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A consideration often not taken into account while undergoing estate planning is the effect of state income taxes on an individual's wealth and the distribution of that wealth to heirs. The top individual income tax rates vary from 0.0% – 13.3% across the fifty states. Obviously if there is an opportunity to take advantage of a tax rate of 0.0%, many individuals would consider it. Incomplete Non-Grantor Trusts (ING) were developed to attempt to allow individuals to do exactly that.
The ING trust could be an effective strategy to mitigate state income tax for individuals who anticipate significant income or capital gains tax exposure. ING trusts are designed to shift income from being taxed in the grantor's current state of residence to being taxed in a state that does not tax trust income. Trust jurisdictions that are commonly used for ING trusts include Delaware (DING), Nevada (NING), Wyoming (WING), and Alaska (AING).
However, this is not an easily implemented strategy. The trust must be drafted in a manner to both be a non-grantor trust, preventing the grantor from being taxed on the income, while also keeping the transfer to the trust from being a completed gift, avoiding the need to use any applicable lifetime gift exclusion credit to the transfer. In many instances the costs associated with an ING strategy may outweigh the potential state income tax savings and the avoided gift tax consequences.
How it Works
An ING trust is created under the laws of one of the states that permit self-settled asset protection trusts and does not levy tax on capital gain or income accumulated in the trust. The trust is irrevocable and typically requires a local trustee in the trust jurisdiction. This is an important point as some states, like California, attempt to tax trust income if the trustee is a resident of that state.
The Grantor retains certain access to the gifted assets during their lifetime and, as such, the trust will be included in the Grantor's estate. While the inclusion of assets in the gross estate will cause them to be subject to the federal estate tax, the trust assets should receive the resulting advantage of a step-up in basis at death.
Commonly, an individual funds an ING trust by transferring assets that have gone up or will go up in value or create significant annual income to the trust. There is no advantage to transferring loss assets or depreciating assets to such a trust. In addition, assets that are sourced to a state such as real estate should not be utilized. After allowing for the passage of time to avoid the Internal Revenue Service applying the step-transaction doctrine, usually a year or two, assets are typically sold by the ING trust, which triggers federal but not state income taxation.
To illustrate the concept of using an ING trust, assume a married resident of Minnesota has substantially appreciated securities they expect to sell in the next few years. They anticipate having a $10 million gain resulting from the sale of the securities. The individual is considering transferring the securities into an ING trust a couple of years prior to the sale. For federal income tax purposes there is very little difference between selling it as individuals and selling it through an ING type trust. The top federal tax rates for capital gain will be 20% plus the Net Investment Income Medicare surcharge of 3.8% will apply; however, as seen below the state income tax savings could be significant. The state income tax savings only apply if the income is not distributed by the trust as income distributed by a trust is taxable to the beneficiaries receiving it.
When it Works
ING trusts are most appealing to the following individual situationsi:
An individual should also likely already be taxed in the top federal individual income tax bracket of 39.6%. An ancillary yet significant additional benefit is the asset protection features commonly associated with such trusts under their applicable state law.
These trusts work best for "intangible" property, such as an investment portfolio, because intangible property has no physical presence and is taxed where its owner is based; or, in the case of an ING trust the state law it was properly created and administered under. By contrast, they are not effective for real estate and physical tangible property in the grantor's home state because the tax consequences are tied to the state where the property is physically located.
Details and Drafting Considerations
Private Letter Rulings (PLRs) 20131002 through 20131006 involved identical fact situations and provide a useful reference for drafting the trust structureii. The Grantor created an irrevocable trust for the benefit of himself and his descendants. The corporate trustee was required to distribute income or principal as follows:
Additionally, the Grantor retained the power to distribute principal (but not income) to any of the grantor's issue, but not to the grantor, upon direction from the grantor in a non-fiduciary capacity for health, education, maintenance and support ("Grantor’s Sole Power").
In the Private Letter Rulings the IRS agreed with the taxpayer and ruled that:
Based upon this guidance (albeit not reliable legal "precedence") some key considerations for executing an ING trust strategy successfully include maintaining Non-Grantor Trust status, having the transfer of assets be an incomplete gift and self–settled asset protection status.
Considerations for Non-Grantor Trust Status
The trust must be carefully drafted to avoid the grantor trust rules so that the income is not subject to income tax in the settlor's state of domicile and instead taxed in the state where the trust is settled. To avoid grantor trust status, the trust typically has a Distribution Committee comprised of the settlor and other beneficiaries who have an adverseiii interest to each other. They have the power, by unanimous consent, to determine when and the amount of distributions that would be made out of the trust and to which beneficiaries. In addition, several PLRs conclude that because the Distribution Committee members have substantial adverse interests to each otheriv, they do not possess general powers of appointment over the trust. As such, distributions from the trust will not be subject to gift tax.
Considerations for an Incomplete Gift
In order to avoid a completed gift upon formation of the trust, the grantor retains a testamentary non-general power of appointment over trust assetsv. The settlor retains the right to control who ultimately receives the trust assets creating an incomplete gift for gift tax purposesvi. The trust permits the original settlor at death to re-distribute the remaining assets of the trust amongst the remaining beneficiaries excluding the settlor or his/her estate or creditors. The limitation of the power to apply only at death and only to other beneficiaries ensures that the trust will not be a grantor trust.
Asset Protection Trust
An ING trust should be formed in a state that has adopted a self-settled domestic asset protection (DAPT) trust statute. DAPTs are used for asset protection and also to ensure non-grantor trust status, because the rights and restrictions of creditors under state law will affect Grantor "access" issues for federal estate tax purposesvii. Beginning in Alaska, followed by Delaware and Nevada, states began adopting statutes that allowed self-settled trusts that are projected from the claim of creditors. Today there are 16 states that allow for the formation of DAPTs.
State Tax Law Concerns
States are becoming more aggressive in taxing income, whether an individual's or through a trust. The trustee selection and residence of the trustee can often play an important factor in determining whether a state will attempt to tax the undistributed income of a trust. Distributed income is and will be taxed to the beneficiary upon receipt.
In addition, some states are beginning to explore decoupling their state definition of a "grantor trust" from the federal definition. In 2014 New York changed their law regarding the income tax treatment of ING trusts. New York residents will no longer be able to use an ING trust to avoid the New York State and New York City income taxes, for New York City residents, after January 1, 2014. Individuals should be aware of the potential for their state to follow New York's lead in regard to this issue.
The ING trust can help wealthy individuals reduce state income tax at the trust level while taking advantage of asset protection laws that shield trust assets from creditors. It is a sophisticated tax strategy with the potential to reap significant benefits. However, those benefits should be weighed against the costs of establishing and maintaining the trust, as well as the absence of definitive statutory or legal authority.
Any such sophisticated strategies should be considered only after thorough consultation with your entire team of tax and legal advisors. Your Oxford advisors can facilitate the appropriate consultation and guidance to determine whether this strategy is suitable to your unique situation.
iING trusts are also utilized in more complex transactions such as corporate inversions (where a corporation relocates its legal domicile to a lower-tax nation or tax haven, usually while retaining its material operations in the United States), or the restructurings of publicly traded limited partnerships (e.g. Kinder Morgan).
iiPrivate Letter Rulings can only be relied upon by those receiving the ruling.
vSee PLR 200715005; PLR 200647001; PLR 200637025; PLR 200612002; and PLR 200502014
viTreasury Regulations 25.2511-2(b) and 2(c)
viiTreasury Regulations 1.677(a)-1(d)