California wants to crack down on a type of trust that allows millionaires to avoid state income taxes and federal gift taxes. And it's not just the Golden State. Many state officials are targeting a loophole known as an incomplete non-grantor trust (ING). Gov. Gavin Newsom's administration proposed banning the trust in its 2023 budget proposal.
New York passed a similar law in 2014, and the idea is starting to gain momentum in a state where many of its wealthiest citizens use ING to avoid taxes. Below, we delve deeper into this controversy and explain how the ING Trust works.
You can lower your taxes by working with a financial advisor.
California wants to ban ING Trust
Naturally, high-income, high-tax states stand to lose more from tax loopholes for the wealthy. These trusts have also been criticized by some tax policy analysts, who say that, along with the carried interest loophole, they are effectively tax avoidance practices used by the very wealthy. This criticism is further sharpened by the fact that ING trusts are particularly useful only to those seeking to avoid gift taxes, and gift taxes do not apply until the taxpayer transfers approximately $13 million in gross assets.
In 2014, New York state prohibited the use of ING trusts to avoid state taxes. They accomplished this by redefining what New York state considers grantor and non-grantor trusts. Specifically, we updated the Income Tax Act to include income generated by non-grantor trusts funded by incomplete gifts. (Although this conflicts with the IRS's interpretation, the law only applies to New York state taxes, so it does not conflict with any supremacy clause issue.)
California hopes to follow New York's lead. Under Newsom's proposal, states would update their own tax laws based on the Empire State model. The IRS would no longer use the IRS's definition of an incomplete gift and would instead create its own definition of when a taxpayer makes a complete transfer of an asset. As proposed, this change applies to California residents and may leave unanswered questions regarding nonresident taxpayers. Legislators will need to resolve the issue when drafting the actual law.
According to a state news release, the proposal “takes effect starting in tax year 2023 and is projected to increase tax revenues by $30 million from 2023 to 2024 and $17 million annually thereafter.” As of this writing, this remains in the Governor's budget proposal. But Congress appears to have omitted the issue from the text of the budget bill, which is expected to be voted on later this week.
What is ING Trust?
An incomplete non-grantor trust is a special form of trust designed to shift the tax basis of assets. If properly created, the creator does not have to pay state taxes on the assets held in the trust, and at the same time, does not pay federal gift taxes on the underlying transfer. Given the IRS's high gift tax caps, his ING, which is a self-settled irrevocable trust, is typically useful only to taxpayers with very high net worth.
To understand how this works, you need to understand the nature of trusts.
A trust is a legal entity established to hold, manage, and distribute assets. Every trust has three (or more) key parties.
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Grantor – The individual who creates a trust and places assets in it.
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Trustee – The person or company that manages and distributes the assets of the trust.
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Beneficiary – the individual who receives assets from the trust
When you create a trust, you set its terms. This means you can identify who the trustees and beneficiaries will be, how and when its assets will be distributed, and other rules regarding how the entity will function. The trust then becomes an independent third party that can legally own, manage, and distribute the assets.
There are many types of trusts, but for tax purposes they fall into two broad categories: grantor trusts and non-grantor trusts.
grantor trust
A grantor trust is a trust in which you, as the grantor, retain some control over the trust assets. For example, you can authorize yourself to take assets out of the trust. Alternatively, you may retain the right to change the trust's beneficiaries and rules, take loans from the trust, and collect investment income. An entity is considered a grantor trust if it maintains a meaningful standard of ownership or control over the trust's assets in any manner.
With a grantor trust, you pay the trust taxes. The assets are still considered functionally yours, and any income or capital gains generated by the trust are reported on your taxes.
non-grantor trust
A non-grantor trust is a trust in which you, the grantor, have no real control over the trust assets. Although you may maintain a small connection, you have gifted your assets outright to the trust. A trust that is not considered a grantor trust is a non-grantor trust.
Non-grantor trusts pay applicable gift taxes at the time of transfer. The trust itself then pays all applicable income and capital gains taxes as the full owner of the underlying assets.
Incomplete non-grantor trust
ING is a type of trust designed to thread the needle between these two categories. This is a non-grantor trust and the tax burden of the trust's assets is transferred to the trust itself. However, because the funds are funded by a legally incomplete gift, the giver can avoid federal gift taxes while maintaining control of the asset.
A grantor takes three basic steps to set up an ING trust.
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Create a legal trust in a state that does not pay taxes on income and capital gains. This effectively negates any state taxes payable by the trust. Note that this does not affect the federal income tax status of the trust.
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Fund the trust as a non-grantor trust. This transfers the tax basis of any assets into the trust itself and pays taxes in the state where the trust is based (thanks to step 1, this is zero). To do this, the grantor must fund the trust with a gift that effectively relinquishes control and ownership of the assets to the trust.
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Configure the gift as a defective transfer. This is the difficult part of ING. Carefully wording an asset transfer can structure it as sufficient to qualify for non-grantor trust status, but not enough for the IRS to consider it a taxable gift . This is typically done by transferring substantially all ownership rights to the underlying assets, while still retaining limited and specific control over them. A financial advisor can help.
Properly structured, you create a non-grantor trust that assumes all tax liability on the assets you transfer without paying gift taxes on them. Since the trust is based in a tax haven state, it has no debts to the state. While the income and capital gains it generates are taxed, you are left with some control over how those assets are managed.
conclusion
California Governor Gavin Newsom has proposed closing a tax loophole known as an incomplete non-grantor trust. It's a system that very wealthy people use to avoid paying state income taxes and federal gift taxes, and it may soon become less available than it used to be.
Inheritance tax planning tips
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A financial advisor with estate planning experience can help you plan for your future, including ways to minimize future taxes. Finding a financial advisor doesn't have to be difficult. SmartAsset's free tool matches you with up to three vetted financial advisors serving your area. You can also have a free introductory call with an advisor to determine which advisor is right for you. If you're ready to find an advisor who can help you reach your financial goals, get started today.
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There are grantor trusts and non-grantor trusts. There are also revocable and irrevocable trusts, intentionally flawed grantor trusts, lifetime trusts, testamentary trusts, and more. Let's see which one is suitable for you.
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