Kitces: Avoid Big Tax Bills With This Special Trust
Most income tax planning is focused on shrinking federal tax liabilities. With state income tax rates as high as 13.3%, strategies that reduce those liabilities are increasingly popular, as well.
A newly-popular strategy is the so-called NING trust, a Nevada Incomplete Gift Non-Grantor trust. It’s an extension of the DING trust, a Delaware Incomplete Non-Grantor trust. In the case of the former, portfolio assets that may generate significant income are stowed in a Nevada trust, shifting the tax exposure to that state’s 0% state tax rates, rather than the rate imposed in the settlor’s home state.
The end result? It can be a significant savings while the client avoids unfavorable gift tax ramifications. There are no adverse tax consequences for individuals in the top federal tax brackets. As an added benefit, the trust qualifies as a Nevada asset protection trust indirectly, which is necessary for the favorable tax treatment.
Unfortunately, the costs to create and manage a NING trust — along with the potentially unfavorable federal income tax treatment for those not already at top tax rates — can limit the strategy’s appeal. Nonetheless, for those who do have significant assets and income, and investments with significant tax exposure, a Nevada trust structured as a NING trust can generate substantialstate income tax savings… at least, until the remaining states with high tax rates follow recent actions by New York and crack down on the strategy altogether.
THE NING STRATEGY
A NING trust is useful for reducing state income tax liabilities, while also obtaining asset protection benefits.
The strategy can help someone who has significant potential income or capital gains. For instance, an individual who holds a multi-million-dollar portfolio which may be generating both significant federal and state income tax liabilities can try to shift the income from the state in which they live, to another state that has more favorable tax treatment. Notably, the goal is only to generate stateincome tax savings, as federal taxes will be due no matter what.
Imagine an investor who has a $10 million portfolio comprised mostly of stock with a cost basis of only $1,000,000. In a state such as California, the annual dividends from the trust, along with the capital gains when the stock is sold, will be subject to a California tax rate as high as 13.3%.
That’s in addition to federal capital gains tax rates as high as 23.8%, including the 3.8% Medicare surtax on investment income.
For a looming $9 million capital gain, the tax liability for California alone is almost $1.2 million, in addition to almost $2.2 million of federal taxes. However, if the individual lived in a state with a 0% tax rate, such as Texas or Nevada, the stock sale would still trigger $2.2 million of federal taxes, but would entail zero capital gains taxes at the state level, for a tax savings of $1.2 million.
Of course the investor could potentially obtain this treatment by simply moving to the state with the more favorable tax treatment. Yet even for such a significant tax savings, not everyone wants to relocate a family just to save money.
MAKING THE TRANSFER
The solution is to transfer the stock to a NING trust, which is based in (and subject to) the tax laws of Nevada, not California. Accordingly, once the stock is inside the NING trust, when it is sold and the trust reports the gain on its tax return and pays its bills, the trust will face onlyfederal capital gains taxes, because that Nevada-based trust would be subject to the state’s 0% tax rate.
In the meantime, the assets in the NING trust may still be distributed back to the original settlor, subject to some constraints as discussed below, and/or to other family members. The end result: money stays in the family, but enjoys a whopping $1.2 million of state income tax savings by avoiding California income tax rates on the gain.
The caveat: In order to receive favorable treatment, the trust must be drafted to carefully navigate through a series of tax laws to ensure that it is taxed in Nevada and not the higher-tax-rate home state of the settlor. In addition, funneling money intoa NING trust doesn’t generate a big gifttax liability at the time.
A NON-GRANTOR TRUST
The first key characteristic of a NING trust is that it is taxed as a non-grantor trust. By operating as such, it is treated as a separate and distinct entity for income tax purposes. Even if the person who funded the trust (the settlor/grantor) lives in a state with a high-income tax rate such as California, the assets held inside the trust are taxed separately based solely on whichever state the trust is based.
This fact lets the trust settlor contribute assets into the trust and shift the income tax consequences of those assets from the settlor (and his home state tax rules) to the trust’s state, deliberately chosen to be more favorable. Because real estate and physical tangible property is always taxed on the basis of where the property is located, this state-tax shifting opportunity for NING trust assets is usually for intangibleproperty such as portfolio assets, and the interest/dividends/capital gains generated by those investments.
