Does looking back at 2020 bring on a feeling of panic? What happened? An unforeseen viral pandemic spread globally and brought financial destruction in its wake. Economists estimate that the pandemic’s total cost was more than $16 trillion in the U.S. alone. Each family of four had an estimated financial loss of $200,000.1 That, or a similar event could bring unexpected health costs, job loss, financial devastation, and undue stress to even the most financially comfortable. Disruptors, such as a pandemic, economic crisis, or a major political shift, may cause you to reevaluate your financial situation to determine how best to protect your family’s financial assets and security moving forward.
Taxpayers planning for their financial future may be worried about the current $11.58 million per person federal estate tax exemption reverting to around $5.6 million in 2026.2 The effect of this change on estate planning is a topic we will address in a future article. Taxpayers may also consider the effects of the $10,000 limit on the SALT deduction and how this limited their ability to minimize state income taxes. A timely topic to address in this article is how to minimize state income taxes in the high state income tax environment, which New York and California residents find themselves in today. The best defense in a disruptive situation is to be well-prepared and know your options.
States with the highest personal income tax in 2019
- California 13.3%
- Minnesota 9.85%
- Vermont 8.95%
- Hawaii 11%
- Iowa 8.98%
- District of Columbia 8.95%
- Oregon 9.9%
- New Jersey 8.97%
- New York 8.82%
- New York City 3.876%
- Wisconsin 7.65%
State income taxes—a larger tax hit than ever before.
Do you live in a high-income tax state such as New York or California and want to sell a low basis asset such as business, stock, or depreciated out-of-state rental property? A sale that is going to result in a large federal and state capital gains tax. Do you have a large brokerage account ($2mm+) that generates yearly capital gains subject to your state’s extremely high-income tax rate? Do you own a business that earns income not generated in your home state and want to avoid state income taxes?4 In these situations and others, the ideal would be to have the assets in an irrevocable trust protected from creditors and located in a state with no state income tax that could provide disbursements to you and your beneficiaries.
An incomplete gift non-grantor (ING) trust for California residents or a completed gift non-grantor trust for New York residents may be the financial solution you’ve been looking for. Properly structured, these trusts can protect you from exorbitant state income taxes and allow you to preserve more of your wealth, make gifts to family members as desired, and still retain a level of control over your assets if you find yourself in an unprecedented situation that stresses your financial reserves.
How do these trusts work?
An incomplete gift non-grantor (ING) trust has two critical features, the gift must be incomplete, and the trust, not the grantor, is taxed by a state with a zero state income tax rate.
What is an incomplete gift?
A gift is considered complete when the grantor no longer controls the gift and how it is used. Perhaps you gift each of your children with $15,000. You no longer control how that money is used, and therefore it is a complete gift. With an incomplete gift, you, as the grantor, would reserve some power to revest or bring back some asset value for your use and retain some control over how the asset is used. A complete gift is subject to the federal gift tax, while an incomplete gift is not. When determining whether a gift to a trust is complete, the IRS considers whether the grantor has reserved the power to change who benefits from the trust assets.
The giftor, not the recipient, pays the federal gift tax. Recipients do not owe income taxes on their gifts. Each person can gift up to $15,0000 (2020) to any number of people each year without facing a gift tax. Any gifts over $15,000 to a single person are reportable but not necessarily taxable until the lifetime gift tax threshold is reached. The annual gift tax accumulates to a current cap of $11.58 million in a lifetime of gifting without paying federal gift taxes. However, this generous cap will expire in 2026.
What is non-grantor trust status?
A grantor is a person who sets up the trust. The beneficiary is the person or people who receive a benefit from the trust, and the trustee is the person who administers the trust. If the grantor retains control over the trust, then the trust is a grantor trust. In a grantor trust, the grantor, beneficiary, and trustee can all be the same person. A grantor trust is subject to the same taxes as the individual who set up the trust—it is essentially a see-through vehicle. A grantor trust would not serve the purpose of avoiding state income taxes—we need to look elsewhere.
When a trust is granted non-grantor status, it means that the trust is its own taxable entity and that taxation occurs at the trust level and not at the individual level. Taxing the trust instead of the individual opens up the possibility to locate the trust in a state with no income tax. This means that when assets are sold, there is the potential to save a large capital gains tax.
States with no personal income tax in 2019
- Alaska: none
- Florida: none
- Nevada: none
- South Dakota: none
- Washington: none
- Wyoming: none
- Texas: none
Who is a suitable candidate for an ING trust?
The ideal candidate for an incomplete gift non-grantor trust is someone who lives in a state with a high-income tax and has significantly appreciated assets that had a low-cost basis. Therefore, New York and California residents are perfect candidates for these types of trusts (though New York residents will use a completed gift non-grantor trust as discussed below).
