Personal Finance

Rich Californians May Lose Access to This Profitable Tax Loophole

This Estate Planning Tool Can Help Wealthy Households Save Big on Taxes, But Your State May Be Cracking Down

This Estate Planning Tool Can Help Wealthy Households Save Big on Taxes, But Your State May Be Cracking Down

California would like to crack down on a type of trust that lets the very wealthy avoid state income and federal gift taxes. And the Golden State is not alone: A number of state officials have taken aim at the loophole, known as an incomplete non-grantor trust (ING). In its 2023 budget proposal, the administration of Gov. Gavin Newsom proposed banning the trust.

New York state passed a similar law in 2014, and the idea has begun picking up steam in states that have seen many of their wealthiest citizens use INGs to avoid taxes. Below we dive deeper into the controversy – and explain how an ING trust works.

You can work with a financial advisor to lower your tax bill.

California Wants to Ban ING Trusts

This Estate Planning Tool Can Help Wealthy Households Save Big on Taxes, But Your State May Be Cracking Down

This Estate Planning Tool Can Help Wealthy Households Save Big on Taxes, But Your State May Be Cracking Down

Naturally, high-income, high-tax states have a lot to lose from tax loopholes on the wealthy. These trusts have also come under fire from some tax policy analysts, who cite it – alongside the carried interest loophole – as a substantial tax-avoidance practice employed by the very wealthy. This criticism is sharpened by the fact that an ING trust is only particularly useful to someone seeking to avoid the gift tax, which does not apply until a taxpayer has transferred roughly $13 million in total assets.

In 2014, New York state banned the use of ING trusts to avoid state taxes. They did this by redefining what New York state considers a grantor and non-grantor trust. Specifically, it updated its income tax laws to include any income generated by a non-grantor trust funded by an incomplete gift. (While this contradicts the IRS interpretation of the matter, because this law applies only to taxes in the state of New York it has not run afoul of any supremacy clause issues.)

California would like to follow New York’s lead. Under Newsom’s proposal, the state would update its own tax laws based on the Empire State’s model. It would stop using the IRS definition of incomplete gifts and would instead set its own definitions for when a taxpayer has made a complete transfer of assets. As proposed, this change would apply to California residents, which could leave an open question regarding non-resident taxpayers. Legislators would have to resolve that issue when drafting the actual law.

This proposal “which would be effective beginning in tax year 2023, is projected to increase tax revenues by $30 million in 2023-24 and by $17 million annually thereafter,” according to a state news release. At time of writing, this remained in the governor’s proposed budget. However, the legislature appears to have omitted this issue from the text of the budget itself, which is scheduled for a vote later this week.

What Is an ING Trust?

An incomplete-non grantor trust is a specialized form of trust designed to shift the tax base of its assets. If properly created, it allows the creator to pay no state taxes on the assets they put in trust while also paying no federal gift taxes on the underlying transfer. Given the high IRS cap on gift taxes, an ING, which is a self-settled irrevocable trust, is typically only useful for taxpayers with a very high net worth.

To understand how this works, we need to look at the nature of trusts.

A trust is a legal entity set up to hold, manage and distribute assets. Every trust has three (or more) main parties to it:

  • The Grantor – The person or persons creating the trust and putting assets in it

  • The Trustee – The person or firm who manages and distributes the trust’s assets

  • The Beneficiary – The person or persons getting assets from the trust

When you create a trust, you set its terms. This means you can identify who the trustee and beneficiaries will be, how and when its assets will be distributed, and any other rules for how the entity should work. The trust then becomes an independent third party that can legally own, control and distribute its assets.

While there are many kinds of trusts, there are two broad categories for tax purposes: grantor and non-grantor trust.

Grantor Trusts

This Estate Planning Tool Can Help Wealthy Households Save Big on Taxes, But Your State May Be Cracking Down

This Estate Planning Tool Can Help Wealthy Households Save Big on Taxes, But Your State May Be Cracking Down

A grantor trust is one in which you, as the grantor, maintain some measure of control over the assets in trust. For example, you might allow yourself to take assets out of the trust. Or you may retain the right to change the trust’s beneficiaries or rules, to take loans from the trust, or collect its investment income. However you do it, if you keep a meaningful measure of ownership or control over the trust’s assets, the entity is considered a grantor trust.

With a grantor trust, you pay the trust’s taxes. The assets are still considered functionally yours, so any income or capital gains that the trust generates are reported on your taxes.

Non-Grantor Trusts

A non-grantor trust is one in which you, as the grantor, have no meaningful control over the assets in trust. While you might retain some de minimis connection, you have made a complete gift of the assets to the trust. Any trust that is not considered a grantor trust is a non-grantor trust.

With a non-grantor trust, you pay any applicable gift taxes at the time of your transfer. Then, as the full owner of the underlying assets, the trust itself pays all applicable income and capital gains taxes.

Incomplete Non-Grantor Trusts

An ING is a type of trust designed to thread the needle between these two categories. It is a non-grantor trust, which moves the tax burden of the trust’s assets onto the trust itself. However, it is funded with a legally incomplete gift, which allows the grantor to avoid federal gift taxes while maintaining a measure of control over the assets.

Grantors take three basic steps to set up an ING trust:

  1. Create a trust that is legally based in a state with no taxes on income and capital gains. This effectively nullifies state taxes the trust would otherwise be liable for. Keep in mind, this will not affect the trust’s federal income tax status.

  2. Fund the trust as a non-grantor trust. This shifts the tax base of any assets to the trust itself, which pays the taxes of the state in which it is based (thanks to step one, this will be zero). To do this the grantor must fund the trust with a gift that effectively relinquishes control and ownership of their assets to the trust.

  3. Structure the gift as a defective transfer. This is where an ING gets tricky. By carefully wording the asset transfer, you can structure it as complete enough to qualify for non-grantor trust status yet not complete enough for the IRS to consider it a taxable gift. This is typically done by transferring almost all ownership rights to the underlying assets, but still retaining some narrow, specific measure of control over them. A financial advisor can help guide you.

If properly structured, you will have created a non-grantor trust that assumes all the tax liability for its assets without paying gift taxes on the assets you transfer in. Since the trust is based in a tax-haven state, it will owe no state taxes on the income and capital gains that it generates, while leaving you a small measure of control over how those assets are managed.

Bottom Line

California Gov. Gavin Newsom has proposed closing a tax loophole known as the incomplete non-grantor trust. This is a structure used by the very wealthy to avoid paying state income taxes and federal gift taxes, and which may soon be less available than it was before.

Estate Tax Planning Tips

  • A financial advisor with estate planning experience can help you plan for the future, including how to minimize future tax bills. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • There are grantor trusts and non-grantor trusts. There are also revocable and irrevocable trusts, intentionally defective grantor trusts, lifetime trusts, testamentary trusts and many more. Let’s take a look at which, if any, are right for you.

Photo credit: ©iStock.com/rarrarorro, ©iStock.com/Andrii Yalanskyi, ©iStock.com/EXTREME-PHOTOGRAPHER

 

The post California Takes Aim at Tax Loophole for State’s Richest appeared first on SmartAsset Blog.

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