Authored by Sean C. Tannenbaum
It is no secret that California has some of the best weather and the worst taxes in the United States. For some Californians, weather is enough of a reason to stay. For others, taxes are enough of a reason to leave. As a lifetime California resident myself, I’ll gladly pay the sunshine tax when necessary. But fortunately, I don’t always have to thanks to an estate planning tool known as the Nevada Incomplete-Gift Non-Grantor Trust (NING for short). And, with the exception of some states such as New York, the NING can similarly help residents of other high income tax states as well!
A NING is a popular trust used to defer (and in some instances eliminate) state income taxes on the sale of certain appreciated assets such as stocks and cryptocurrency.
To understand how a NING works, it is helpful to start with an overview of how the federal government and various state governments tax the sale of appreciated assets. Therefore, the first Section of this article covers general concepts of taxation and the different ways governments tax the sale of appreciated assets. The remainder of this article focuses on the NING. Section II explores the NING structure and how it works; Section III identifies common pitfalls in NING planning to watch out for; and Section IV addresses common questions clients often have about the NING structure.
This will be published in installments, beginning with Sections I and II. Sections III and IV will each be published separately in subsequent editions of the Lobb Report.
Before understanding how a NING can help reduce taxes on the sale of appreciated assets in high-tax states such as California, New Jersey, and Oregon, it is first necessary to understand how these sales are generally taxed at the federal and state level.
Taxes due on the sale of an appreciated asset is always a function of two things: the gain on the sale and the applicable tax rate applied to that gain.
Taxes = Gain x Tax Rate
Gain is likely a familiar concept. It is used to quantify the increase in the wealth of an individual who holds property that has appreciated in value. A cornerstone of the American taxation system is that during life, people should be taxed on their annual earnings rather than their net worth. Therefore, when an individual sells an appreciated asset, that person is not taxed on the total sales price, but rather on the gain from the sale. The idea is that the money used to acquire the property has already been taxed, thus only the increase in the value of the property—the gain—should be subject to tax. Gain (or loss) is equal to the difference between the Sale Price and the Purchase Price plus Certain Costs (e.g., costs associated with the acquisition and improvement of the asset). The sum of the Purchase Price plus these Costs is known as Basis.
Gain = Sale Price – Basis
The applicable tax rate is a less straightforward concept, in large part because it varies significantly from government-to-government. At the most basic level, the tax system of any democratic government represents the People’s negotiated consensus about the essential functions of government, their associated costs, and where the money should come from to pay these costs. It is in determining this last point that we get the various rates of taxation, which are applied to various types of people doing various types of things. As one might imagine, each government’s taxonomy of the relevant types of people and economic activities is different, and they are, almost invariably, complicated. Fortunately, to understand the NING, we need only discuss the taxation of capital gains by the federal government and various states.
At the federal level, the tax rate applied to capital gains depends, first and foremost, on how long an investment is held. The sale of an asset held for less than one year (i.e., short-term capital gains) is treated as ordinary income and taxed at a top marginal rate of 37%. The sale of an asset held for at least one year (i.e., long-term capital gains), on the other hand, receives preferential tax treatment and is taxed at a top marginal rate of 20%.
In addition to these federal taxes, a state may also impose its own tax on capital gains. Currently, eight states do not impose any tax on capital gains. These include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming. The remaining states all impose some form of tax on capital gains, which ranges from a top marginal rate of 2.9% (in North Dakota) to 13.3% in California. Unlike the federal government, most states, including California, do not differentiate between short-term and long-term capital gains.
Because of this disparity in tax treatment of capital gains (and other types of income), many high-net worth families have made the decision to migrate outside of high-income tax states to low-to-no income tax states like Florida, Nevada, and Texas. But why move to Nevada when you can have a trust move there for you? That’s where the NING comes in!
As the name suggests, there are three relevant features to a Nevada Incomplete-Gift Non-Grantor Trust.
- Non-Grantor Trust. Under the grantor trust rules found in Internal Revenue Code §§ 671 – 679, every trust is classified as either a grantor trust or a non-grantor trust for income tax purposes. The difference between these two classifications hinges on how the trust’s annual income is taxed—to the person who established the trust (i.e., the grantor) or to the trust itself—and the different tax rate schedules applied to individuals as opposed to trusts. Generally, an individual pays less taxes than a trust on the same amount of income. This is true even though trusts and individuals are subject to the same top marginal tax rate of 37% because trusts hit the top marginal rate well before individuals. At the time of the writing of this article, trust income over $13,050 is taxed at the top marginal tax rate. Conversely, for a single taxpayer, the top marginal tax rate is only imposed on income over $523,601. For married couples filing jointly and heads of households, the income threshold for the top marginal tax rate is even higher.
While the grantor of a grantor trust is alive, the trust is not treated as a separate taxpayer and is not subject to the trust tax rate schedule. Instead, the trust’s income is reported on the grantor’s tax return and is subject to the grantor’s tax rate schedule. Conversely, a non-grantor trust is always taxed at trust levels. So why would anyone ever want to set-up a non-grantor trust?