The second key characteristic of a NING trust is that the transfer tothe trust is treated as an incomplete gift. This is actually a benefit. Because the gift is not completed means transferring property into the NING does not trigger the filing of a Form 709 gift tax return that requires the settlor to use a portion of his lifetime unified credit amount for gift and estate taxes. The settlor of a NING trust can obtain the income tax benefits, withouttriggering unfavorable gift or estate tax treatment.
Notably, the fact that the transfer of assets to a NING is an incomplete gift also means the investments inside the NING trust will be included in the settlor’s estate, providing for a step-up in basis on those investments at death.
BEFORE THE NING TRUST
The first type of income-shifting, non-grantor, incomplete-gift trust was not based in Nevada, but in Delaware — and thus went by the acronym DING.
DING trusts were designed to allow investors to shift state income tax costs from a high rate state to the more favorable Delaware tax rates.
The key provisions of the early DING were:
1) The DING would have a distribution committee responsible for determining how much of the investment was sent out of the trust. This committee, comprised of the settlor and at least one other adult beneficiary, would determine when distributions would be made and to which beneficiaries. If any one person on the committee had too much power, it could cause the assets of the trust to be in thatperson’s estate instead. Thus, a balance of powers was necessary.
For instance, the DING trust might stipulate that the distribution committee could make distributions to various beneficiaries based on the unanimous consent of the committee. The fact that members of the committee couldn’t act alone ensured that trust assets wouldn’t be in their estates. Because the trust could make distributions back to the settlor only by acquiescence of an adverse party, it would not be treated as a grantor trust under IRC Section 672(a), either.
2) The DING trust would permit the original settlor, at death through a will, to redistribute the remaining assets of the trust among the remaining beneficiaries. The fact that the settlor had given away the property to the DING trust, but retained the right to control who ultimately received the money, meant that the gift was not complete for gift tax purposes under Treasury Regulations 25.2511-2(b) and -2(c). That would avoid any gift tax consequences in funding the trust. Terms would apply only at death and only to other beneficiaries, ensuring that the trust would not be a grantor trust.
3) What made the first DING trust feasible were laws passed in the late 1990s that allowed for domestic asset protection trusts (or DAPT). Before that, any trust that was created by a settlor for her benefit would be subject to her creditors. Having the settlor’s trust be subject to the settlor’s credits under Treasury Regulation 1.677(a)-1(d) made the trust a grantor trust. When Delaware and other states passed laws permitting a self-settled domestic asset protection trust to enjoy state creditor protection, it was possible for such a trust to not be a grantor trust, which in turn introduced the potential to shift state income tax consequences as a DING trust.
DEATH OF THE DING
The initial DING trust strategy lost momentum after a series of IRS pronouncements — in particular CCA 201208026 — which declared that while the DING was a valid non-grantor trust, the testamentary power of appointment only ensured that the trust’s remainderwas an incomplete gift. The lead or income interest in the trust — the share that could be distributed to other beneficiaries while the original settlor was still alive — was deemed to be a completed gift, which would have triggered gift taxes when funding the DING.
The solution to this was to give the settlor some kind of lifetimepower to recover or control investment assets. If the settlor could get access to the trust property while alive, it would become subject to his creditors, which in turn would cause the trust to become a grantor trust, invalidating the strategy altogether.
Fortunately, though, providing the grantor greater lifetime powers created a problem for DING trusts under Delaware law, but it was not fatal for similar incomplete-gift, non-grantor trusts based in Nevada. Nevada is the only state that provides such robust creditor protection for a domestic trust. Even if the settlor still has some retained powers, the trust can stillbe protected. That means the trust can avoid grantor trust status, even as the settlor retains enough control to make the transfer an incomplete gift.
Accordingly, in PLR 201310002, the IRS approved a structure with a Nevada asset protection trust where the settlor retained the power to appoint trust assets to beneficiaries for their health, education, maintenance and support (HEMS), a power that rendered the transfer to the trust an incomplete gift for both the income and remainder interests. The power was still eligible for creditor protection under Nevada law and therefore avoided grantor trust status.
The fact that Nevada was the only state to permit this asset protection treatment led to the rise of the NING trust over the prior DING trust. There is now a similar Alaska asset trust statute suggesting that could be a potential option for clients.
