Uncle Sam isn’t the only one raising taxes. Some states are increasing rates in a bid to boost revenues. California, for example, lifted state income tax rates last year so that high-income taxpayers will owe as much as 13.3%—and the new rates apply to capital gains as well as ordinary income. Taking federal and state obligations together, some clients may face marginal rates of over 50%.
That means advisors with high-bracket clients might want to suggest a state tax shelter rather than a federal one. And one innovative type of trust structure that has been around for a decade has started to draw more attention.
These trusts are generally known as Delaware Incomplete Gift Non-Grantor trusts, or “DINGs,” nicknamed for the state that popularized them. Such trusts are now offered in several other states, including Alaska and Nevada. Delaware, for example, does not impose income or capital gains taxes that accumulate in a trust for ultimate distribution to out-of-state beneficiaries. Nor are the contributions to this type of trust considered federal taxable gifts. The upshot is, if a client lives in a state that does not hold resident grantors responsible for trust income, that client may not owe state tax on income from a DING- on NING-type trust.
Clients could transfer their investments to these vehicles, and perhaps avoid state income tax on any investment income that’s generated.
Vince D’Addona, senior consultant in the New York City office of Strategies for Wealth, a Guardian Life agency, says Delaware has largely owned this market until recently, thanks to the promotion by the state, well-known for its favorable business climate. But now, he says, a new ruling from the IRS has “sealed the deal” for the state of Nevada, opening the door for a “NING” trust.
Steve Oshins, a trusts and estates attorney with Oshins & Associates in Las Vegas, handled the Nevada state law review for the trust covered in the favorable IRS ruling. He says these trusts work best for clients with investment portfolios of $5 million and up, while D’Addona puts the figure at merely $2.5 million.
In any case, for the right clients, the long-term benefits can be enormous, Oshins says.
Suppose, for example, that a client transfers a $5 million investment portfolio to such a vehicle. Say that his portfolio yields $300,000 (6%) of taxable interest, dividends and capital gains each year. Further suppose that his home state has a 10% income tax rate for high-bracket taxpayers, but the home state does not hold resident grantors responsible for trust income.
That would allow the grantor to avoid a 10% tax on that investment income, saving him $30,000 per year, as long as the trust is in a state that does not tax trust income.
“If [the grantor] can reinvest the annual tax savings at a 6% after-tax rate of return,” Oshins says, “the savings would grow to over $1 million after 20 years.” This amount could be much higher if the grantor funded the trust with low-basis assets that would later be sold by the trust, Oshins adds, though care would be needed in disposing of the appreciated assets.
Indeed, careful planning is vital to the DING/NING strategy. Such a trust can’t be a grantor trust. If so, the trust creator would be taxed on trust income. To form a non-grantor trust, and thus avoid state taxation, the grantor must be willing to give up some control over the trust’s assets.
At the same time, wealthier investors wouldn’t want to give up too much control over the transferred assets. Not only would it mean relinquishing their hold on millions of dollars, but they might trigger gift taxes if the transfer of the assets were considered to be a completed gift. In legal lingo, a trust that clients are likely to accept could be “self-settled,” meaning that the grantor can receive distributions from the trust.
Send In The Clouds
Several IRS private letter rulings issued from 2001 to 2007 upheld the DING concept, but the agency seemed to reverse course in 2007, announcing it was re-examining its position on these trusts. It issued another ruling in 2012, indicating that a transfer to such a trust was not an incomplete gift, which dropped a cloud of uncertainty over DING trusts.
But five new private letter rulings in 2013 offered hope. According to Oshins, the main ruling said the petitioning grantor could distribute assets from his trust to specific recipients (his sons), using a “HEMS standard.” That is, he could distribute to his beneficiaries amounts deemed “advisable” for his four sons’ health, education, maintenance and support. Such language is commonly used in trusts for estate tax exclusion. The IRS ruled that the trust was a non-grantor trust for income tax purposes and that the transfers were incomplete for gift tax purposes. Those decisions cleared the way for the promised state income tax benefits. In four related rulings, the IRS ruled (happily) that the distribution committee members (the four sons) don’t make gifts when they distribute trust assets.
Private letter rulings, of course, apply only to the taxpayers requesting them. However, the fact that the IRS issued five rulings with similar findings indicates that DING/NING trusts can be valid, as far as the IRS is concerned, if they’re well-drafted and conform to those approved in these rulings.
What’s more, in a private letter ruling, the IRS applies federal law; DING/NING trusts are designed to reduce state income tax. If Client X, a New York resident, sets up such a trust in Nevada, why wouldn’t New York seek state income tax on trust investment income from X? “It’s true,” says Oshins, “that an IRS PLR doesn’t bind the state. However, most states follow the federal grantor trust rules. If the IRS finds that a trust is a non-grantor trust, it would likely be the case that the state would find similarly.” Thus, the grantor would not be taxed on the trust income at home state tax rates.
In Oshins’ view, the attractiveness of these trusts will depend on the client’s home state. California, New York, New Jersey and Hawaii are among the states with laws that could permit their residents to use these trusts without incurring state income taxes.
The recent private letter ruling also makes Nevada the preferred jurisdiction now for setting up such a trust, he contends. “Other states could change their laws if taxpayers are unable to obtain favorable PLRs,” he says, “but time would be lost while waiting for any changes.”
Oshins hastens to add that setting up a NING trust in Nevada doesn’t mean that advisors will have to relinquish the management of their clients’ portfolios. “We work with local trust companies, which could serve as trustee, while the advisor can continue as asset manager.”
Exceeding The Expenses
D’Addona, for example, says he has had some experience working with trust companies in Nevada, which offer “open architecture” to advisors who manage trust assets. “There will be substantial up-front costs to this type of trust,” he says, “so the key is to save enough in state income tax in the first year to offset those expenses. Going forward, the administrative charges won’t be great, and the client can have those tax savings every year.” The tax savings, D’Addona adds, might be loaned to another trust, which could buy life insurance, or otherwise just accumulate in the incomplete gift non-grantor trust.
D’Addona says that he would definitely consider such a trust for appropriate clients.
But even those who agree insist it’s vital that this vehicle be suitable for a client. “The case for these trusts is more compelling now, since the  PLR was published, but I’d like to see more support,” says Rob Anderson, an advisor with Private Ocean, a wealth management firm in Walnut Creek, Calif. Additional IRS rulings or court decisions would help, he adds.
He notes that the technical requirements for creating an acceptable incomplete gift non-grantor trust are onerous, and that California law creates some additional obstacles. “I’ve never seen a client with the right set of facts and circumstances to justify using this type of trust,” he says, “but I would look into it if I had that client.”
Clay Stevens, a principal and director of strategic planning in the Los Angeles office of wealth management firm Aspiriant, echoes the sentiment about California. “We have looked at [the trusts] for several clients, but we haven’t used them previously for various reasons,” he says, “primarily because they don’t work well to avoid state income tax for California clients.” According to Stevens, for trust income to avoid the state’s income tax, a trust must meet certain restrictions that apply to trustees and beneficiaries. Even if those hurdles can be cleared, withdrawals might be taxed.
“It’s not easy to do,” Stevens says, “and it’s hard to sell to clients, if the benefits are not secure. From what I’ve heard, these trusts may be more likely to work for clients in some other states, such as New York.”
All that being said, Stevens goes along with the conclusion that the 2013 private letter rulings make DING or NING-type trusts more appealing than they were. “I would consider them for clients who want the possible benefits and would be willing to jump through all the hoops,” he says. “With state income taxes higher now, there’s more interest in reducing those taxes. I think we’re going to see a lot of different techniques designed to cut state income tax for high-income clients.”