It turns out, the non-grantor trust’s greatest weakness is also its greatest strength. Because a non-grantor trust is treated as a separate taxpayer, independent of the grantor, it is often subject to the laws of the state in which the trust was established, rather than where the grantor resides. Thus a grantor living in a high income tax state like California can establish a non-grantor trust in another state, such as Nevada, thereby gaining access to some of the advantageous tax laws of that state. Under a doctrine known as mobilia sequuntur personam (the rule of mobilia for short), intangible assets such as stocks and cryptocurrency, are subject to the laws and jurisdiction of the state in which the owner of that property resides. Thus, under this doctrine, stock held by a California resident and sold by that California resident is subject to the laws (and taxes) of California. Conversely, stock initially held by a California resident, who then transfers the stock to a NING (which is deemed a resident of Nevada), which then sells that stock is subject to the laws (and taxes) of Nevada.
It is important to bear in mind, however, that states do not always adhere to this general rule. While some high-tax states do not tax non-grantor trusts established outside of their borders (subject to certain exceptions), other states, such as New York have passed special laws to eliminate the tax benefits of establishing a non-grantor trust in no-to-low income tax states. Moreover, even in states like California that do allow the use of NINGs, there are several pitfalls for the unwary that can subject a non-grantor trust, established outside of California, to California income taxes. Such pitfalls are the subject of Section 3 of this article, which, as aforementioned, will be published in a subsequent installment.
To qualify as a non-grantor trust—while still providing the client with access to the funds in the trust—a NING has special provisions which provide for a Distribution Committee tasked with approving distributions to trust beneficiaries. This differs from most trusts in which a Trustee is given the sole and absolute discretion to make distributions. There must always be at least three members on the Distribution Committee and the grantors can never compose a majority of the Distribution Committee. Moreover, a distribution to a grantor beneficiary must be approved by a majority of the Distribution Committee, and a distribution to a non-grantor beneficiary must be approved by the then-living grantor(s).
- Incomplete-Gift Trust. Internal Revenue Code §§ 2035 – 2038 define whether a gift is treated as complete or incomplete. Effectively, a gift is not complete unless the grantor gives up the right to use or control the property (including income from the property) and the right to revoke, modify, or reclaim the gift. This concept is important for two reasons—the transfer tax and the step-up in basis.
- In addition to income taxes, there is another class of taxation relevant to the NING—the transfer tax. Also known as the gift tax or death tax, the transfer tax applies to the transfer of wealth from one individual to another by gift, inheritance, or testamentary bequest (i.e., a gift made in a will or trust). At the time of the writing of this article, the top marginal tax rate for the transfer tax is a whopping 40%, however, the transfer tax only applies to transfers in excess of the “basic exclusion amount”. Currently, the basic exclusion amount is set at twelve-million and sixty-thousand dollars ($12,060,000). This means that an individual can accumulate and transfer (by lifetime gifts or upon death) up to twelve-million and sixty-thousand (post-income-tax) dollars ($12,060,000) without owing any money in transfer taxes. However, transfers in excess of the basic exclusion amount (whether made during life or after death) are subject to the transfer tax. Consequently, estate planners often recommend that their ultra-high net worth clients transfer assets that are expected to significantly appreciate during a client’s lifetime to a completed gift trust such as an Intentionally Defective Grantor Trust (IDGT), thereby removing the future growth of the asset from the client’s taxable estate and reducing the client’s future transfer tax liability. This is called an estate freeze and will be the subject of a future article. Completed gift trusts are a relevant comparison when discussing incomplete-gift trusts, however, because while completed gifts can be a useful tool when planning for ultra-high net worth individuals, completed gifts also have a significant drawback for individuals holding properties that have already significantly appreciated.
- One of the great advantages of using an incomplete gift trust, as opposed to a completed gift trust, is that the assets in an incomplete gift trust get a step-up in basis to fair market value upon the death of the grantor under Internal Revenue Code §1014. Considered by many tax experts to be the most advantageous tax provision in the Tax Code—including the late Marty Ginsburg (husband of former Supreme Court Justice Ruth Bader Ginsburg)—Section 1014 allows those who receive appreciated property from a decedent to adjust the basis of the property to the fair market value of the property at the time of the decedent’s death. Thus, the recipient of the decedent’s appreciated property can sell the property at a gain without paying any capital gains taxes. Conversely, if the decedent sold the property a day before his passing, he (or more precisely his estate) would owe capital gains taxes on all of the gain from the sale. Typically, the step-up in basis is not a big consideration when preparing a NING, given that clients interested in a NING are interested in selling highly appreciated assets during life—presumably to enjoy the proceeds of that sale before death—yet it nonetheless a feature of the NING worth keeping in mind.
- Nevada and Asset Protection. By appointing an independent Nevada Trustee and establishing a NING under the laws of the State of Nevada, the grantor of a NING not only benefits from the advantageous tax laws of the Sagebrush State, but also its robust asset protection laws, which are considered to be amongst the best in the country and which has been the subject of several previous articles published in the Lobb Report (https://www.lobbplewe.com/nevada-asset-protection-trust/).
We recommend NINGs to most of our clients living in high income tax states with appreciated stocks, cryptocurrency, and certain other intangible assets. The costs to forming and maintaining a NAPT vary based on the NAPTs complexity. In addition to the legal formation fees, if you hire a professional trustee, he, she, or it will charge an annual fee. If you or anyone you know is interested in further discussing the benefits of a NING, please do not hesitate to contact us directly at the contact information provided on our website (https://www.lobbplewe.com/).