How non-grantor trusts can help clients save big on state income taxes

Here's how to prevent state-level taxes from taking a large bite out of clients' holdings

Jan 20, 2015 @ 5:53 pm

By Darla Mercado

Hoping to save your estate planning clients some money on state income taxes? Try a NING or DING — a Nevada or Delaware Incomplete Non-Grantor Trust.

When it comes to estate planning, it's easy to focus on what's going on federal level with capital gains, income and estate taxes. But state-level taxes can take a relatively large bite out of clients' holdings. Consider the fact that income taxes are 13.3% in California, but in a place like Nevada, there's no income tax. Delaware, meanwhile, doesn't levy income taxes on trusts if beneficiaries reside outside of the state.

In a Tuesday session at the American Institute of Certified Public Accountants' Personal Financial Planning conference, estate planning attorney Steven J. Oshins of Oshins & Associates covered the ins and outs of NINGs and DINGs.

It makes sense that Mr. Oshins, who practices out of Las Vegas, does a good bit of NING work for clients in the Golden State.

“These aren't the only jurisdictions where you can build these trusts, but they are the most popular,” he said.

SAVINGS OPPORTUNITIES

There isn't a great deal of difference between NINGs and DINGs. The biggest distinction is that Nevada has enhanced creditor protection of trusts.

Mr. Oshins pointed to two planning opportunities for these trusts.

The first involves a scenario in which the client is a resident of a state with high income taxes, and he or she contributes a low basis asset to a NING trust based in a jurisdiction that doesn't tax trust income. If the trustee sells the low-basis asset, he avoids state income taxes on the sale.

The second opportunity is a situation in which the client is a resident of a state with high income taxes, and she contributes an investment portfolio to a NING trust. The trustee continues to invest that portfolio and avoids state income taxes on any gain.

This second scenario is something that advisers are more likely to see, noted Mr. Oshins.

In an example illustrating the power of the NING, Mr. Oshins posed a scenario where a client sells a $5 million business and resides in a state with a 10% capital gains rate. Federal capital gains are at 20%, plus 3.8% for the net investment income tax.

The proceeds go into the NING, the client is on the hook for $1.19 million in federal income taxes, but there are no state income taxes — which would've been $500,000 had the client proceeded without the NING.

TAXING SOURCE INCOME

Before weighing this strategy, advisers need to consider the resident's state income tax rules. Many states will tax source income — wages and other pay for services performed in the U.S. “There's nothing that I'm aware of to get around taxing source income,” Mr. Oshins said.

Non-source income is key — that's the income the client is trying to protect from state level taxes with the NING. Get familiar with the rules of the client's state and determine if the NING is permitted. What's most important is to know how the resident's home state taxes trusts: Is it based solely on the residency of the grantor or the settlor? If so, the NING may not work, said Mr. Oshins.

Other states tax trusts based on whether they're administered in that state. Or they might be taxed on whether there are one or more resident trustees living in that state — a potential trap in a state like California.

BINDING RULES

Bear in mind the rules that bind trustees, too.

If you're creating a NING in Nevada, at least one trustee must be a natural person who resides there, a trust company that is organized under federal law or state law to do business there — and it must have an office in that state for the transaction of business.

In addition, the trustee can be a bank that's organized under federal or state law that has an office in that state for the transaction of business, and possesses and exercises trust powers, according to Mr. Oshins.

Another requirement: At least one Nevada trustee must have powers that include maintaining records and preparing income tax returns for the trust. All or part of the administration of the trust must take place in Nevada.

As a result, you probably don't want your client's uncle who happens to live in Nevada act as the trustee. “It makes a lot of good sense to use an actual corporate trustee when drafting these trusts,” said Mr. Oshins.

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