Introduction
The passing of the Tax Cuts and Jobs Act resulted in a significant tax increase for many in high income tax states. It also elevated the need of many residents of high tax states to utilize planning opportunities to reduce their overall tax liabilities. An incomplete gift non-grantor trust (hereinafter “ING”) formed in a state such as Nevada, Delaware, Wyoming, or South Dakota- that is, a “NING,” “DING,” “WING,” or “SDING,” may offer a planning opportunity to reduce state income tax liabilities.
As a general rule, states impose income tax based on residency. For example, a Maryland resident is subject to Maryland income tax and a California resident is subject to California income tax. The same can be said of an ING. An ING is subject to taxation in the state of its residence. With proper planning, an ING can potentially be utilized to reduce or even eliminate state income tax attributable to the sale of an asset.
Understanding the Basics of an ING
With an ING, an individual (called the “grantor”) irrevocably transfers intangible assets, such as securities, to a trust that is a resident of Nevada, Delaware, Wyoming, or South Dakota while remaining a contingent beneficiary of the trust. The grantor has no ability to receive distributions from the ING without the consent of at least one other non-spousal beneficiary of the trust. This individual is known as an “adverse party.” However, a grantor maintains the ability to allocate trust principal to anyone other than himself or his spouse. Because the grantor retains the ability to appoint the trust principal, the transfer to an ING is characterized as an incomplete gift for gift tax purposes. In other words, the grantor retains certain powers over the ING, but these powers will not be deemed substantial enough so that the grantor will be regarded as having retained control for federal gift tax purposes, thereby avoiding being subject to the gift tax rules.
To fully understand an ING trust, three basic concepts must be understood. The first concept to be understood is that the grantor trust rules of the Internal Revenue Code govern INGs.
Second, a number of states such as Nevada, Delaware, Wyoming, and South Dakota do not impose a state income tax. The object of an ING is to have an individual domiciled or residing in a high tax state establish an ING trust structure in a state which does not impose a state income tax so as to eliminate the imposition of state income tax associated with the sale of an asset. With that said, the third and final concept that is the primary objective of an ING should be clear. The true purpose of establishing an ING is state income tax savings. ING trusts are utilized by grantors for purposes of making incomplete transfers to a trust to potentially avoid state income tax recognition. INGs are purposefully set up as nongrantor to become a separate and distinct taxpayer from the grantor. Since an ING is established in a state without an income tax, at least at the trust level, an ING does not realize a state tax liability.
The Provisions of Subchapter J of the Internal Revenue Code and the Implications of the Internal Revenue Code on ING Trust Structures
The grantor trust rules of the Internal Revenue Code state that if a grantor retains certain powers over trust assets, a trust will be classified as a grantor trust. A grantor trust will never obtain the income tax benefits of an ING. In order for a grantor to avoid being subject to state income tax on the asset or assets being transferred to an ING and achieve non-grantor status under the grantor trust rules, the grantor cannot be treated as the owner of any portion of the ING. See IRC Section 677(a). Those who are involved in tax planning may ask how it is possible to transfer the ownership of an asset to an ING without incurring a gift tax or at a minimum using up some of the unified credit against the gift tax of $5.6 million in 2018.
“An [ING] exists to establish arbitrage between differing federal income tax and gift tax
concepts of what constitutes retention of strings of control by the [grantor] * * * The
Objective in designing the [ING] is to avoid [state] income tax while avoiding federal
Gift tax * * * Administrative and distributive powers must be crafted in a way that
makes them qualified as retained interests under the gift tax, but not so under the
Income tax. At the same time, the design must comport with the settlor’s actual
Disposition intent” See Considering NINGS, The Nevada Incomplete gift non-grantor
trust may allow investors to avoid California income tax and federal gift tax. By Neil
Scoenblum and Catherine Colombo, Los Angeles Lawyer, October 2015
With respect to potential income tax savings, the grantor trust rules set forth in Internal Revenue Code Sections 671 through 679 apply. These code sections provide guidance to the Internal Revenue Service (hereinafter “IRS”) as to whether or not they will disregard an ING under the grantor trust rules. To avoid establishing a grantor trust, a distribution committee is utilized to oversee disbursements of trust income and principal. By doing so, the trust’s income and principal is placed sufficiently out of the grantor’s control. A distribution committee acts as an intermediary between the grantor and the trust. The committee is comprised of individuals known as “adverse parties.”
Internal Revenue Code Section 672(a) defines an “adverse party” as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. A person having a general power of appointment over the trust property shall be deemed to have a beneficial interest in the trust.” These adverse parties direct an ING trustee as to distributions of the trust. Any distributions back to the grantor must be made with the consent or approval of members of a distribution committee. It is important to note that neither the grantor nor the grantor’s spouse can qualify as an “adverse party” for ING trust purposes.
