California has the highest state income tax rate in the nation at 13.3%. Even after diligent tax planning, many individuals pay enormous tax bills every year. If you are one of these people, you may achieve huge tax savings by setting up an Incomplete Gift Non-Grantor Trust, also known as an ING. Through careful planning and administration, an ING is an estate planning tool with the potential to save taxpayers over 50% on their California income tax bill without triggering a taxable gift.
Incomplete Gift Non-Grantor Trusts, or INGs, offer a one-of-a-kind taxation situation in which the transfer of assets to a trust does not constitute a taxable gift for gift tax purposes, but it is considered a gift for income tax purposes. The difference in treatment is possible because the IRS has different criteria for each type of gift.
For gift tax purposes, a gift is considered complete only when the individual funding the trust, also known as the grantor, has given up all control of an asset and no longer has the power to change the disposition of the property. For income tax purposes a gift is considered complete when the grantor has given up sufficient control of an asset. Sufficient control typically means the ability to control income and distribution of income earned by the trust.
Why is any of this important and how does it create tax savings? There are three ways and they often work together to provide benefits to the individual.
First, INGs present an enormous opportunity for state income tax savings. When the trust is established, limited powers are assigned to the grantor, therefore a second trustee must be appointed to receive the remaining powers. In the state of California, fiduciary income taxes are allocated based on the residence of the trustees. If this second trustee is a resident of another state, then up to 50% of the trust’s taxable income may be allocated to the other state. In setting up an ING, you should seek a trustee from a state that does not pay fiduciary income taxes such as Nevada or Delaware in order to minimize state taxes.
Second, an ING allows a grantor to set up and fund irrevocable trusts without paying gift taxes or using up the lifetime gift tax exclusion. In most other situations, funding an irrevocable trust during one’s lifetime creates a taxable gift which either reduces the grantors lifetime exemption or forces the grantor to pay gift tax. Since a transfer to an ING is an incomplete gift for gift tax purposes, no taxable gift occurs. This allows for the creation and funding of an irrevocable trust without the gift tax burden.
Third, an ING is a tool that creates asset protection for the grantor. For legal purposes, the ING is a separate entity from the grantor. This separation prevents the trustor’s personal creditors from having the ability to access the trust funds for collection purposes.
INGs are most beneficial to high net worth individuals who are looking to transfer a considerable amount of assets or assets that will appreciate in value over time into a trust. Since the assets are includible in the grantor’s estate, the assets will receive a step up in basis at death. Additionally, INGs can lead to tax savings for individuals expecting to sell, exchange, or dispose of assets and incur substantial gains. The income earned, however, cannot be sourced to the state of the grantor’s residence since that type of income cannot avoid state income taxes using an ING.
INGs are complex estate planning tools that must follow specific guidelines in order to function correctly. If you are considering creating an ING or are in the process of planning for your estate, it is important to seek professional legal and tax assistance. To determine if creating an ING or other estate planning tools may be beneficial to you, please feel free to contact your L&B professional at (858) 558-9200.