An incomplete gift non-grantor trust, or ING, is a kind of self-settled trust where the grantor’s ownership of the underlying trust assets avoids the creation of a taxable gift while simultaneously maintaining trust ownership of the assets for income tax purposes. This planning structure is useful for shifting income out of states with high income taxes and into states without income taxes, creating considerable tax savings. INGs can also be drafted to take advantage of favorable asset protection statutes in the chosen state locus. The use of INGs is increasing as their benefits become more widely known; this document will explain important facets of these trusts so you can determine whether an ING is right for you.
Drafting an ING
Careful and precise drafting is an essential part of any ING, as it must establish the grantor’s funding of the trust as an incomplete gift while maintaining the resulting trust’s non-grantor status. To make an incomplete gift, an ING usually includes provisions providing the grantor with a retained testamentary power of appointment and a retained non-fiduciary inter vivos power of appointment over principal for the purposes of health, education, maintenance, and support (these uses being known as an “ascertainable standard”). To avoid creating a grantor trust, a distribution committee is used to oversee disbursements of trust income and principal, placing them sufficiently out of the grantor’s dominion and control
The Distribution Committee: Purpose and Composition
Under sections 673-677 of the Code, a grantor is considered to be the owner of a trust if:
- The grantor retains a reversionary interest of 5% or greater in the trust;
- The power to dispose of the beneficial enjoyment of the trust is held by the grantor or a non-adverse party;
- The grantor or a non-adverse party can deal with the trust for less than adequate and full consideration or borrow without adequate interest or security;
- The grantor, the grantor’s spouse, or a non-adverse party has borrowed from the corpus or income of the trust and not fully repaid the loan before the start of the taxable year, excepting loans for adequate interest and security made by a trustee other than the grantor;
- A power of administration may be exercised in a non-fiduciary capacity by any person;
- The grantor or a non-adverse party has the power to revest the title in the grantor; or
- The grantor or the grantor’s spouse has a right to the income of the trust, or distribution of the income of the trust to the grantor or grantor’s spouse is in the discretion of the grantor or a non-adverse party.
The presence of a distribution committee which holds absolute discretion to authorize distributions to beneficiaries and determine the amounts of those distributions serves to avoid triggering these rules. However, to accomplish this goal, it is very important that the distribution committee contain adverse parties. An adverse party is defined in section 672(a) as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. A person having a general power of appointment over the trust property shall be deemed to have a beneficial interest in the trust.”
Because of this adverse party rule, a distribution committee is not precluded from including relatives or even the grantor himself or herself. In PLR 201310002, the IRS examined an instance where the distribution committee of an irrevocable trust was composed of the grantor and his four sons, with the distribution committee dissolving at the death of the grantor or when less than two members remained on the committee. Within this committee, a decision could be reached during the grantor’s lifetime by a majority of the committee members together with the grantor’s written approval, or by a unanimous vote of all committee members except the grantor. Additionally, the grantor had a non-fiduciary capacity to distribute to one or more of his descendants for health, education, maintenance, and support. The IRS ruled that this trust structure still created a non-grantor trust for income tax purposes.
Another issue to be aware of is the issue of related or subordinate parties. When a related or subordinate party is used to control the beneficial interest or administrative powers of a trust, he or she is presumed to be subservient to the grantor and the trust will be regarded as a grantor trust. Under section 672(c) of the Code, a related or subordinate party is defined as:
- The grantor’s spouse;
- The grantor’s father, mother, brother, sister, or issue;
- An employee of the grantor;
- A corporation or employee of a corporation in which holdings of the grantor and the trust are significant from a voting perspective; or
- A subordinate employee of a corporation which the grantor holds an executive position.
The preponderance of evidence must demonstrate the independence of an agent falling under one of these categories for such an agent to be an acceptable choice, an ambiguous and potentially difficult standard to meet. For this reason, it should be carefully considered whether alternatives to related or subordinate parties can be used to fill the distribution committee.
Powers of Appointment
Typically, a non-grantor trust in which the grantor retains no right to the trust property creates a completed gift subject to a gift tax of up to 40% of the gift’s value. To avoid this outcome, the grantor must retain a certain degree of power over the trust. This is accomplished by authorizing the grantor to appoint trust income and principal to members of the remainder interest for health, education, maintenance, and support during the grantor’s lifetime and by providing the grantor with a limited testamentary power to appoint to anyone except the grantor, the grantor’s estate, the grantor’s creditors, or creditors of the grantor’s estate.
For a gift to remain incomplete, the grantor must not lose dominion and control over the gift. The limited testamentary power of appointment, according to PLR 201310002 and CCA 201208026 maintains the grantor’s dominion and control over the remainder interest of the trust. Other rulings indicate that an inter vivos power to appoint the remainder interest for health, education, maintenance, and support will make the term interest an incomplete gift. The ruling in PLR 201310002 also took the grantor’s additional role in authorizing the distributions of the distribution committee (which was composed of non-adverse parties for gift tax purposes) into consideration for its ruling; ING grantors may wish to consider adopting similar provisions.
Funding the ING
All the property in an ING is held and managed by an out-of-state trustee; therefore, it is easiest to use intangible property, such as portfolio investments and LLCs or FLPs holding patents, to fund an ING, as such property is simple to move out of the grantor’s jurisdiction. Interest, dividends, and capital gains deriving from intangible property held by an ING will all be captured in the state where the trust is resident. Tangible property must be considered for ING planning on a case by case basis. Collectibles and artwork will typically need to be transferred to the trustee’s state in order to be taxable in that state. Real estate is not ideal for an ING, as it is typically immovable; however, real estate engaged in a business purpose and held in an LLC or other business entity may be movable for purposes of determining tax nexus.