With that said, the “adverse party” rules do not preclude a distribution committee from including the grantor or relatives of the grantor from serving on the committee. However, they cannot be the only parties sitting on a distribution committee. For example, in Private Letter Ruling 201310002, the IRS determined that a grantor and his four sons may serve on an ING distribution committee. The IRS also determined that the grantor had a non-fiduciary capacity to distribute to one or more of his descendants for the health, education, maintenance, and support of them.
Besides Internal Revenue Code Section 672, in order to avoid grantor trust status, the provisions of Internal Revenue Code Sections 671 through 679 must also be sidestepped. Going through each of the relevant remaining grantor trust rules, Internal Revenue Code Section 673 provides that a grantor will be treated as the owner of a trust in which he or she retains a reversionary in the trust, the value of which, at the time of the creation of the trust, exceeds five percent of the value of the trust. With respect to Internal Revenue Code Section 674, a grantor will be treated as the owner of any portion of a trust over which the grantor or a nonadverse party (or both) have the power without the consent of an adverse party, to dispose of trust property, including any power that can affect the beneficial enjoyment of the trust property. In addition, if any person has a power to add beneficiaries, grantor trust status is triggered.
With respect to administrative powers, a trust is treated as a grantor trust if any of the following administrative powers are present: 1) grantor or nonadverse party has power to deal for less than adequate and full consideration; 2) grantor or a nonadverse party can make loans to the grantor without adequate interest or security unless an independent trustee can make loans to others under the same conditions; and 3) any person, in fiduciary capacity and without the approval of a fiduciary, has power to vote stock, control investments, or substitute property. Internal Revenue Code Section 676 treats the trust as a grantor trust if the grantor has the power to revoke a trust and revest title to the asset in the grantor without the consent of an adverse party.
Internal Revenue Code Section 677 provides that if the grantor, without the consent of an adverse party, has the discretion to: 1) distribute trust income to the grantor or the grantor’s spouse; 2) hold or accumulate trust income for future distribution to the grantor or the grantor’s spouse; 3) apply the trust income to pay premiums on insurance on the life of the grantor or the grantor’s spouse; and 4) if trust income is distributed to discharge a legal obligation of the grantor or the grantor’s spouse, the trust will be treated as a grantor trust even though neither the grantor nor the grantor’s spouse are beneficiaries. In regards to Internal Revenue Code Section 678, a trust is a grantor trust as to an individual other than the grantor when he or she has the power to appoint trust principal or income to himself or herself or had such a power that has been released but, after the release, such individual has control that, if he or she was the grantor, would cause the trust to be treated as a grantor trust. Finally, Internal Revenue Code Section 679 deals with foreign trusts and is beyond the scope of this article.
A review of the above discussed grantor trust rules indicates that three important rules must be followed to avoid having an ING be classified as a grantor trust. First, under no circumstances can the grantor be treated as the owner of any portion of the trust. Second, none of the distribution committee members should have power exercisable solely by him or her to vest the trust income or principal to that individual or be treated as the owner of any portion of the trust. Third, there should not be any administrative provisions that could be construed as being for the benefit of the grantor.
Incomplete Transfers for Gift Tax Purposes
Besides establishing that an ING does not violate the grantor trust rules, a transfer to an ING must not be a complete gift for gift tax purposes. But what exactly is a transfer to an ING that is not a completed gift for gift tax purposes? As discussed above, an ING exists, as a result of an arbitrage between gift tax concepts of what constitutes retention of strings of control by the grantor. An ING is designed to avoid state income tax while avoiding federal gift tax. In regards to avoiding state income tax, the grantor trust rules of Internal Revenue Code Sections 671 through 679 discuss the rules of control a grantor may exercise over an ING in order to avoid the recognition of income taxation. These same rules are incorporated into many state tax laws. The same control a grantor exercises over trust assets for grantor trust purposes must be examined for federal gift tax purposes. For gift tax purposes, the grantor must exercise powers over trust assets that must not be substantial enough to run afoul to the grantor trust rules. However, the grantor must retain enough control over an ING assets as not to make a complete gift.
Understanding these differences is not easy. A grantor’s powers over an ING’s assets must be substantial enough as to retain control for the purposes of the gift tax rules. At the same time, the grantor cannot exercise such control as to be subject to income tax. The IRS has issued a number of private letter rulings which address this confusing matter. These private letter rulings now can serve as a model as to how much power a grantor may exercise over an ING for gift and income tax purposes. For example in Private Letter Ruling 201310002, discussed above, the IRS determined that the power of a grantor which allowed him to make distributions to his issue for their health, education, support, or maintenance in a nonfiduciary capacity is an incomplete gift for gift tax purposes. Another power discussed in Private Letter Ruling 20310002 is the power to appoint trust power to persons other than himself, his estate, his creditors, or creditors of his estate. The IRS held that because the grantor has power over only the remainder of the trust, there is no complete gift with respect to the remainder. To sum it up, for purposes of an incomplete gift, a grantor should have considerable authority over an ING and even indirect control over the trust assets. However, he or she cannot have solo power over the ING. This would result in an ING violating the grantor trust rules.