Assets with a low-cost basis are those in which the original price, purchase price, or original investment is low. This purchase price determines capital gains, which is the difference between the selling price and the purchase price. Examples of investments with a low-cost basis and the potential for high capital gains might include selling a business started from the ground up, out-of-state real estate, or a stock portfolio purchased years ago. Earning high capital gains on an investment is a financial positive; paying taxes on it is not. An ING trust can help.
Why not use the SALT deduction or transfer property in a will instead?
The SALT deduction is a deduction that permits taxpayers who itemize when filing federal taxes to deduct certain taxes from federal income taxes that are paid at the state or local level. The Tax Cuts and Jobs Act capped this limit at $10,000 per year. This limit includes non-business property taxes plus state income or sales taxes, but not both.6 Establishing an ING trust can help avoid SALT limitations, and since the ING trust is a separate tax entity, it has its own $10,000 SALT limit.
The federal gift tax exemption encourages citizens to give away their money before they die so that their estate is not subject to federal estate tax. The first $11.58 million of an estate is not taxed at the federal level, but any amount over that is taxed at a rate as high as 40% (2020 rates).5 It is not a coincidence that the lifetime gift tax exemption is $11.58 million, and the estate tax exemption is $11.58 million as the estate and gift taxes work under what is referred to as a unified credit. Gifts that are given in excess of the annual gift tax exemption reduce the estate tax exemption otherwise available at death.
How can an ING trust save you state income tax?
Suppose a resident of a state with a high state income tax has a low-cost basis asset that they would like to sell, but they want to avoid the capital gains tax from the sale. If the resident contributes the asset to an ING trust, and the trust is based in a state with a zero state income tax, state income tax could be avoided when the asset is sold. The confusing issue is that each state has its own rules about whether trusts are residents of its state and, therefore, subject to its state income taxes. Your attorney will need to work with you to ensure the trust is properly structured to avoid state income taxes – any misstep will probably result in a worthless structure.
When establishing an ING trust, the goal is to have the trust viewed as a separate taxpayer and locate it in a state with zero state income tax. This means that the grantor cannot be viewed as the trust owner. If they are, the trust would be liable for state income tax in the grantor’s state of residence. This sets up a conundrum. The grantor must hold on to enough control of the trust assets so that a disbursement is not considered a complete gift. However, at the same time, the grantor must relinquish enough control, so they are not considered the owner of the assets for income tax purposes. To meet both the criteria of being an incomplete gift and a non-grantor trust requires not only knowing each state’s rules on taxing trusts and how they apply but also judiciously selecting a trustee, committee members, and advisors and carefully defining each of their powers.
How do you choose a state for the trust?
Choosing the state for your trust depends on your goals and personal situation. Some states, such as Nevada, Alaska, Florida, South Dakota, Texas, Washington, and Wyoming, will not tax undistributed trust income. Delaware and Wyoming will not tax undistributed tax income if the beneficiaries live in another state. California may tax income from an out-of-state trust if even one beneficiary lives in California.
Asset protection is also essential. The trust must also be set up in a state with a domestic asset protection statute that allows a person to be the beneficiary of their own asset-protected trust. Otherwise, the assets are open to the grantor’s creditors, and the tax bill goes back to the grantor. Nevada is ranked number one on the “11th Annual Domestic Asset Protection Trust State Rankings Chart” and where we do all of our ING trust work.
Of the states that offer domestic asset protection, look for one with no state income tax and allow the grantor to maintain lifetime power of appointment so that asset transfers remain incomplete gifts. The grantor can maintain a lifetime power of appointment when reserving the right to disperse money from the body of the trust to their children for health, education, maintenance, or support.
How do you pick trustees for an ING trust?
You can choose a single corporate trustee who lives in the state where the trust is to be located. Another option is to use an investment trustee and a jurisdictional trustee. The jurisdictional trustee is generally a corporate trustee in the state in which the trust is located. The investment trustee determines how the assets will be invested and when they will be sold. For an ING trust, an investment trustee cannot live in the grantor’s state or a state that taxes trusts based solely on the trustee’s residency or place of administration.
How is an ING trust structured?
An ING trust is an irrevocable trust that is set up to benefit the grantor and their beneficiaries. The terms of the trust cannot be modified, amended, or terminated without permission from the beneficiaries. In addition to the trustee, a distribution committee is an essential part of an ING trust. The committee members are typically trust beneficiaries other than the grantor. The committee members have a stake in how the assets are distributed and are, therefore, adverse parties. If the committee directs money to be dispersed to the grantor, then that is money deducted from the amount available for the rest of the beneficiaries.
Grantors must be careful when selecting committee members and ensure that they choose members who will follow the grantor’s wishes. The grantor can fire and hire trustees, but not committee members. The committee members are often the grantor’s children but can be siblings, parents, nieces or nephews, or other beneficiaries—those you trust implicitly.
Distributions from the trust can be made in the following ways, among others:
- When there is a unanimous vote of the three or more committee members, the grantor and spouse do not count towards this majority.
