Solution: (1) terminate grantor trust status; and (2) move trust to FL prior to sale

o Procedure: Settlor (and trustees if applicable) release all grantor trust powers; CA resident trustee resigns; no legal proceedings required in FL

o May also change governing law as well as situs

Issue: When does a trust cease to be a CA taxpayer?

o Default position is “close the book” method: no longer CA taxpayer on date CA trustee resigns (See Form 541 instructions and Pub. 1100)

o Example: CA trustee resigns on 12/1/19 in favor of DE trustee; CA return required only for 1/1/19 – 11/30/19; if sale occurs on 12/15/19, no gain reportable to CA

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Moving Existing Trusts Out of CA

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Incomplete Gift Non-Grantor Trusts: What Are Clients Actually Doing?

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How An ING Trust Works

An ING trust is an irrevocable trust transfers to which are incomplete for transfer tax purposes, and are structured as a non-grantor trust for income tax purposes

Goals:

o Avoid state-level income taxes

o Provide creditor protection as a type of domestic asset protection trust

o Allow trust assets to receive basis adjustment at grantor’s death

o Allow distributions to the grantor

Grantor would not owe any gift taxes on ING funding. Properly-established ING trust would not owe California income tax on the sale of any appreciated asset it owns, or on the ongoing income and realized gains upon reinvestment of the sale proceeds. Even if California tax is due on a distribution, the ING trust assets would continue to grow tax free

By avoiding state-level income tax, the ING trust creates a greater initial pool of wealth that can then grow and compound at a lower effective rate of tax than if assets transferred had instead been sold

Fine line to retain enough control to make the gifts incomplete but not so much control that trust is considered a grantor trust

Best used as an accumulation trust. ING trust would not be subject to California throwback tax and could be structured as a perpetual trust

Issues:

o Need to potentially obtain PLR

o Trust should not have California source income, or California (a) trustees, (b) fiduciaries, or (c) non-contingent beneficiaries

o GST exemption would not be allocated on funding and ING trust does not avoid estate tax in grantor’s estate

o FTB allegedly looking for case with bad facts to audit

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ING Trusts: Overview of Mechanics

Basics

Individual taxpayer resident in high state income tax jurisdiction creates an irrevocable non-grantor trust governed by laws of a state with no income tax, and transfers appreciated assets contemplated to be sold

States with no income tax on trusts under any circumstances: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming. Delaware and New Hampshire have no income tax on trusts unless beneficiaries live in state

Requirements:

1) Distribution Committee and/or Grantor directs distributions. Permissible beneficiaries typically include: grantor, the grantor’s spouse, grantor’s descendants. Unique feature of ING trusts: Trustee has no power to make any distribution to grantor or grantor’s spouse unless made at the discretion of the Distribution Committee

a) “Grantor’s Consent Power”: Distributions are directed by majority of Distribution Committee members + grantor

b) “Unanimous Member Power”: Distributions are directed by unanimous consent of all Committee members (not including grantor)

c) “Grantor’s Sole Power”: Grantor, in non-fiduciary capacity, may distribute principal to beneficiaries (usually issue) for HEMS. has no power to make any distribution to grantor or grantor’s spouse, unless pursuant to Grantor’s Consent Power.

2) Incomplete Gift

3) Non-Grantor Trust

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ING Trusts: The “Distribution Committee”

Neither “Grantor’s Consent Power” or “Unanimous Member Power” results in possession of general power of appointment by the power holder. IRC §2514(c)(3)

The Distribution Committee must have at least two members other than the grantor and his or her spouse who are “adverse.” Well-drafted ING trust provides that if Committee has only one member other than the grantor, Committee will cease to exist

o “Adverse party” is defined under IRC §672(a) and Treas Reg §1.672(a)-1: someone who has a substantial beneficial interest in a trust, which would be adversely affected by the exercise or non-exercise of the power he possesses with respect to the trust

o These members are typically other beneficiaries of the ING trust, including family members with an adverse interest in the trust

o But See: PLR 201729009 for Distribution Committee that had only one member who was a remainder beneficiary. The other members were potential appointees. IRS found grantor was not the owner under IRC §§673, 674, 676 or 677, and although trust did not contain any provisions that would cause the grantor to be treated as the owner under 675, IRS would not conclude it was a non-grantor trust until the income tax returns are examined. This is not dispositive, but suggests IRS is less concerned with ING trusts being viewed as grantor trusts

o In Delaware, grantor is not allowed to serve on Distribution Committee. Even if grantor is allowed to serve on the Distribution Committee (e.g., under Nevada law), best practice is to avoid it

