In 2017, the Tax Cuts and Jobs Act (TCJA) was signed, restricting many of the deductibles on state income taxes. As a result, a great deal of discussion lately has surrounded the use of the Nevada Incomplete Non-Grantor (NING) Trust.
Unlike grantor trusts which are taxed to the grantor, a non-grantor trust is a “separate taxpayer.” This means that it can reside in a different state, like Nevada, with no existing state income tax.
The NING is an exceptional tool to avoid state income taxes and protect assets. By eliminating state income taxes, the net rate of return on investment is increased.
For instance, in the case of California, which imposes a maximum 13.3 percent income tax, the elimination of state tax may mean huge savings and corresponding increase in the net return on investment. It may also mean extraordinary savings upon the disposition of highly appreciated securities and other intangible investments.
Even better news—this powerful tax planning tool has actually been approved in several private-letter rulings by the IRS. Wyoming and Delaware have also followed suit with their own WING and DING Trusts respectively.[Editor’s Note: Read more about tax strategy with the article “Multigenerational Tax Strategy for High Net Worth Families,” by Gerry Nowotny.]
Not all Californians or residents of other tax-heavy states can benefit from the NING Trust. Care must be exercised in structuring it.
First, the trustee needs to be in Nevada or another state with a well-designed asset protection trust statute. If the NING trust is not created in such a state, the grantor’s creditors are able to reach the trust assets and the income is taxed to the grantor.
In addition, distributions to resident beneficiaries will commonly be taxed. So, the NING trust is for those prepared to accumulate income over some period of time. Of course, annual accumulation of tax-free income has a cascading effect on the growth of the accumulated amount. This growth can mimic an IRA.
Pay close attention to the laws in your state of residence. New York, for example, changed its laws to tax the grantor in all situations.
Another limiting factor relates to the character of the assets—the NING is for investors who own intangibles like stocks, bonds, mutual funds or other securities.
If, for example, the NING holds California real estate or tangible property like works of art, the state income tax cannot be avoided. But even this is hardly an insurmountable obstacle. These tangible assets can be owned by an entity whose shares or units, being intangible, could be owned by the NING. By converting the tangible into an intangible, the benefits of the NING become available at little or no additional cost. Note that intangibles received as stock option compensation would not be appropriate for a NING, since all compensation can be taxed when and where it’s earned.
A final limiting factor relates to the grantor’s loss of control over the assets placed in trust. Although the grantor of the trust cannot exercise direct control over the assets, this does not mean that the grantor is without access or must surrender total say in the eventual disposition and investment. For example, the grantor can be a discretionary beneficiary.
Furthermore, through careful design of powers, the grantor can exercise considerable influence over who gets what when distributions are ultimately made. With respect to investment decisions, the grantor’s involvement can be even more direct.
When it comes to financial planners, the trust can still use financial planners from the grantor’s state of residence. If the trust has an investment committee, the committee can direct trustees living in Nevada to use a financial planner in California, for example.
Let’s look at an illustration to demonstrate just how powerful the NING is for certain taxpayers using California as an example.
Assume the Cal Investor owns shares in a corporation, and the shares he owns have a low basis. The corporation might be a tech startup and the Cal Investor might originally have put up some minimal capital. The company has taken off and is now being wooed by a number of mega Silicon Valley suitors. Let’s suppose that this actually occurs and our investor will be receiving $50 million above his basis in payment for his shares. If the shares are held by a NING, there will only be federal tax on the gain realized and recognized. There will be no California income tax.
On the other hand, if Cal Investor owns the shares directly, his additional income tax will be in the range of $6,650,000. This is assuming he is already in the maximum 39.6 percent federal income tax bracket due to other income he reports within the transactional year.
Depending on the particular taxpayer, this amount of tax savings may be somewhat overstated. There are a number of reasons for this.
First, there will likely be an offsetting federal deduction for the state taxes paid. However, this benefit may not be available if the taxpayer is subject to alternative minimum tax, because the calculation of that tax does not allow a deduction for state income taxes.
Another reason that benefits from a non-grantor trust may be overstated is due to the low level of taxable income of a trust where the maximum marginal rate of taxation for the federal income tax and the net investment income tax come into play. An individual does not hit the maximum bracket until the taxpayer has much more taxable income. On the other hand, if the taxpayer is already in the 39.6 percent bracket due to other sources of income during the year, the rate differential between trusts and individuals will not be a factor.
In the case of the Cal Investor, let’s assume a net $6 million savings on the sale of the stock after various offsets. This is not the end of the story. Assume the proceeds from the sale are accumulated in trust for 15 years. Assume further an annual return, net of federal tax, of four percent. In this scenario, that original $6 million savings from the NING trust will equal $10,805,661. Without the NING, this significant sum would not be available to the taxpayer or other beneficiaries
The foregoing “big hit” example is not the only instance in which the NING Trust may prove appealing. Suppose the Cal Investor’s brother, LA Larry, who is single and earns $450,000 per year, contributes $10 million worth of inherited securities to a NING. The securities average an eight percent return each year, or $800,000. The trust will accumulate this income for 15 years. Each year’s income will incur roughly $80,000 in California income tax, based on the 2018 rate table, which is adjusted for inflation. Assuming a net return after federal tax of five percent on these taxes saved annually, at the end of 15 years, there will be an accumulated savings of $2 million that otherwise would not exist. The NING enables this result and does so without requiring LA Larry to surrender any real access to the assets should he need them.
[Editor’s Note: Learn more about protecting your assets in the webinar Estate Planning & Asset Protection in an Hour. Or, get up to speed on The Legal & Tax Aspect of Investing: Asset Protection; Estate Planning, and Tax Efficiency.]
As the “Big Hit” and “Steady Accretion” examples demonstrate, the NING Trust is a powerful vehicle for preserving and increasing wealth for people who are subject to high state income taxes. Every situation differs, and a particularized analysis is required before choosing the NING route. Still, for many tax-burdened individuals, the non-grantor trusts may be the perfect remedy.
[Editor’s Note: This article is an updated version of an article first published by Financial Poise on September 9, 2015.]
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Senior Vice President, Wealth Management & Relationship Manager, First American Trust of Nevada, LLC
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