The passing of the Tax Cuts and Jobs Act elevates the need for residents of high income tax states to capitalize on planning opportunities. The $10,000 federal deduction cap on state and local taxes, inclusive of property taxes, means most business owners who own homes in California, or any other high tax state, are at a significant tax disadvantage. The use of a Nevada Incomplete Gift Non-Grantor Trust, or “NING”, may be the ointment to take away some of that tax sting.
In general, income tax is imposed based on your residency. A California resident is subject to California income taxes and a New York resident is subject to New York income taxes. The same is true for certain irrevocable trusts, like the NING, which are subject to and pay income taxes, just like individuals.
NINGs are unique so don’t think that any trust will do the job. First, the NING must be deemed a separate and distinct entity for income tax purposes, which is different from most trust planning. Your standard revocable living trust is taxed to the person who established the trust. Many other irrevocable trusts are also taxed to the person who established the trust or to the beneficiary. They are not separate and distinct taxpayers.
Second, the NING must be deemed owned by you for estate tax purposes, which, again, is different from most irrevocable trust planning. More often than not trust planning aims to remove assets from your estate for estate tax purposes, but the NING does the opposite. As a result, you can fund the NING easily without incurring gift tax or using installment sales.
Third, the NING must carefully navigate the state’s residency rules. While Federal law will primarily determine whether the trust is a separate legal entity for tax purposes, and therefore the same rules apply to everyone, each state will apply its own residency rules. Both issues play a key role from a planning standpoint and no other trust addresses these issues like a NING.
NINGs are designed to be subject to Nevada income tax. Nevada has no income tax. So it follows that if assets in NINGs generate income, that income will not be taxed by the state of Nevada.
The next question is whether or not you, or the NING, will be taxed by the state in which you reside. The answer depends on your state’s residency rules and, in most cases, the source of the income. A specific analysis of the asset producing the income is required and the principals governing the determination are far too broad to cover in this concise memo. Suffice it to say that you will not implement or use a NING unless it can and does avoid the income tax of the state in which you reside.
So, when should you use a NING and why would you use a NING over an alternative trust structure? A NING will help you if any of the following apply:
- You reside in a state with a high income tax rate;
- You anticipate or regularly generate significant long-term capital gains;
- You desire to retain the possibility of using or enjoying the benefit of income producing asset(s); and
- The value of the assets you intend to transfer in trust exceeds your gift tax exemption or you otherwise do not desire to use the gift tax exemption.
A proper and valid NING is precision driven and must be drafted with the utmost care and expertise. It requires a trust agreement containing unique provisions, the formation of a committee responsible for directing distributions from the trust (aptly named the “Distribution Committee” which is more fully discussed below) and a Nevada trustee (such as a Nevada Trust Company or Bank).
A NING may be established at any time but special consideration should be given if you intend to liquidate the assets the NING will own shortly after formation. Certain actions may cause the transfer to the NING to be set aside and the tax planning eliminated. If a sale is contemplated, additional planning may be required.
Although all the essential elements are equally important, the Distribution Committee requires special focus. Individuals that serve on the committee must also be beneficiaries of the Trust. Normally our clients name children as beneficiaries, but this is not a requirement. If all of your children are minors, special arrangements must be made for a Guardian Ad Litem to represent the children until they reach the age of majority.
Distributions from the trust are subject to the discretion and the agreement of the committee members. Any amount, at any time, may be distributed back to you, so long as a majority of the committee members agree.
The following examples illustrate how the distribution committee functions:
Example 1: Adult Children
Client and spouse have three adult children. Client, spouse, and all three children are identified as beneficiaries of the NING. If Client and spouse both serve on the distribution committee, at least two adult children must serve on the committee at all times. Client and spouse may authorize distributions to the adult children at any time without the approval or consent of any person. However, distributions to Client or spouse require the consent of both adult children serving on the committee. The committee members may change from time to time.
Example 2: Minor Children
Client and spouse have two children, one of which is 16 years old. Client and spouse and both children are identified as beneficiaries of the NING. If client and spouse both serve on the distribution committee, both children must serve on the committee at all times. Because one child is a minor, and because that child should not be represented by the Client or spouse (the child’s parents), Client petitions a Nevada court to appoint a Guardian Ad Litem (“GAL”) for the minor child to represent the child’s interests under the NING. Subject to court approval, Client may propose that a friend or relative represent the minor child. After court approval, the GAL represents the minor child on the distribution committee. Client and spouse may authorize distributions to the children at any time without the approval or consent of any person. However, distributions to Client or spouse require the consent of the adult child and the GAL. When the child turns 18, the Guardian Ad Litem terminates and that child represents him or her self on the distribution committee.
We recommend that all our clients residing in states with high income tax rates (e.g. California, Oregon, Minnesota, New Jersey, to name a few) consult with us to determine if a NING will reduce their income tax burden. The costs to forming and maintaining a NING vary based on the NINGs complexity. In addition to the legal formation fees, if you hire a professional trustee, he, she, or it will charge an annual fee. These charges will more than pay for themselves in the form of a significantly reduced tax bill, year and after year.