The landscape of estate and tax planning has undergone a substantial transformation due to the Tax Cuts and Jobs Act of 2017 (TCJA), which effectively doubled the federal estate exemption to over $11 million (indexed for inflation to $13,610,000 in 2024) and is not scheduled to sunset until the end of the 2025 tax year. Considering these changes, some emphasis has shifted towards optimizing income tax strategies. One such strategy for individuals seeking to maximize income tax savings is to set up an incomplete non-grantor trust (ING).
ING Trusts in General
The establishment of an ING trust entails adherence to two pivotal requirements:
- Non-Grantor Trust Status: To initiate a non-grantor trust, the individual establishing the trust must relinquish specific controls over the trust's assets, effectively removing themselves from any ownership considerations. The trust is recognized as an independent legal entity and bears the responsibility for paying income taxes, the amount of which is dictated by the state in which the trust is created. Notably, states such as Delaware, Nevada, and South Dakota levy no income tax, while other states impose a varying range of progressive income tax structures.
- Incomplete Transfer of Assets: Traditional asset transfers to non-grantor trusts typically result in taxable gifts to the trust beneficiaries. However, structuring the trust as an incomplete non-grantor trust effectively sidesteps the requirement to utilize the lifetime gift and estate tax exemption.
ING trusts can offer several advantages. One significant advantage can be state income tax savings. Grantors, especially those residing in high-income tax states, optimally transfer a portfolio generating significant investment income and gains and/or appreciated assets with a low basis into the ING trust. Since the ING trust is established in a state with minimal or no income tax, the eventual sale of these assets typically incurs nominal, if any, state income tax. Furthermore, the ING trust allows grantors to transfer assets into it, maintain access to cash flow, and avoid creating a completed gift subject to federal gift tax consequences. This feature is particularly appealing to individuals who have already maximized their lifetime gift tax exemption. It’s important to note that upon the grantor’s demise, the trust assets are included in the grantor’s gross taxable estate, potentially qualifying these assets for a step-up in basis at that time.
On the other hand, since ING trusts and other non-grantor trusts are recognized as distinct legal entities, subject to taxation on their undistributed income, it is important to note that non-grantor trusts adhere to a compressed income tax bracket. For instance, the highest tax bracket of 37% can be triggered at a relatively low threshold of $14,450 (2024 tax year) in taxable income. While state-level tax benefits may accrue, any potential increases in federal income tax obligations must be carefully considered.
Enhancing Tax Benefits With ING Trusts
Under IRC Sec. 1202, eligible gains from the sale or exchange of Qualified Small Business Stock (QSBS) held for at least five years are excluded from a taxpayer’s adjusted gross income. QSBS stacking is a strategic planning approach that attempts to multiply the holders of the QSBS and enable each holder to have their own eligible, excludable gain under Sec. 1202, effectively stacking the QSBS exemption. ING trusts and other non-grantor trusts are eligible QSBS holders per Sec. 1202(h)(2), which allows these trusts to be useful in QSBS stacking strategies and maximizing the tax benefits under Sec. 1202.
ING trusts may offer a valuable tool for federal tax planning by converting a taxpayer’s income from active to passive or vice versa. While the IRS views income from an ING trust as inherently passive, courts have rejected this interpretation, enabling ING trusts to determine income as passive or active based on the trustee’s identity and participation. Taxpayers can appoint a trustee who is neither an owner nor an employee of the business transferred into the trust, thereby ensuring that income previously considered active becomes passive within the trust. This conversion strategy may help allow for the absorption of otherwise unusable passive activity losses and tax credits, which are restricted under Code Section 469.
Other State Tax Planning Considerations
New York
New York resident estates and trusts typically include all income sources in New York taxable income, while non-resident estates and trusts usually consider only income from New York sources. However, a resident trust can be exempt from tax under NY Tax Law Section 605(b)(3)(D) if:
- All trustees are domiciled outside New York.
- The trust's entire corpus, including property, is located outside New York.
- All trust income and gains are derived from sources outside New York, similar to a non-resident trust.
New York does not recognize incomplete non-grantor trusts and treats them as grantor trusts. Therefore, New York resident grantors who establish an ING trust are still subject to New York tax on the trust’s income, even though it’s treated as a separate taxable entity for federal purposes.
In contrast to an ING Trust, assets transferred to a NY Exempt Resident Trust are treated as completed gifts, utilizing the individual’s lifetime estate and gift tax exemption. These trusts must file a NY fiduciary income tax return with Form IT-205-C to certify their exempt status. On the other hand, New York implements an “accumulated distribution” regime for exempt resident trusts, requiring Schedule J filing. Under this regime, previously untaxed trust income can be distributed to a New York resident beneficiary and subject to tax in a subsequent year.
California
In 2023, California introduced significant changes to the tax treatment of incomplete gift non-grantor trusts for California state income tax purposes. Previously, ING Trusts were only subject to tax in California if the trust had California-sourced income, had fiduciaries located in California, or had any noncontingent beneficiaries located in California. However, under the newly enacted Cal. Rev. & Tax. Code Section 17082, incomplete non-grantor trusts are treated as grantor trusts, requiring California grantors to report ING trust’s income on their individual California income tax returns. These changes are retroactive to January 1, 2023.
New Jersey
Like New York, a New Jersey resident trust does not have sufficient nexus with New Jersey and is not subject to New Jersey tax if it has no:
- Physical assets in New Jersey; and
- Income from New Jersey sources; and
- Trustees or executors in New Jersey
The fiduciary of a trust that meets all the above requirements must file Form NJ-1041, check the box on line 27 of the NJ fiduciary income tax return, and include a statement written by the fiduciary certifying that the trust is not subject to tax.
Distinct from New York and California, New Jersey currently recognizes ING trusts and treats them as non-grantor trusts for New Jersey income tax purposes.
Takeaways
Incomplete non-grantor trusts, often referred to as ING Trusts offer numerous benefits, including opportunities for income tax savings. Nevertheless, it’s important to note that the regulations governing these trusts can be complex. To discuss trust planning or income tax strategies that align with your specific needs, please contact Withum’s Founders and Tech Executive Services Team.
Author: Evan Finer, CPA, CFP | [email protected]
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