Mechanism should be included by which additional beneficiaries/adverse parties can be added to Committee

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ING Trusts: The “Distribution Committee” (cont’d)

Committee terminates if it does not have at least two members other than the grantor. Distribution Committee members should hold their distribution power in a personal, as opposed to a fiduciary, capacity. This ensures each member is adverse to each other, the grantor and the grantor’s spouse, and does not owe a fiduciary duty to any of the other beneficiaries. If committee members serve in a non-fiduciary capacity, California should arguably not be able to tax the ING trust based on their California residency

Best practice: all Distribution Committee members all reside outside of California. Reality: many clients don’t have anyone outside of California that they trust to serve on the Committee

Risks:

The FTB takes position that California resident Committee members are fiduciaries

ING trust can include an express statement that Committee members are not fiduciaries, but there is no guarantee the FTB would respect that position. Also, grantor may want Committee members to be held to fiduciary standard

Instructions for California Fiduciary Tax Return Form 513 (Sch G) addresses apportionment of income between California and non-California sources, but discusses residence of trustees only when determining allocation of trust income

FTB could argue that Distribution Committee members who live in California and hold the distribution power in a personal capacity are non-contingent beneficiaries. This argument is unlikely to be successful because the Committee members cannot exercise the distribution power unilaterally

Disagreements between Committee members and grantor could arise – grantor risks inability to receive distribution

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ING Trusts: Ensuring Gift Is Incomplete

ING Trusts are not used for estate tax reduction, but must be careful not to trigger gift tax

IRC §2511: If, upon transfer of property, the grantor reserves any power over its disposition, gift may be wholly incomplete. Treasury Regulations provide examples of incomplete gifts, including the grantor’s retention of testamentary special power of appointment to appoint remainder among descendants.

If gift is deemed to be complete, transfer will consume gift tax exclusion or trigger payment of gift tax

To avoid two potential traps, taxpayer could obtain PLR to confirm:

o Transfers from grantor to the trust are incomplete gifts

o Distributions by the Distribution Committee to the grantor are not considered gifts by any member of the Distribution Committee to the grantor

o Distributions by the Distribution Committee to any other beneficiary are not considered gifts by any member of the Distribution Committee to the beneficiary

Retained powers to ensure gift is incomplete:

o Grantor holds testamentary special power of appointment (IRC §674(b)(3)) and lifetime non-fiduciary power to distribute property to beneficiaries based on an ascertainable standard (§674(b)(5))

o Early ING trusts relied on testamentary SPOA. Then, IRS issued guidance that while the testamentary SPOA would result in an incomplete gift of the remainder interest, the share that could be distributed to others during the settlor’s life was a completed gift. Solution: give grantor lifetime power to distribute for HEMS. Under §674(b)(5), this will not cause grantor trust status and trust will still be eligible for creditor protection. Approved by subsequent PLRs.

o Even if incomplete at the outset, a gift would become complete as to the grantor when there are distributions to beneficiaries other than the grantor

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ING Trusts: Ensuring Non-Grantor Trust Status

To avoid California state tax, trust must be a non-grantor trust

Grantor trust rules must be carefully considered

Follow approved formula for drafting and obtain PLR

Going beyond the formula: PLR 201642019 (October 14, 2016): IRS held that an ING trust was a grantor trust under §673(a) because the trust created a reversionary interest. There, the grantor and his two daughters comprised the Distribution Committee. If the daughters ceased to serve on the Committee, the trust would terminate and the money was to be distributed to the grantor. (This PLR revokes ruling in PLR 201426014)

PLR 201650005 (December 9, 2016): ING Trust was created for the benefit of the grantor, the grantor’s spouse, mother and two minor children. Where no reversionary language was included, IRS provided favorable ruling

o TIP: Avoid reversion to grantor or grantor’s spouse

o NOTE: Under Delaware law, including provision that would result in reversion would invalidate the trust as a DAPT because the grantor cannot retain the right to receive a return of the trust assets

Typical PLR approves structure under §§673, 674, 676 and 677 for grantor and grantor’s spouse, and as to Committee members under §678 (no Committee member has sole power to vest income or principal in himself). Under §675, the grantor is the owner for income tax purposes if, under the terms of the trust or circumstances attendant to its operation, administrative control is exercisable primary for the benefit of the grantor rather than beneficiaries of the trust. This is determined after federal income tax returns are filed

IRS routinely issues favorable PLRs on ING trusts; perhaps not coincidentally, the federal government stands to benefit from them. Non-grantor trusts pay at compressed tax rates, and there are no estate/gift tax benefits to the structure.

