Residents in 43 states pay state income tax, with the highest rate being 13.3%.[1] When combined with the top federal marginal tax rate and the net investment income tax, residents subject to the highest state income tax rate could face a total levy of 54.1% of income. As a result, those residents are interested in finding ways to mitigate the tax. An incomplete gift nongrantor trust (ING trust) could be the answer.
What is an ING trust?
An ING trust is an irrevocable trust designed to reduce or eliminate state income taxes for individuals who reside in high income tax states. They are created in states that do not tax trust income and gains in hopes of eliminating state income taxes on the assets transferred to the trust. The most common jurisdictions for ING trusts are Nevada, Delaware and Wyoming. In Nevada, the trust is a called a “NING,” in Delaware, it’s a “DING” and in Wyoming, it’s a “WING.”
What are the key features of an ING trust?
ING trusts have a few key features. First, ING trusts are nongrantor trusts. This means the trust is a separate taxpayer for federal and, more importantly, state income tax purposes and therefore files its own tax return and pays its own taxes.
Second, transfers to the trust are incomplete for gift tax purposes. This means no gift tax returns are required to be filed for transfers to the trust, and the trust assets are included in the grantor’s (or trust creator’s) gross estate for estate tax purposes, making them eligible for a step-up in basis upon the grantor’s death.
Third, the grantor is a permissible beneficiary of the trust during the grantor’s life. This means the grantor can continue to benefit from the assets transferred to the trust.
What are the main tax considerations?
Sure, saving state income taxes is one of the primary motivations for creating an ING trust, but it is the grantor trust and gift tax rules that are the main considerations for proper structure.
The grantor trust rules enumerate certain powers that, if retained by the grantor, will cause trust income, deductions and other tax items to be included on the grantor’s individual tax return. The result is that a grantor trust is disregarded for income tax purposes, which is desired for most estate planning techniques because it allows the grantor to sell to or exchange assets with the trust without triggering gain or loss. However, residents of high income tax states will not want the additional trust income to hit their individual tax return because then it will be subject to state income tax in their home state. Therefore, they will want to opt out of grantor trust status, which actually proves more difficult than opting in.
The gift tax rules set forth the powers a grantor must relinquish to make transfers to a trust complete and, therefore, subject to gift tax.
The catch with an ING trust is the grantor must relinquish sufficient control to avoid being taxed on trust income and gains under the grantor trust rules, on the one hand, and retain sufficient control to render transfers to the trust incomplete gifts under the gift tax rules, on the other.
Avoiding grantor trust status
To avoid grantor trust status, the grantor must not retain any grantor trust powers,[2] but three grantor trust powers require precise navigation.
Power of disposition
The grantor is treated as owning any portion of a trust over which the grantor or a non-adverse party or both has a power to dispose of income or principal without the consent of an adverse party.3
Power over income for the grantor
The grantor is treated as owning any portion of a trust whose income may be distributed (or accumulated for later distribution) to the grantor or the grantor's spouse without the consent of an adverse party.4
Beneficiary withdrawal power
A beneficiary is treated as owning any portion of a trust over which he or she has the power alone to withdraw income or principal.5
The grantor can avoid retaining these powers by involving one or more other parties in distribution decisions. The first two powers require that third party to be an “adverse party.” An adverse party is any person having a substantial beneficial interest in the trust who would be adversely affected by the exercise or non-exercise of the power held by the grantor or non-adverse party.[6] In other words, an adverse party is another beneficiary (other than the grantor) who has a substantial interest in the trust.
Making an incomplete gift
A gift may be incomplete if the grantor reserves any power over its disposition, whether for the grantor’s benefit or for the benefit of another.[7] Retained powers that can cause a gift to be incomplete include the grantor’s power to (1) revest beneficial interest in the transferred property in him or herself, (2) add new beneficiaries or (3) change the beneficiaries’ interest among themselves (unless the power is retained in a fiduciary capacity and limited by an ascertainable standard).[8]
The grantor is considered to possess these powers even if the power can only be exercised with someone else, unless that other person has a “substantial adverse interest in the disposition of the transferred property or the income therefrom.”[9] A co-holder of a power is considered to have an “adverse interest” where that person “continues to possess the power after the grantor’s death and may exercise it in favor of him or herself, his or her estate, his or her creditors, or the creditors of his or her estate.”[10]
Notably, “adverse” has a different meaning under the gift tax rules than it does under the grantor trust rules. A properly structured ING trust will need to have individuals who meet the definition of “adverse” under the grantor trust rules but fall short of being “adverse” under the gift tax rules.
How are ING trusts configured?
ING trusts are configured to thread the needle of the grantor trust and gift tax rules. Some of these trusts’ important features include:
Distribution committee
The efficacy of the distribution committee is key to avoiding grantor trust status and making transfers to the trust incomplete for gift tax purposes.
