By Anthony Diosdi
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 states 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 $11.4 million in 2019.
“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.
What is an Incomplete Transfer 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?
For gift tax purposes, a gift occurs when the gift is complete. Certain retained powers will render a gift incomplete. See Treas. Reg. Section 25.2511. For example, if a person transfers property in trust, but retains a power to determine who will actually receive property, the gift is incomplete, and will not be considered a taxable gift until it is completed. See Treas Reg. Sections 25.2511-2(b), 25.2511-2(c).
In other words, 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. This is the only way a transfer of property will be recognized for tax purposes.
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 sole power over the ING. This would result in an ING violating the grantor trust rules.
An ING may be a very powerful tax planning tool for certain individuals. However, anyone considering establishing an ING must make sure the grantor trust rules are not violated and any transfers to the ING can be classified as an incomplete gift for gift tax purposes.
The tax attorneys at Diosdi Ching & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.