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ING Trusts: Step-Up In Basis

The retained powers that cause the transfers to be incomplete for gift tax purposes also cause estate tax inclusion under §2036(a)(2) and §2038 and ensure adjusted basis on Grantor’s death

ING trusts can be created by married couple. If the ING trust is funded with community property, the death of the first spouse to die will cause a full basis step-up of the ING trust assets. PLR 201550005 and Treas. Reg. §1.1014-2(a)(5)

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ING Trusts: Taxes

PLRs silent on state taxation and California is not required to follow PLR on the non-grantor trust status

R&T §17745 - California’s “throwback tax” will apply to distributions to California grantor. California taxes resident beneficiaries on accumulated income from trusts established in other states in the year it is distributed to the beneficiary (with offsetting credits for taxes paid in other states) (see pps 6-7)

Throwback tax imposed on California beneficiaries who receive distributions if

o The trust has been noncompliant in paying California income taxes previously due OR

o The beneficiaries previously contingent become vested by reason of distribution (R&T §17745(d))

R&T §17745(e): In the event that a person is a resident beneficiary during the period of accumulation, and leaves this state within 12 months prior to the date of distribution of accumulated income and returns to the state within 12 months after distribution, it shall be presumed that the beneficiary continued to be a resident of this state throughout the time of distribution

Without the throwback tax, only income from the current tax year would be subject to tax, and accumulated income from prior years would basically be treated as principal distributions

However, no penalties or interest due on throwback tax

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ING Trust: Taxes (cont’d)

Risks

California audits entire trust upon filing of tax return for partial distribution. If deemed as a step transaction or sham, taxpayer could owe penalties and interest

o Grantor should consider timing of sale and distribution to avoid application of step transaction doctrine

o Need non-tax reasons for the trust, to rebut tax shelter argument

New York: ING trusts are treated as grantor trusts for purposes of New York income tax purposes. INGs are specifically identified in the New York statute, which took effect in 2014. Can be treated as a non-grantor trust for federal income tax purposes but will be a grantor trust for state tax purposes. California may follow New York and decide to treat INGs as grantor trusts

ING trusts will pay compressed tax rates so ineffective for small amounts of investment income but if client is already in highest tax bracket, the California tax savings will usually offset the higher federal tax rate applied to the ING trust

Uniform Voidable Transactions Act (“UVTA”) replaced Uniform Fraudulent Transfer Act effective 1/1/16

o May make it easier for creditors in California to recover assets that are transferred to third parties, including ING trusts, even when there is no actual fraud, if the ING trust assets can be used by the grantor. Issue will be whether the grantor made the transfer to “hinder, delay, or defraud any creditor.” FTB could argue that it is a creditor of the grantor

Grantor is non-contingent beneficiary

Grantor is a fiduciary

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Best Use of ING Trusts

In Conjunction With Move Out of State

No barrier to distributions if grantor leaves California

o Ex: Client created ING trust while living in California, then moved to Oregon. Oregon has no throwback tax so full distribution to grantor is allowed. Client has decided to keep assets in ING trust for creditor protection but could take the distribution without tax risk

Timing of a move to avoid taxes: risk that FTB challenges the date of the actual move and claims state taxes are due. Using an ING in conjunction with the move can be an effective strategy

QSBS Stacking

Possible to claim separate QSBS gain exclusion for ING? Some say “yes”

§1202 does not make a distinction between incomplete and complete gift – only refers to a “gift”

Case Study

Client is decanting a trust into a ING trust to avoid a potentially harmful triggering event in the original trust and also avoiding CA state income tax on non-CA assets

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ING Trust: Lending Issues

ING assets should not be used to collateralize loans to grantor

Client transfers significant portion assets to ING trust. When client wants to borrow money, client points to ING assets as part of his net worth, and claims he can ask the Distribution Committee to make a distribution

o Neither grantor nor lender should look to the ING trust assets as part of the grantor’s net worth, because there is no guarantee the ING trust Distribution Committee would approve a distribution. Because grantor has no authority to pledge the assets, Lender would have to sue the ING trust to force the distribution, and ING trusts are drafted as APTs

o The Lender can ask the ING trust to pledge the assets but grantor should not want the ING trust to do this, to keep all transactions at arm’s length