Structure of the committee
The distribution committee is a committee always comprised during the grantor’s life of at least two discretionary beneficiaries in addition to the grantor. The committee’s role is to direct distributions in a nonfiduciary capacity. While the committee is acting, the trustee cannot make distributions without the committee’s direction. The committee ceases to exist upon the grantor’s death.
[2] The grantor trust rules are contained in IRC §§671-679.
[3] IRC §674(a)
[4] IRC §677(a)
[5] IRC §678(a)
[6] IRC §672(a)
[7] Treas. Reg. §25.2511-2(b)
[8] Treas. Reg. §25.2511-2(c)
[9] Treas. Reg. §25.2511-2(e)
[10] Treas. Reg. §25.2514-3(b)(2)
[11] IRC §672(e)
[12] Treas. Reg. §25.2511-2(e)
[13] Treas. Reg. §1.677(a)-1(d)
[14] Rev. Proc. 2020-3
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
The distribution committee is given the following powers to direct distributions:
A majority of the distribution committee with the written consent of the grantor may direct the trustee to distribute income and principal to the grantor or the grantor’s issue (Grantor’s Consent Power).
The grantor alone may direct the trustee to distribute principal to the grantor’s issue (Grantor’s Sole Power).
All of the distribution committee members, other than the grantor, may direct the trustee to distribute income and principal to the grantor or the grantor’s issue (Unanimous Member Power).
How the distribution committee avoids grantor trust status
The distribution committee avoids grantor trust status by having nongrantor beneficiaries serve as members. These nongrantor beneficiaries are considered “adverse parties” under the grantor trust rules discussed above, because distribution decisions favorable to the grantor are naturally unfavorable to the nongrantor beneficiaries -- and vice versa. Distributions to the grantor reduce the assets available for the nongrantor beneficiaries whereas distributions withheld from the grantor increase the assets available for the nongrantor beneficiaries.
Furthermore, because none of the committee members can act alone and withdraw income or principal, none of the members are deemed to have a beneficiary withdrawal power discussed above.
Caution should be given to naming the grantor’s spouse as a distribution committee member, because powers held by the grantor’s spouse can be attributed to the grantor.[11]
How the distribution committee avoids completed gifts
Grantor’s Consent Power. By retaining the Grantor’s Consent Power, the grantor is considered to possess the power to distribute income and principal to any beneficiary. As discussed above, the retention of this power causes transfers to ING trusts to be incomplete gifts as long as the co-holders of the power do not have a “substantial adverse interest in the disposition of the property or the income therefrom.”[12]
The co-holders in the case of an ING trust are the nongrantor beneficiaries on the distribution committee. As discussed above, in order for the nongrantor beneficiaries to have a “substantial adverse interest” for gift tax purposes, the nongrantor beneficiary committee members must possess powers to direct distributions after the grantor’s death in favor of themselves, their estates, their creditors, or the creditors of their estates. However, the nongrantor beneficiaries’ powers terminate at the grantor’s death because the distribution committee ceases to exist at that point. Thus, the nongrantor beneficiaries do not have a “substantial adverse interest” for gift tax purposes.
Grantor’s Sole Power. By retaining the Grantor’s Sole Power, the grantor has the power alone to change the interest of the beneficiaries, which, as discussed above, is a retained power that renders transfers to the trust incomplete gifts.
Unanimous Member Power. Although the Unanimous Member Power gives the nongrantor committee members the power to direct distributions without the grantor, the Unanimous Member Power does not change the fact that the grantor retains sufficient dominion and control with the Grantor’s Consent Power and the Grantor’s Sole Power to make transfers to the trust incomplete gifts.
Limited power of appointment
In addition to the powers the grantor retains as a member of the distribution committee, the grantor also retains a testamentary limited power of appointment. This power of appointment gives the grantor the power to redirect the trust remainder to other individuals or entities, which prevents a completed gift with respect to the remainder interest.
The right state
Choosing the right state in which to create the ING trust is critical. As a starting point, the ideal state should (1) not tax trust income and gains and (2) allow for self-settled spendthrift trusts.
A self-settled spendthrift trust (also known as a domestic asset protection trust [DAPT]) is an irrevocable asset protection trust created by the grantor for the grantor’s benefit. A DAPT allows the grantor to create a trust for his or her benefit and still protect the trust assets from the grantor’s potential future creditors. This feature is important in ING trust planning because if creditors can access the trust to satisfy their obligation, then the trust would become a grantor trust. [13] Additionally, this feature is important for clients looking for overall asset protection.
Currently, there are only 19 DAPT states. These states are Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming.
Deciding which of these 19 states is best for your ING trust requires consideration of not only whether the state taxes trust income and gains, but also the state’s rules on the following:
Exception creditors. Many of the DAPT states provide exceptions from asset protection for claims arising from child support, alimony, preexisting torts, certain lenders or state tax liabilities. As mentioned above, creditor access could result in grantor trust status.
Seasoning period. Most DAPT states require the trust to be in existence for a certain period before the trust assets are protected from creditors. The period ranges from 1.5 years to four years for most states. It would be upsetting to create an ING trust in a state with a four-year seasoning period just to be sued in year three or four when the trust could have been established in a state with a two-year seasoning period.