State Tax Reductions With an ING
One may ask: is potential savings of state taxes worth establishing an ING? To answer this question, please see the hypothetical chart below which discusses the state tax consequences of the sale of Small Business Stock for $10 million, in New Jersey, with zero basis, with and without the utilization of an ING:
Without an ING With an ING
Gain of Stocks $10,000000 $10,000000New Jersey State Tax $897,000 $0
Benefit of ING $897,000
The above chart clearly demonstrates that an ING can save a significant amount of state income taxes. As a result, one can imagine that a number of state taxing agencies and state legislators are not pleased with the concept of an ING. One state, the state of New York, enacted anti-ING legislation. In 2014, the state of New York enacted statutory changes to its tax laws. The anti-ING legislation provides: Effective as of June 1, 2014, New York modified N.Y.Tax Law Section 612(b) by adding
new subsection (41), which provides the following inclusion to a New York resident
individual’s New York adjusted gross income:
“Translated, if a New York taxpayer transferred property to a trust intended to be an
ING trust, the income generated from such a trust will be taxed as if such trust were
a grantor trust. As to a New York domiciled grantor, the income is reported on the
Grantor’s New York income tax return even though the trust is a non-grantor trust
For federal income tax purposes.” See State Income Tax Planning for
the Nonresident Floridian: The ING Trust By George D. Karibjanian and Hannah W. Mensch, The Florida Bar Journal/February 2016.As of the date this article was drafted, no other states have been inclined to follow New York’s anti-ING legislation. However, Pennsylvania, Illinois, and Connecticut have tried to push back against INGs. California enacted its own unique legislation in response to INGs and non-grantor trusts in general. California has adopted the “throwback rules” found in the Internal Revenue Code for taxing ING trusts. As discussed below, California’s tax laws regarding the throwback rules are far from clear. Under California Revenue & Taxation Code Section 17742, the California tax status is determined by residence of the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) of a trust, regardless of the residence of the grantor. The key is California Revenue. & Taxation Code Section 17745. This code section provides guidance for unpaid taxes due on distributions from trusts to its beneficiaries. Subsection (a) of this Section 17745 provides that if, for any reason, the taxes imposed on income of a trust that is subject to California income taxation are not paid when due and remain unpaid when that income is distributable to the beneficiary, such income shall be taxable to the beneficiary when it is actually distributed to the beneficiary.
Subsection (b) of California Revenue. & Tax Code Section 17745 goes on to say that if no state income taxes have been paid on the current or accumulated income of a trust because the California beneficiary’s interest in the trust was “contingent,” such income shall be taxable to the beneficiary when it is actually distributed to the individual. As for income accumulation that is added to the principal of a trust, Subsection (c) of California Revenue & Taxation Code Section 17745 states that income accumulated by a trust continues to be taxable income in California. This is the case even if the trust provides that the accumulated income is to be added to principal. The tax is then calculated, and paid under subsection (d), of Section 17745 which goes on to say that tax attributable to the inclusion of that income in the gross income of that beneficiary for the year that income is distributed or distributable shall be the aggregate of the taxes, which would have been attributable to that income had it been included in the gross income of that beneficiary ratably for the year of distribution and the five preceding taxable years, or for the period that the trust accumulated or acquired income for that contingent beneficiary, whichever is shorter.
The effect of California law in regards to INGs is as follows: if an ING is created by a California resident, the trust and its California beneficiaries will likely avoid the immediate imposition of California income tax if the interests of California residents are “contingent.” The regulations under Section 17742(b), specifies that a non-contingent beneficiary is “one whose interest is not subject to a condition precedent.” A further explanation was provided by the California Franchise Tax Board in Advice Memorandum 2006-0002, which provides that “[a] resident beneficiary whose interest in a trust is subject to the sole and absolute discretion of the trustee holds a contingent interest in the trust. The exercise of the trustee’s discretionary power is a condition precedent that must occur before the beneficiary obtains a vested interest in the trust.”
