Estate planners and tax practitioners have been utilizing incomplete non-grantor trusts, or “ING” trusts, with increased frequency. ING trusts can be utilized for a number of reasons, including, but not limited to, federal income tax planning,[1] asset protection, planning for qualified small business stock benefits, income shifting through distributions to descendants, and others. While this article will not take a deep dive into each and every situation an ING trust may prove useful, it will highlight one in which ING trusts are commonly used: mitigating state income taxes.
ING trusts can be effective planning vehicles to mitigate state income taxes for residents of states with high (or any) state income taxes who are contemplating selling a business for a significant gain or own an investment portfolio that generates significant income and gains. ING trusts may mitigate state income tax by threading the needle between two different areas of the tax code – the grantor trust rules[2] and the transfer rules for gift tax purposes.[3] This article provides an overview of the structural requirements an ING trust must meet to thread such needle.
Example of an ING Trust’s Utility
Before diving into the nuanced structural requirements of an ING trust, let’s first look at some (extremely) basic hypothetical examples as to how they may be useful in mitigating state income taxes.[4]
Example 1:
No ING trust: John Doe is the sole owner of ABC Corp, Inc. ABC Corp has a fair market value of $50 million, and John’s basis in ABC Corp is $10 million. John resides in a state with a 10% capital gains tax. John sells ABC Corp for $50 million, incurring $4 million in state income tax.
With ING trust: A few years before John sells ABC Corp, he establishes an ING Trust in Delaware, and transfers his stock in ABC Corp to the ING trust, now the sole owner of ABC Corp. John’s ING trust meets all the proper structural requirements. As Delaware has no state trust income tax, when the ING trust sells ABC Corp for $50 million, it will not be subject to the 10% capital gains tax of John’s home state, saving the trust, and John, as a beneficiary, $4 million in state income tax.
Example 2:
No ING trust: Jane Doe owns an investment portfolio with a principal amount of $100 million, which generates taxable income each year of $5 million. Jane resides in a state that taxes income at 10%, resulting in Jane incurring state income taxes of $500,000 every year.
With ING trust: Jane establishes an ING trust in Nevada, another state with no trust income tax, and transfers her investment portfolio to the trust. The trust, and Jane, as a beneficiary, will not be subject to the $500,000 of state income taxes each year.
The Basic Characteristics of an ING Trust
An ING trust is an irrevocable non-grantor trust that is a separate taxpayer from the trust settlor, with undistributed income produced by trust assets being taxed to the trust itself. Also, as its name indicates, an ING trust is structured to be an incomplete gift for federal gift tax purposes. This structure allows taxpayers to avoid the gift tax consequences that accompany a completed gift, and as the trust is its own tax paying entity, by ensuring the trust’s situs is a state with no trust state income tax, mitigates state income tax liability. Importantly, unlike most non-grantor trusts, the settlor of an ING trust is a permissible beneficiary, allowed to benefit from the assets transferred to the ING trust (provided certain conditions are met).
Threading the Needle
The grantor trust rules provided in Code Sections 671-679 provide a list of certain powers that, if retained by the settlor of a trust, will result in the trust being disregarded for income tax purposes and will cause the trust’s income and deductions to be included on the settlor’s personal tax return. Generally, to obtain the aforementioned state tax benefits of an ING trust, an ING trust must be a non-grantor trust, and it is therefore essential the settlor of the ING trust relinquish sufficient powers to avoid grantor trust status.
On the other hand, if the settlor relinquishes certain other powers, the transfers to the ING trust will be deemed complete for gift tax purposes and will be subject to gift tax. Hence, this is where “threading the needle” comes into play. The settlor of an ING trust must relinquish enough power to avoid grantor trust status, while simultaneously retaining enough power to avoid transfers to the trust being deemed complete for gift tax purposes.
Avoiding Grantor Trust Status
Settlors of an ING trust, as well as their spouse (since under Code Sec. 672(e) the settlor is deemed to hold all powers and interests that his or her spouse holds in the trust), must not retain any of the powers stipulated in Code Sections 671-679. These include, but are not limited to, the following:
- The power to dispose of income or principal of the ING trust without the consent of an adverse party[5];
- The ability to distribute income to the settlor or the settlor’s spouse from the ING trust without the consent of an adverse party[6]; and
- A beneficiary (other than the settlor and his or her spouse) may not have the unilateral ability to withdraw income or principal from the ING trust.[7]
The ING trust can avoid the settlor retaining the powers listed above by requiring an adverse party to consent to such dispositions/distributions. An “adverse party” for purposes of the grantor trust rules is “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercised of the power which he possesses respecting the trust.”[8] In simpler terms, an adverse party is a beneficiary, other than the settlor or the settlor’s spouse, of the ING trust.