Delaware, Nevada, Wyoming: The Popular States for INGs
Delaware, Nevada, and Wyoming are the three most used resident states for INGs. All three of them have no income tax on trusts maintained for the benefit of non-residents. Beyond this, though, the three states have their own advantages and disadvantages.
In all three states, an ING may also serve as an asset protection trust provided it meets certain standards. In Delaware, an asset protection trust must be irrevocable, include a spendthrift clause (a clause which prevents creditors from claiming assets from the trust before they are distributed to the beneficiary), and state that its validity, construction, and administration are governed by Delaware law. A Nevada asset protection trust must be irrevocable, make distributions to the grantor subject to the approval of a different party, and either maintain all or part of the corpus of the trust in Nevada or have the services of a Nevada trustee. A Wyoming Asset Protection Trust must be irrevocable, include a discretionary power to distribute to the settlor and be governed under Wyoming law.
When a trust is an asset protection trust, the assets within the trust are protected against creditor claims by a statute of limitations. In Delaware and Washington, this statute of limitations is four years for the claims of future creditors and two years or within one year of discovery for pre-existing creditors. In Nevada, however, the statute of limitations is a more advantageous two years for the claims of future creditors and one year or within six months of discovery for pre-existing creditors.
While Nevada has the advantage in asset protection, Delaware has the advantage in case law. Delaware is one of the longest-running sites for ING planning and a favorable body of legal opinion has been built up within the state. INGs created in Delaware will likely enjoy greater security.
Wyoming lacks the asset protection advantages of Nevada and the case law of Delaware; however, it is a popular destination state, and clients who own vacation property there may find it is the most convenient location for an ING, as they can plan administrative consultations with the trustee around pleasure trips to the area.
South Dakota, Alaska, and New Hampshire also have ING-supportive planning environments. Additionally, states like Tennessee are working towards trust and tax law reforms that will make ING planning more appealing within their jurisdictions.
The Trust Protector
One problem with using an ING as an asset protection trust is that an asset protection trust typically must be irrevocable. However, a trust protector may be included within the provisions of an ING to maintain greater flexibility in the face of changing circumstances. A trust protector is an officer of the trust empowered to change trusees, change the situs of the trust, or even appoint trust assets. Apprised of the grantor’s wishes and intentions, a trust protector can help ensure that the trust does not become an obstacle to other planning and that it can react to changes of law or regulation.
Which States Benefit Most from INGs?
Any grantor who resides in a state that imposes an income tax could potentially benefit from ING planning. However, the burden imposed by some states is much more prominent than that imposed by others.
States with a maximum tax rate over 7% include Arkansas, South Carolina, Idaho, North Carolina, Wisconsin, Minnesota, Hawaii, Maine, New York, Vermont, New Jersey, Iowa, Oregon, California and Maryland, as well as the District of Columbia.
States with a maximum tax rate over 5% include Utah, Massachusetts, Oklahoma, Virginia, Ohio, Rhode Island, Georgia, Kentucky, Louisiana, Mississippi, Kansas, West Virginia, Nebraska, and Montana.
The key to ING planning is not establishing the ING in another state; it is eliminating any tax nexus for the grantor’s home state. Each state has its own rules regarding nexus for trusts, but certain developments bode well for ING planning across all states.
In Illinois, the Linn case struck down the existing state nexus rules for trusts as unconstitutional. Before the case, any testamentary or inter vivos trust created by an Illinois resident was subject to Illinois tax, regardless of whether or not the trust continued to have a connection to Illinois. In Linn v. Department of Revenue, the court considered a trust with no Illinois assets, trustees, or beneficiaries that was still be subjected to Illinois tax and ruled that the trust was outside of Illinois nexus and that taxation of that trust by Illinois was unconstitutional.
In Maryland, income tax paid to another state on income earned in that state was credited against Maryland’s state income tax but not any of its local income taxes. In Comptroller of the Treasury of Maryland v. Wynne, this imposition of local income tax on out-of-state income was found to be an unconstitutional violation of the commerce clause.
It must be noted that both Linn and Wynne had very favorable fact patterns for the tax payer. The closer that the facts and circumstances of any individual case adhere to the situations examined by the court, the more certain the ING’s position is.
Some high-income-tax states such as New York and Pennsylvania have tried to push back against ING planning. Pennsylvania’s attempt to enforce a state tax on a DING trust was overruled in court, but New York’s law treating INGs as grantor trusts are still on the books. California and Connecticut, meanwhile, have relied on extremely strict tax nexus rules to discourage INGs. In California, a trust is subject to California tax if a non-contingent beneficiary interest of the trust is a California resident or if any fiduciary duties are carried out in California. Connecticut’s tax nexus rules take a similar stance to Illinois’ pre-Linn, although it is now less likely that those rules would survive constitutional scrutiny. Surmounting state obstacles such as these is the most crucial step in ING planning.
By establishing a trust that avoids both triggering the grantor trust rules and completing a gift, the burden of state income tax can be minimized without incurring federal gift tax. Shifting the trust assets out of a state with a high-income-tax regime to one with a low income-tax-regime, such as Delaware, Nevada, or Wyoming, requires nuanced planning tailored to the specific trust nexus rules of the grantor’s resident state, but the result can be a substantial benefit for the grantor and his or her heirs.
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