Have you heard of an ING-teresting trust planning vehicle that can help to reduce or eliminate state income taxes upon the sale of highly appreciated assets? If you live in a high-income tax state such as New Jersey, this trust structure may be particularly appealing to you. Under New Jersey’s new tax code, the top tax bracket, which was previously $5 million of income, now will kick in at $1 million. This means that those earning over $1 million now will see their rates increase to 10.75% on that portion of income. That means that the sale of a highly appreciated asset such as a business, real estate or appreciated stocks may be subject to a 10.75% tax rate.
The Incomplete Non-Grantor Trust (ING) is a trust that walks a fine line between the estate tax code and the income tax code. If structured correctly, it can help to eliminate state taxes generated from the sale of an asset, without giving up lifetime access to the assets. For people who live in high tax states such as New Jersey, these trusts are particularly attractive. Let’s explore how this all works and who it may benefit.
The Incomplete Non-Grantor Trust is a legal document drafted by specialized estate planning attorneys. Once the document is created, a physical trust account can be opened with a trust company and administrator who can domicile the trust in a state that has favorable income tax rules. Nevada, South Dakota and Delaware are often the states of choice because they all have no income tax and they allow for the creation of self-settled asset protection trusts.
Once the account is established, assets can then be re-titled and transferred into the trust. The “incomplete” nature of this transfer into the trust is important from an estate planning perspective. This is not an irrevocable gift, there is a framework built into the trust that allows the trust assets to be distributed back to the grantor at some future point in time. However, the “Non-Grantor” status of this trust is also important from an income tax perspective. Grantor trusts are typically structured so that the income generated within the trust flows back to the grantor’s tax return. In a non-grantor trust, the income stays in the trust and is taxed differently. Since the trust “lives” in a state without income tax, the income generated within the trust avoids state taxation. The trust is still required to pay Federal taxes.
Utilizing these types of trusts certainly add complexity to the sale of an asset. However, the financial benefits of doing so can be significant, especially with a large amount of capital gains involved. For example, assume a married New Jersey business owner sells their business and realizes a $5,000,000 capital gain on the sale. Based on the new tax law, this owner may owe up to $500,000 in New Jersey state income taxes. Proactive planning well before the sale actually occurs, could result in significant tax savings.
The fine print of ING Trusts
ING trusts should be established and funded well in advance of the actual sale of the asset. If both transactions are completed too close in time to each other, a state’s taxing authority may challenge the transaction as a tax avoidance scheme. It is also important to weigh the state income tax benefits versus the federal income tax costs. Non-grantor trusts pay taxes at different rates and breakpoints compared to individuals. For example, for married couples, the top tax bracket of 37% kicks in after $612,351 of income. Trusts, in comparison, reach the 37% bracket at just $12,700 of income. That is a big difference!
Not all states will allow this trust structure either. New York, for example, does not recognize the ING trust and will tax the income. For the time being, New Jersey does permit this planning technique.
After the sale is complete
Assuming this trust structure makes sense and is implemented correctly, what happens to the cash within the trust after the sale is complete? There are a couple of options. First, if the cash is not needed immediately, it can stay in the trust and be reinvested. The new income generated from the reinvested cash will still avoid NJ state taxation. However, if the original grantor of the trust would like to withdraw funds, it must run through what is referred to as the “distribution committee”. The distribution committee is comprised of trust beneficiaries other than the original grantor, who is considered an adverse party. This is a critical feature of the trust so that it can maintain its non-grantor status and avoid NJ taxation. The other trust beneficiaries may include family members, such as adult children or siblings.
Important disclosure information
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