Avoiding a Completed Gift
For gift tax purposes, the transfer to the ING trust will be incomplete if the settlor retains the power to revest the property to himself or herself, the power to name new beneficiaries, or to change the interests of the beneficiaries.[9] While retention of this power seems, and indeed does, conflict with the powers the settlor must relinquish to avoid grantor trust status, the regulations provide an important caveat that the settlor “is considered as himself having a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or the income therefrom.”[10]
The Distribution Committee
Notably, an “adverse party” for grantor trust rule purposes and an “adverse interest” for gift tax purposes have different definitions. For gift tax purposes, a person is considered to have an adverse interest “where he may possess the power after the [settlor’s] death and may exercise it at that time in favor of himself, his estate, his creditors, or creditors of his estate.”[11]
Therefore, to effectuate the intended purpose of the ING trust, and to thread the needle of avoiding grantor trust status while also avoiding a completed gift for gift tax purposes, ING trusts establish a distribution committee. The distribution committee is comprised of the settlor and the other beneficiaries of the ING trust.[12] Individuals on the distribution committee must be an “adverse party” for grantor trust purposes, meaning they must have a substantial beneficial interest in the ING trust, but must not have an “adverse interest” for gift tax purposes, meaning they must not retain the aforementioned powers after the settlor’s death. As such, the distribution committee is dissolved following the settlor’s death.
During the settlor’s life, the distribution committee, by majority or unanimous vote, directs the trustee to make distributions to the settlor or the other beneficiaries of the ING trust. As the distribution committee is comprised of beneficiaries of the trust, any distributions to other beneficiaries, including the settlor, is adverse to their own interest, and as no member has the power to unilaterally withdraw income of principal, the ING trust avoids grantor trust status. Additionally, as the settlor is a member of the distribution committee, he or she retains the power to change the interests of the beneficiaries, and the transfer to the ING trust is an incomplete gift pursuant to Regulation § 25.2511-2(c). Furthermore, the settlor retains a limited power of appointment over the ING trust’s assets, preventing the remainder interest of the ING trust from being deemed a completed gift.
Another Important Factor – Trust Situs
For purposes of mitigating state income taxes, ING trusts must be established in a state that does not impose tax on trust income and gain[13], as well as one that allows domestic asset protection trusts (“DAPT”). A DAPT is a self-settled spendthrift trust, an asset protection trust established by a settlor for his or her own benefit. It is imperative an ING trust is established in a DAPT friendly state, as the ability of the settlor’s creditors to reach trust assets could trigger grantor trust status.[14] For these reasons, most ING trusts are established in either Delaware or Nevada,[15] states with particularly friendly trust statutes, and the trustee must be a resident of the respective trust situs.
Conclusion
ING trusts are effective tools for a litany of planning purposes, including federal tax planning, asset protection, qualified small business stock limitations, income shifting through distributions to descendants, qualified business income phaseout planning, and others not directly discussed in this article. A common purpose of ING trusts is mitigating state income tax for those individuals contemplating selling a business, or those who have a large investment portfolio. To effectively provide this utility, however, ING trusts must meet the proper structural requirements to avoid grantor trust status, as well as the gift tax consequences that accompany a completed gift.
It is also worth noting that ING trusts are not a “one size fits all” method of mitigating state income taxes. ING trusts will prove wholly ineffective in mitigating state income taxes in most situations not directly covered in this article. For example, ING trusts cannot mitigate state income taxes on salaries, income from a trade or business, or income from real property located in the taxpayer’s home state.
Some issues should be considered before implementing an ING trust. First, some states have either enacted or have proposed legislation designed to restrain the use of ING trusts in mitigating state income taxes. Second, non-grantor trusts are taxed at the highest individual rate of 37% for all income over $14,450. While this may not be an issue to many, especially considering that most individuals looking to implement an ING trust are probably already subject to the top marginal tax rate, it should be considered. Also, the Internal Revenue Notice has said they will no longer pre-approve ING trusts by issuance of private letter rulings.[16] Notwithstanding the foregoing, an ING trust is certainly worth considering for those taxpayers in situations like the ones mentioned herein, as well as my previous article,[17] and those taxpayers should consult a tax professional to inquire if implementing an ING trust can be beneficial to them.
[1] https://esapllc.com/ing-trusts-2022-apd/. See here a previous article I authored regarding an ING trust’s utility regarding federal tax planning.
[2] I.R.C. §§ 671-679.
[3] I.R.C. § 2511.
[4] It is worth noting that some states, including California and New York, have either enacted or proposed legislation designed to restrain the use of ING trusts to mitigate state income taxes.
[5] I.R.C. § 674(a).
[6] I.R.C. § 677(a).
[7] I.R.C. § 678(a). Note that violation of such rule will result in at least part of the trust being deemed grantor to such beneficiary, and tax attributes will flow through to such beneficiary’s individual return.
[8] I.R.C. § 672(2).
[9] Treas. Reg. § 25.2511-2(c).
[10] Treas. Reg. § 25.2511-2(e).
[11] Treas. Reg. § 25.2514-3(b)(2).
[12] Note that the grantor’s spouse is often not included on the distribution committee. Although the spouse may be a beneficiary of the ING trust, powers held by the grantor’s spouse will be attributed the grantor under § 672(e), which may complicate compliance with the requirements enumerated herein.
[13] Note that this requirement is not always necessary if the purpose of the ING trust is one other than mitigating state income taxes. For example, if the purpose of the ING trust was to obtain extra qualified small business stock limits, the settlor could establish the ING trust in Mississippi, a state that does impose state income tax but allows domestic asset protection trusts.
[14] Treas. Reg. § 1.677(a)-1(d).
[15] Alaska, Tennessee, and South Dakota are also popular states in which to situs an ING trust.
[16] Rev. Proc. 2020-3
[17] https://esapllc.com/ing-trusts-2022-apd/
