Many methods of income tax planning focus primarily on reducing federal tax liability. Individuals living in high state tax jurisdictions, such as California, also seek to mitigate state income tax.
With some state income tax rates as high as 13.3%, it can be a significant burden for those with considerable income-generating assets. Establishing a NING trust may help reduce the state tax liability.
What is a NING Trust?
A Nevada Incomplete Non-Grantor Trust (sometimes referred to as a Nevada Incomplete Gift Non-Grantor Trust) is a type of self-settled trust. NINGs are drafted under Nevada law and thus receive the premier asset protections of Nevada. A NING is an irrevocable trust created for the grantor’s benefit and often their spouse and descendants.
The NING structure is as follows:
- The trust must appoint a Nevada resident trustee (often, this is a Nevada trust company).
- The trust will have a distribution committee that includes the grantor and other beneficiaries; including two other members at all times. (Minor beneficiaries must have an appointed guardian-representatives on the committee.)
- The gift must be incomplete for gift and estate tax purposes. The assets are considered part of the settlor’s estate and do not require filing a gift tax return. Additionally, the assets receive a step-up in basis upon the passing of the settlor. (See advantages below)
- The transfer of assets to the trust is complete, for income tax purposes, meaning the trust is now the taxpayer.
- Distributions back to the grantor by the distribution committee must not be considered gifts by the members. Instead, it is a return of property to the grantor.
- Gifts to others (not to the grantor) by the committee must be considered completed gifts from the grantor, not by committee members.
Pros and Cons of a NING Trust
While a NING Trust may help mitigate the effect of state income taxes, it is dependent on the assets transferred to the trust. Additionally, NINGs can provide various benefits, beyond state tax mitigation:
Benefits of a NING Trust:
- Taxation: A Non-Grantor Trust is treated as a separate entity from the grantor and reports the income on a separate return. When a Non-Grantor Trust is established in a non-income-tax state, like Nevada, the trust will pay federal tax on the income, but not the state tax. Distributions made to a beneficiary are taxable to the beneficiary if their state of residence employs an income tax.
- Asset Protection: NINGs provide asset protection from creditor claims, between 6 months and 2 years after the trust is established, with certain exceptions related to fraudulent transfers.
- Step-Up in Basis: Assets transferred to a NING trust are considered incomplete gifts, for estate tax purposes, providing a step-up in basis upon the grantor’s passing. It does not trigger filing a gift tax return at the time of funding of the trust.
- Limited Power of Appointment: The grantor retains a limited power of appointment, permitting them to re-distribute the assets upon one’s death.
However, not all grantors, assets, or beneficiaries will be able to derive benefits from a NING Trust strategy.
Disadvantages of a NING Trust:
- Residents of New York will not benefit from a NING strategy. New York law declares that it will treat NING Trusts as a grantor trust, for state tax purposes.
- Beneficiaries receiving distributions will be liable for the income tax on the gains in the year the distribution was received, in the state in which they are domiciled.
- California residents may be subject to a throwback income tax upon the distribution of accumulated income. See the California Throwback Tax consideration below for more information.
How are NING Trusts Taxed?
Ideal assets to contribute to a NING Trust may be intangible assets, such as an investment portfolio or assets intended to appreciate precipitously and may be sold in the future. Funding of the trust should generally come from the grantor’s surplus assets, where the grantor does not need the assets for their primary support.
NINGs are not the best option for every scenario and require thoughtful planning and drafting. Most significant are the considerations related to state income accumulation and state throwback tax rules.
California, for example, may subject accumulated income to a throwback tax, under certain circumstances. Check with your CPA and tax attorney for your state’s requirements.
- Timing of Accumulation and Distribution: Where income has accumulated in the NING and is not subject to California tax in the year of accumulation, it may still be subject to California tax upon the later distribution:
- If the asset was subject to California tax in the year it was earned, the tax will be due upon distribution to a California non-contingent beneficiary.
Example: Privately held stock transferred to the NING appreciates in the same year of transfer; it also sold in the same year, but California tax was not paid. California tax is due upon distribution.
- California Throwback Tax: The rules are specific to the type of asset, date of accumulation, the timing of distribution, and residency of the non-contingent beneficiary.
1. If the asset was not subject to California tax at the time of accumulation, but there was a California resident non-contingent beneficiary, upon distribution to such beneficiary, the throwback rules apply. The distribution will be taxed in the year of distribution based on if the distribution had been made ratably over the number of years preceding the actual year of distribution.
Example: Privately held stock transferred to the NING, appreciates in the following year, is then sold, and subsequently distributed to the California resident non-contingent beneficiary 4 years later; California income tax will be due as if the distribution had been included in the beneficiary’s income over the preceding four years.
2. If the asset was not subject to California tax in the year of accumulation, and the non-contingent beneficiary is not a resident of California, then upon distribution, the distribution would not be subject to California tax.
Example: Privately held stock transferred to the NING, appreciated in subsequent years from the transfer date. The asset is then sold and later distributed to a non-California resident beneficiary; no tax should be due.
Note: If at any time in the preceding years the non-contingent beneficiary had been a California resident, examination of the residency rules must be addressed; throwback rules may still apply.
NING Trust Limitations
To be treated as a NING trust and avoid state income tax, by the grantor’s state of residence, it must be a non-grantor trust, also referred to as a complex trust. The IRS specifically delineates when a grantor will be treated as the “owner” of the trust, for income tax purposes. IRC sections 673-677 state how a grantor may be treated as the owner and would thus undermine the intent of a NING.
Those circumstances are as follows:
1. The grantor shall be treated as the owner of any portion of a trust:
- Reversionary Interest: in which s/he has a reversionary interest in either the corpus (principal) or income of the trust which exceeds 5 percent of the trust value. (see IRC 673)
- Power to Control Beneficial Enjoyment: in which the beneficial enjoyment of the corpus (principal) or the income is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of any adverse party. (see IRC 674)
2. Administrative Power: The grantor shall be treated as the owner of any portion of a trust if the trust allows for administrative control exercisable for the primary benefit of the grantor rather than for the other beneficiaries named in the trust. (see IRC 675) Including:
- a power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control;
- a power to control the investment of the trust funds either by directing investments or reinvestments or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or
- a power to reacquire the trust corpus by substituting other property of an equivalent value.
3. The grantor shall be treated as the owner of any portion of a trust:
- Power to Revoke::Where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party, or both. (see IRC 676)
- Income for Benefit of Grantor: Where the income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be distributed to the grantor, the grantor’s spouse, or applied to insurance premium payments on the life’s of or either of them. (see IRC 677)
In a related section, IRC 678 states that a person other than the grantor shall be treated as the owner of any portion of a trust if such person has the sole power to vest the corpus or the income in himself. Or such person has previously partially released or modified such power and then retains such control which would subject a grantor to treatment as the owner (within the principles of sections 671 to 677.) Meaning, that members of the distribution committee will not be treated as owners of the trust in such circumstances where none of the members have solely exercisable powers. (see PLR 201410002)
Why Choose Alliance Trust Company of Nevada?
Alliance has the benefit of Nevada’s favorable asset protection laws behind it, helping wealthy families from all across the globe. Please contact Alliance today if you believe a NING Trust could benefit your financial plan.
Alliance has been in the trust industry since 2005, offering directed and delegated services on top of being a full fiduciary. In addition, we have relationships with many reputable lawyers, CPAs, and financial advisors that can help you finalize your documents and put your plans into motion.