- When there is a majority vote by the committee along with the grantor
Having a committee of adverse parties allows the trust to maintain non-grantor status. A non-grantor status is required for the trust to be a separate tax-paying entity. Likewise, the grantor retains some control over the distribution of the trust assets, which meets the requirements of an incomplete gift.
When might an ING trust not work?
Locating a trust in a state with zero state income tax and defining the trust as a separate tax-paying entity is essential to reap the benefits of an ING trust. There are some situations in which this might be a challenge. Consider the following circumstances that may make setting up an ING trust a challenge:
- If the state taxes a non-grantor trust based solely on the grantor’s residency, an ING trust will not work. Examples: Pennsylvania and Illinois.
- If the grantor wants to be the trustee. The trustee cannot live in the grantor’s home state.
- If the residence or distributions go to a beneficiary who lives in the state where the trust is located, some states will tax the trust. The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue case helped alleviate this issue.
- If the state administers the trust, it may tax the trust.
- If the trust’s income is rental or business income from the state where the trust is located, then it is source income, and an ING trust is not an option.
- If the assets may be threatened by a predator which can open the trust up to be a grantor trust, then it will no longer meet the definition of an ING trust.
- If the grantor lives in a state such as New York, which outlawed incomplete gifts. Instead, a New York resident will use a completed gift non-grantor trust, which essentially accomplishes the same state income tax avoidance goals, just via a completed gift non-grantor trust.
In addition to the challenges of setting up the ING trust, other situations are “red flags” to the state tax authorities. Funding a trust with assets that are sold right after the trust is set up, funding the trust with assets that the grantor requires to maintain their standard of living, or selling the trust’s principal asset and distributing all or most of the proceeds back to the grantor are all situations which indicate that the sole purpose of the trust was to avoid incurring state income taxes.
An ING trust makes sense for those who are exceedingly high earners who have income generated outside of their home state, live in a state with high-income tax, and want to sell low basis assets such as a business or appreciated brokerage account. Besides locating a trust in a trust-friendly state such as Nevada, it is essential to understand the laws on non-grantor trusts for both the home state of the grantor and the state in which the trust is located. Meeting requirements for an ING trust is a nuanced process requiring an experienced attorney’s assistance and knowledge of the particular fact patterns of the grantor, beneficiaries, committee members, and trustees. To avoid flagging the trust to the state tax authorities, the grantor of an ING trust should be able to show a significant non-tax purpose for their ING trusts. Examples of such benefits are centralized asset management or the avoidance of transfer of assets between family members who own a business together.
ING (California) and completed gift (New York) non-grantor trusts provide a powerful opportunity to avoid state income tax in today’s high tax environment. If you feel these trusts could be a good fit for you, contact us today to discuss ways we can help you put an estate planning structure in place that allows you to leave more assets to those most entitled to them—your family and loved ones.
- Cutler DM, Summers LH. The COVID-19 Pandemic and the $16 Trillion Virus. JAMA. 2020;324(15):1495–1496. doi:10.1001/jama.2020.19759
- Bloink, R. & Byrnes, W. (2019). ING Trusts: The Hot Trend in HNW Estate Planning | ThinkAdvisor. Retrieved from https://www.thinkadvisor.com/2019/02/13/ing-trusts-the-hot-trend-in-hnw-estate-planning/
- Intuit TurboTax (2020). States with the Highest and Lowest Taxes – TurboTax Tax Tips & Videos. Retrieved from https://turbotax.intuit.com/tax-tips/fun-facts/states-with-the-highest-and-lowest-taxes/L6HPAVqSF
- Oshins, S. (2020). 2020 NING Trust Update: saving significant state income taxes for your clients in high state income tax jurisdictions. [Video]. https://www.oshins.com/
- Intuit TurboTax (2020). The Gift Tax. Retrieved from https://turbotax.intuit.com/tax-tips/estates/the-gift-tax/L1sFpFeXV
- What is the State and Local Tax (SALT) Deduction? (2020). Retrieved from https://taxfoundation.org/tax-basics/salt-deduction/
- Lipkind, W., Shenkman, M., & Blattmachr, J. (2018). How ING trusts can offset adverse effects of Tax Law: Part 1. Retrieved from https://www.epceasternnewyork.org/assets/Councils/EasternNewYork-NY/library/2018%2009%20-%20How%20ING%20Trust%20Can%20Offset%20Adverse%20Effects%20of%20Tax%20Law-Part%201.pdf
- Carlson, B. (2020). How to Find the Best State to Place Your Trusts. Retrieved from https://www.retirementwatch.com/how-to-find-the-best-state-to-place-your-trusts
- Lipkind, W., Shenkman, M., & Blattmachr, J. (2018). The benefits of Incomplete Non-grantor Trusts. Retrieved from https://www.wealthmanagement.com/high-net-worth/benefits-incomplete-non-grantor-trusts
- Northern Trust. (2014). Incomplete non-grantor trusts: The basics. Retrieved from https://www.northerntrust.com/documents/line-of-sight/wealth-advisor/incomplete-non-grantor-trusts.pdf