An array of recent federal policy actions is putting pressure on state budgets and leaving lawmakers scrambling for ideas on how to responsibly address these new challenges. One federal action of particular concern is the hollowing out of the IRS, which limits the ability to crack down on tax cheating by wealthy people and corporations. As IRS auditing power continues to wither, states should shore up their own tax bases through policies that crack down on cheating, such as closing the ING trust loophole.
The Trump administration slashed the IRS workforce by 25 percent in the first half of 2025 and recently convinced Congress to enact yet another cut to the agency’s funding on top of the near total elimination of Inflation Reduction Act spending on IRS enforcement that already took effect. In total, the IRS budget is now 40 percent smaller than it was in 2010, after adjusting for inflation. This dramatic reduction in IRS capacity will significantly weaken federal tax enforcement and, crucially, leave states in a worse position to enforce their own tax laws as well.
The IRS has long been a valuable partner to states in income tax enforcement. The agency shares audit findings, tax return data, and employment tax information with state tax authorities. Because most states base their income tax systems on federal definitions of income, information uncovered about a taxpayer’s federal noncompliance is critical to ensuring they are paying the appropriate amount of state tax as well. Put another way, as IRS capacity shrinks, more tax cheating will go undetected and state and federal tax bases will wither.
In response to this new challenge, states should increase their own efforts to protect their revenue bases from illegal tax evasion, as well as legal but aggressive tax avoidance. Policing tax rules that are of little interest to the IRS, such as tax residency for individuals or sales factor apportionment for businesses, are natural places to start. Another highly promising approach, laid out in a Center on Budget and Policy Priorities (CBPP) report, is for lawmakers to enact legislation closing loopholes that let high-income individuals use trusts to shift income out of reach of their home state’s tax system.
Trust use is widespread among the wealthiest households, with reports showing that roughly half of the nation’s wealthiest people rely on trusts for tax avoidance reasons. At a basic level, a trust is a legal agreement among three parties: a grantor, who contributes the assets; a trustee, who manages those assets; and one or more beneficiaries, who receive income generated by the assets.
Trusts owe income taxes when the assets they govern generate interest, dividends, royalties, realized capital gains, or other types of income from wealth. One essential difference across various types of trusts is whether taxes on the trust’s income are paid by the grantor or by the trust itself. Grantors can establish grantor trusts, in which they retain control over the assets and pay the income taxes on their personal returns, or non-grantor trusts, in which control over the assets is relinquished to the trustee and the trust files and pays taxes as a separate entity.
In states that tax income from trusts, which includes most states, wealthy residents can avoid paying taxes at home when they establish incomplete non-grantor (ING) trusts in tax haven states such as Delaware, Nevada, South Dakota, and Wyoming. As CBPP explains, under these trusts:
“…the property transfer is both ‘complete’ and ‘incomplete,’ using carefully drafted trust provisions that skirt close to faking the facts. A common way to walk this tightrope when drafting the trust agreement is… to give the grantor ongoing ‘strings of control’ — like the power to make payouts to beneficiaries for their health and education.”
In other words, under these ING trusts the grantor has largely, but not entirely, relinquished control of the assets to the trustee, and the trust is taxable in the state in which it is established—generally a tax haven state with no income tax on trust income. A New York State Bar Association report confirmed that ING trusts exist primarily as vehicles for tax avoidance, costing states revenue. Tax planners often concede this point. Just last week, a trust and estates attorney based in Reno explained that “the tax objective is straightforward: to shift taxation… from an individual who lives in a high-tax state to Nevada, where there is no state income tax.”
But states are not powerless to address this problem. California and New York have enacted the most robust ING trust tax reforms in the nation, essentially treating income generated by ING trusts as taxable income to the grantor, rather than as the income of a separate entity taxed elsewhere. This straightforward reform closes the income-shifting loophole and restores taxing authority to the state where the grantor resides.
In some other states, less robust statutes taxing trusts based on the grantor’s residency at the time the trust was created are potentially serving a similar purpose, though the enforceability of this approach is less certain. All states with taxes on investment returns should strengthen their income tax statutes pertaining to trusts based on either the California approach found in California Revenue and Taxation Code Section 17082, or the New York approach found in NY Tax Law Section 612(b)(41).
Closing the ING trust loophole is a commonsense reform. It is even more urgent during this time when state revenues are under pressure, federal funding is retreating on many fronts, and the IRS is losing enforcement capacity. Enacting this reform would protect state tax bases and ensure that wealthy households pay taxes where they live in a way that better reflects their ability to pay. It should be considered low-hanging fruit for good government advocates and tax reformers alike.
