Tax Whack-a-Mole

Our beloved internal revenue code currently runs 4,968 pages. That’s a lot of fingers and toes! But you can reduce the whole exercise to three simple steps. First, Washington writes the rules to ensure that Uncle Sam collects an “appropriate” amount of tax from the income we earn. (Reasonable people can disagree on what’s appropriate, which is why we have a two-party system.) Second, clever attorneys and accountants find ways to help clients sidestep those rules. (They get paid very well to do it, which is why they drive Porsches and Jaguars.) Third, Washington re-writes the rules to close the loopholes the accountants and attorneys discover in Step Two. Rinse. Repeat.

We also have 43 state governments collecting income taxes to finance their operations. Most of them start by piggybacking on the same definition of income as the IRS. However, they generally don’t tax residents on income they earn in other states. That leads to the same sorts of games that planners play to exclude income from federal tax. Now California Governor Gavin Newsom is taking dead aim at one of those strategies that let Golden Staters avoid tax on certain investment income.

The strategy is called an “incomplete non-grantor trust,” or ING. Google it if you’re a masochist—honestly, the details would just put you to sleep. The bottom line is, INGs let rich actors, producers, and tech bros establish trusts in states with no tax to avoid California’s bite on trust income. The trusts are specially drafted so that transfers fail to qualify as “complete” for gift tax purposes. (Think of this as the tax equivalent of intentionally fouling your opponent in basketball.) Typically, they’re established in Delaware, Nevada, or Wyoming, which is why planners swap talk about DINGs, NINGs, and WINGs.

Now, if you live in a state like Pennsylvania, where the tax on investment income is just 3.07%, you’d probably find the juice you get from establishing an out-of-state trust just isn’t worth the squeeze. But California’s top tax rate is 13.3% on income over $1 million. That’s the highest in the country. It’s certainly enough to hurt. And if it hurts enough, it justifies paying a white-shoe trust lawyer for some fancy paperwork razzle-dazzle.

California isn’t the first high-tax state to notice residents parking trust income elsewhere. In 2014, New York (with a top rate of 10.9%) rewrote their law to close the loophole. Oh, and just to add insult to injury, California’s proposal would be retroactive to January 1 of this year.

How much tax will that capture? Less than you think. Newsom’s budget estimates it would collect $30 million in 2023-24 and $17 million annually thereafter. That’s barely 1/100th of one percent of the state’s $224 billion budget. Money is tight in California, and the state needs every dime it can collect to finance its ambitious spending. But rewriting the law to collect something less than a rounding error strikes some observers as the revenue-raising equivalent of college kids scrounging through their couch cushions to pay for Taco Bell after a night of binge drinking they’ll soon regret.

Nobody likes paying taxes. And it’s easy to think of the IRS as the big bad wolf when it comes to looking for someone to blame. But the tax collectors who staff the underbudgeted service aren’t to blame. They’re just enforcing the laws that Congress writes and the president signs. The same is true at the state level. Our job, as always, is to keep up with those laws at all levels to ensure you keep as much as you legally can . . . without having to take a road trip to visit your money!