Can trustee provide guaranty, in exchange for guaranty fee?

o Not recommended. If ING trust guarantees loan for the benefit of the grantor, may create case for FTB to tax the trust’s income

Can trust be co-borrower?

o Also not recommended. The ING trust can borrow money on its own, but should not be a co-borrower

Solution

Trust could borrow the money and loan it to grantor with adequate interest and security

Possible that the Distribution Committee could allow the assets to be used as collateral and treat it like a distribution to the grantor, but there is no favorable precedent approving this strategy

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ING Trust: Other Issues

Marriage and Divorce

Establish trust with joint grantors and fund with CP or sole grantor and transmute assets to SP?

If one spouse sets up the trust, remainder beneficiaries will typically be the children. Must exercise the testamentary special power of appointment in favor of the spouse

o Easy to change in the event of divorce

o Will the ING trust assets be included in the division of assets?

If set up as joint trust and couple divorces, can either spouse force Distribution Committee to make distribution?

Access to Assets

How much should be transferred to the ING trust?

How long should the grantor wait before Distribution Committee makes a distribution to him/her?

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The Idea

Client sells a low value asset (but with high appreciation potential) to parents; client recognizes and reports any gain on sale

Parents should purchase asset with their own cash; not with a note or cash gifted from child (client)

Parents then gifts asset to an non-grantor irrevocable trust for the benefit of client (and other beneficiaries if desired); trust established in a no-tax state

Client achieves following goals:

Any future income/gain on trust assets not subject to current CA taxation

Client still has ability to receive distribution of trust assets (through a discretionary distribution) if needed; however, distribution subject to CA throwback tax if client lives in CA

Trust assets out of client’s estate and protected from creditors

When This Idea Might Make Sense (or Not Make Sense)

Works well if done very early on when value of assets sold to parents is nominal, e.g., stock in a newly formed company or potentially interests in a newly formed investment fund (but if done with carry/GP interest in a hedge fund, private equity fund or venture fund, need to watch out for 2701 issues)

Doesn’t work well if client already holding substantially appreciated assets (e.g., post-IPO stock) and looking to sell without paying CA tax

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ING Trust: Parent-Funded Trust as a Safer Alternative to an ING Trust?

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Assignment of Income Issues When Moving Assets Out of California

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Assignment of Income Overview

Common Scenarios

Client is selling a business and trying to move out of CA prior to deal close

Irrevocable trust holds stock in client's company and client wants to (i) turn off grantor trust status and/or move the trust out of CA prior to deal close

The Issue

Must pay very careful attention to potential for anticipatory assignment of income

This is not just a federal tax issue that arises in the context of charitable transfers; it is also a state income tax issue that the FTB has focused on

Legal Framework

No bright-line legal test - very fact intensive

See Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999) for review of general principles and prior case law:

o Has stock "ripened from an interest in a viable corporation into a fixed right to receive cash"?

o Is sale/merger "practically certain" to occur?

o If “yes” to either or both of above, can't rely on "mere formalities" or "remote hypothetical possibility" of deal not being consummated

o "Momentum" of deal might also be a relevant factor

o Might also be relevant if taxpayer is negotiating/driving the deal vs. if taxpayer is a passive, uninvolved shareholder

o In Ferguson, taxpayer transferred stock to charity after >50% of shares had been tendered, which, per deal terms, essentially guaranteed merger would be completed. Taxpayer was liable for tax on sale of shares transferred to charity

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How Far is Too Far? When Could Transfer of Shares be Considered an

Anticipatory Assignment of Income?

Taxpayer Has Merely Had Conversations About Selling the Company

Shouldn’t trigger assignment of income concern

Taxpayer Has Received a Term Sheet or Letter of Intent

Not great facts for taxpayer, but arguably taxpayer hasn't yet crossed the line of the stock having "ripened" into a "fixed right to receive income“

Shareholders Have Voted to Approve Sale of Company

Per Ferguson case, likely too late to avoid assignment of income doctrine

If board has to approve deal following shareholder vote, taxpayer could argue board approval is enough of a contingency, but that is not a strong argument

Regulatory Approval Pending (Assuming Shareholders and Board Already Approved Sale

Likely too late to avoid assignment of income doctrine if regulatory approval is deemed a "mere formality" unless argument can be made there is significant likelihood of deal not being approved

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