Directed trust statutes. Since the distribution committee will be directing trust distributions, it is important to consider whether the DAPT state has established rules for directed trusts and the effectiveness of those rules.
Trust duration. State rules vary as to how long a trust may exist before final distribution of the trust assets. Some states allow for perpetual trusts, others limit the time to anywhere between 360 years to 1,000 years, and others have much shorter durations. Because ING trusts are suited to be dynasty trusts, it is important to consider state rules on trust duration. The longer assets are permitted to remain in trust, the longer those assets can grow free of gift and estate taxes.
Trustee
The trustee of the ING trust must reside in the state in which the trust is created (the DAPT state). This is typically accomplished by designating a corporate trustee located in the DAPT state.
When does an ING trust make sense?
Generally, ING trusts make the most sense in situations where there is a:
Potential sale of a business with significant built-in gain, or
Portfolio generating significant income and gains
Potential business sale
Assume Lilly is the founder of Health Corp, Inc., a healthcare startup company, with a fair market value of $20 million and basis of $0. Assume further that Lilly’s home state taxes capital gains at 13.3%. If Lilly created an ING trust in Nevada (a state with no income tax) and transferred Health Corp, Inc. to the trust before sale, she could save $2,660,000 ($20 million x 13.3%) on the $20 million gain.
It is important to note that to achieve these savings, Lilly will need to engage in planning well in advance of negotiating a potential sale. This is crucial to avoid sham transaction, step transaction, assignment of income and other related issues.
Portfolio income
Assume Mason has a $30 million investment portfolio that generates income and gain each year equal to 6% of the portfolio or $1,800,000. Assume further that Mason’s home state taxes income and capital gains at 13.3%. If Mason created an ING trust in Nevada and transferred his investment portfolio to the trust, he could save $239,400 ($1,800,000 x 13.3%) each year in income taxes.
When will an ING trust NOT work?
ING trusts will not work to reduce or eliminate state income taxes on compensation, income from a trade or business in the grantor’s home state, or income derived from assets physically located in the grantor’s home state. Generally, all states with a state income tax will tax this type of income (also known as sourced income). Thus, to reduce or eliminate state income taxes in the grantor’s home state, the grantor will need to move the asset generating the income to the state in which the ING trust is created. Of course, tangible property like real estate cannot be relocated, but the location of intangible property (like interests in a business) can be changed to a different state.
Additionally, ING trusts will not work if the grantor’s home state will ultimately tax the trust despite it being created in a state without income tax. For instance, some states will tax trusts based on the grantor’s residency at the time the trust becomes irrevocable. If that is the case, the grantor’s home state will tax an ING trust from inception. Other states will tax trusts based on factors such as the trustee’s residence or place of business, the trust’s place of administration, or the beneficiaries’ residence. If that is the case, the grantor’s home state will tax an ING while the grantor is a beneficiary and resident of the home state, which could be for the grantor’s remaining life.
Note also that New York’s law specifically addresses ING trusts and treats them as grantor trusts for state income tax purposes. Thus, ING trust income will inevitably be included in the grantor’s New York income.
What are the risks to an ING trust?
For all the potential benefits of ING trusts, there are some risks. First, there are no court cases supporting ING trusts. All support comes from private letter rulings issued by the IRS, which are only binding on the taxpayer who requested the ruling. Although the rulings are informative, other taxpayers cannot rely on them as binding precedent.
Second, the IRS decided in 2020 that it would no longer rule on whether a distribution committee of adverse parties could assure nongrantor trust status.[14] Since the distribution committee is essential to the viability of ING trust, the IRS’s 2020 ruling means that the IRS will no longer preapprove ING trusts.
Third, as more taxpayers turn to ING trusts to reduce or eliminate state income taxes, states may seek to change their rules and specifically tax these trusts similar to New York.
Finally, although not a risk, ING trusts are subject to the compressed tax brackets applicable to nongrantor trusts. In 2023, nongrantor trusts are subject to the top individual rate of 37% at just $14,450 of trust income. Taxpayers looking to engage in ING trust planning are likely already subject to the highest marginal tax rate, so this is not likely an issue, but it should be noted nonetheless.
Why create an ING trust and not a standard nongrantor trust?
Although minimizing or eliminating state income taxes can also be accomplished using a standard nongrantor trust, say for the benefit of the grantor’s children and more remote descendants, such trusts do not have some of the benefits of ING trusts. Notably, the basis of standard nongrantor trust assets is not eligible to be stepped up upon the grantor’s death as is the case with an ING trust. Moreover, unlike an ING trust, the grantor is not a beneficiary of a standard nongrantor trust. These benefits could be deciding factors depending on the situation.
Conclusion
While ING trusts have the potential to provide significant income tax savings for those living in high income tax states, they are fairly complex and do not come without risks. If an ING trust is something you are interested in,contact a Baker Tilly professional to further discuss your options.