California’s throwback rule was enacted to prevent income accumulation in an ING from escaping state income taxation. Despite these harsh rules, California’s tax law may still provide planning opportunities to mitigate or even avoid the throwback rules and California income taxation. It should be understood that the true value of an ING for California tax purposes is the deferral of the gain on assets of the trust. This may permit an acceleration of the return on investment and growth of the ING’s assets. However, certain sources of trust income for ING purposes will be subject to California income tax and cannot be deferred. Gains or distributions from California source income will subject California beneficiaries to income taxation. For example, gains realized from the sale of California real estate or rental income from California real estate will subject California beneficiaries to state income tax. The fact that the ING is domiciled in a state outside of California would not shield the beneficiaries of an ING from recognizing state income taxation. On the other hand, income from certain intangible investments such as gains from the sale of securities or dividend income may be characterized as non-California income. Income from non-California sources may qualify for deferral of income taxation.
Establishing an ING will not automatically mean a deferral of the gain on assets of the trust. In California, careful planning must be considered. The key to California tax planning with an ING is to avoid any California nexus. In order to avoid a California nexus, the ING must not have a California trustee. Members of the distribution committee also cannot be California residents. An ING may also allow California beneficiaries benefits beyond deferral of income taxation. The beneficiaries of an ING have what is known as contingent interests. A contingent interest is special term for ING planning. An ING beneficiary has a contingent interest if a trustee has sole discretion regarding distributions from the trust. In order for a beneficiary to have a contingent interest, the beneficial interest must be such that the trustee would need to determine that a distribution is in the best interest of a beneficiary. An example of a contingent interest would be if a trustee’s discretion involves a distribution for the health, education, support, and maintenance of a beneficiary.
Besides utilizing an ING for state of California income tax deferral purposes, it may be possible to utilize an ING in the context of creative planning for a contingent beneficiary with a contingent interest. For example, an ING can acquire real estate with proceeds that escaped California income taxation and provide the contingent beneficiary a residence while continuing to maintain the property as a trust asset.
California’s tax laws have demonstrated that the key to ING planning is not to simply establish a trust in another state such as Delaware or Nevada. Instead, the best way to plan an ING is to understand the state tax laws of the grantor and where possible, eliminate any tax nexus from the grantor’s state. By establishing an ING, a grantor may avoid paying gift taxes or using up a lifetime unified credit for tax tax. At the same time, a grantor may minimize the burden of state income tax by shifting an asset out of a high tax state. However, careful and early planning is extremely important.
ING Drafting Suggestions
The foregoing discussions make it clear that an ING should be considered a specially designed trust vehicle for potentially avoiding or delaying the recognition of state income tax. At the same time, an ING may be utilized as an estate planning tool to avoid federal gift taxes. An ING will best work for someone that resides in a state with a high income tax and who anticipates selling an asset with significant tax gains.
Anyone considering an ING, should carefully understand federal income tax law governing non-grantor trusts and state tax law in the jurisdiction of the grantor, beneficiaries, and distribution committee members along with the state in which the ING will be domiciled. The trust instrument must also be carefully be drafted with the utmost care and expertise. The following should be taken into consideration in any ING trust structure or included in any ING trust instrument:
1. The ING must be carefully drafted to contain no “triggers” that would cause grantor trust status under Internal Revenue Codes 671 through 679.
2. The ING must contain provisions for the formation of a distribution committee.
3. The distribution committee should be established to supervise distributions from the ING. The distribution committee should be set up in a way that the grantor cannot practice control over the INGs assets.
4. The distribution committee must consist of beneficiaries of the ING.
5. The adverse parties’ consent should required for grantor or spouse to receive discretionary distributions. These instructions must be included in the trust’s instrument.
6. The grantor should not retain a reversionary interest in the ING of more than 5 percent of the value of the trust.
7. However, distributions from an ING back to a grantor may take place if approved by the distribution committee.
8. The grantor cannot cannot deal with the trust for less than adequate and full consideration or borrow money from the ING.
9. The grantor must maintain powers of an ING’s assets that will be deemed substantial enough as to retain control for federal gift tax purposes.
10. In order for an ING to succeed, the trust income should not be taxable in any state. States impose income tax on a variety of bases: 1) situs of administration; 2) residence of fiduciary; 3) residence of beneficiary; and 4) residence of grantor. It is extremely important to understand the state taxing laws of the ING’s grantor, trust beneficiaries, and the trustee’s home state tax laws.
11. Understanding the assets that will be used to fund an ING is critical. Income from operating business or real estate may be considered state-sourced income, which would eliminate the benefit of an ING.
12. If the ING has a California grantor or beneficiaries, the trust instrument should be drafted in such a manner that the trustee’s discretionary power is a condition precedent that must occur before the beneficiary obtains a vested interest in the trust.
As discussed above, an ING may be a very powerful tax planning tool for certain individuals. For individuals expecting a large gain on intangibles personal property, proper planning may result in a significant savings of state income.
Anthony Diosdi and Lynn Ching are founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi and Lynn Ching concentrate their practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Both may be reached at (415) 318-3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com, Lynn Ching – Lching@sftaxcounsel.com.