CAVEATS AND CONCERNS
The first caveat to recognize when exploring a NING trust is that it only works in cases where the trust and the property it owns can completely sever any relationship to the home state of the settlor who contributes to the trust. In turn, this means the NING only works for intangible property — e.g., investment portfolios of stocks and bonds — and not real estate in the grantor’s home state.
With real estate and other tangible property, the tax consequences are always tied to the state where the property is located. Intangible property that has no physical presence is taxed based on where its owner is located. Gains on California real estate would be taxed in California while a stocks and bonds portfolio owned by a California resident may cease to be taxed by California if the property becomes attached to a tax-paying entity elsewhere.
Avoiding any relationship to the original state also means that the NING trust should have a corporate trustee not based in that state, but in Nevada. In practice this means finding a Nevada trustee, or Nevada trust company, to handle the NING. The Nevada trustee could hire a financial advisor in another state, including the grantor’s home state, to manage the trust assets. It’s crucial to employ an estate planning attorney familiar with Nevada law to draft the NING.
The second caveat is to remember that when a non-grantor trust makes distributions, the tax consequences generally flow from the trust to the underlying beneficiary. This means that as beneficiaries receive distributions, state income taxes may ultimately be due on gains/income passed to the beneficiary that year. Of course, not all gains may be passed along every year. Nonetheless, it’s important to recognize that some state income tax liabilities may still come through to the beneficiaries when the NING assets are used.
It’s also important to recognize that if NING trust assets are immediately liquidated, or if liquidated assets are immediately distributed, the trust can draw scrutiny as a potential step transaction, so called because multiple separate steps are taxed as a single event. In other words, if the settlor contributes appreciated stock to a NING then immediately sells it, and in the next year distributes all the property back to himself, it’s clear that the NING was just a short-term conduit and the state tax authorities may claim it should be ignored for tax purposes. As a result as with a backdoor Roth contributionstrategy, let time pass between each step — some advisors suggest several years between — to substantiate that the trust is not being used for step transactions.
Finally, know that some states dislike the NING strategy, equating it as a tax avoidance scheme. Some states have amended state tax laws to prevent its use. In 2014, New York State passed laws to prevent using a NING, declaring that the trust will be treated as a grantor trust for state tax purposes to ensure that the trust’s income is still taxed in New York. Similar discussions are happening in other states — particularly those with high tax rates, where significant dollars are at stake.
WHO SHOULD USE IT?
The process to create a NING can be complex, and costs aren’t trivial. A competent attorney must draft the trust carefully, given that more states are challenging the strategy. A conservative settlor may wish to obtain a private letter ruling to ensure that the trust will be honored for federal tax purposes. Revenue Procedure 2015-1 entails a cost of $28,300 just for the PLR. A corporate trustee must be hired. Using a NING will likely require trust assets capable of generating hundreds of thousands or even millions of dollars in taxable income for the state income tax savings to be worthwhile.
In addition, the reality is that for federal tax purposes, the top 39.6% tax bracket for a non-grantor trust – as well as the 3.8% Medicare surtax on investment income — begins at just $12,300 of income in 2015. By contrast, the the top tax bracket doesn’t start until a married couple reaches $464,850 (with a threshold of $250,000 of AGI for the 3.8% Medicare surtax). If the NING settlor isn’t alreadyat or near top tax brackets there’s a danger than any state income tax savings would be more than what is offset by higher federal taxes.
Of course, the NING only presents tax savings opportunities for those who are facing a high state income tax bracket to begin with. Those investors who are already in states with little or no state tax rate will not benefit from the strategy.
The ideal NING candidate:
– Has exposure to significant taxable income from existing intangible assets (e.g., highly appreciated stock, large portfolio that generates ongoing income, etc.) which could be tied up in a NING trust without creating other cash flow problems.
– Is already at or near the top federal tax rate even after the intangible assets are transferred.
– Lives in a state with high state tax rates.
For those who fit all of these characteristics, the NING could be an especially appealing tax planning strategy to shrink state income tax exposure. But act fast. More high-tax states will likely crack down on the strategy soon.
Michael Kitces, CFP, is a Financial Planning contributing writer and a partner and director of research at Pinnacle Advisory Group in Columbia, Md. He’s also publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.