19 August 2017

Trusts That Can Trim State Income Tax

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These trusts may have funny-sounding names, but for some high-net-worth individuals, they are serious tax-minimization tools. Known as incomplete nongrantor trusts, they are often formed in Delaware, Nevada and sometimes Wyoming, hence their acronyms “DING,” “NING” and “WING.” Those states are chosen because they don’t tax the income of trusts established there, even by people who live elsewhere, or have favorable tax rules.

In a typical scenario, an individual would put into the trust an asset or assets that already have gone up a lot in value or that he or she hopes will appreciate sharply, such as shares in a private company that plans to go public. The aim is usually to sell the securities, at which point federal tax would be due—but not state tax. Alternatively, the trust could be used to hold assets that throw off a lot of income each year, sheltering that income from state tax. At some point, the dollars in the trust would typically be distributed to the person who created the trust and other beneficiaries.

Advisers say the strategy is especially in demand with residents of California and New Jersey, where top marginal income-tax rates are 13.3% and 8.97%, respectively. One risk is that additional states could negate the tax benefits for their residents.

To see the benefits of a DING or related trust, consider an example from Suzanne Shier, the chief tax strategist at Northern Trust, of a hypothetical individual who has a $10 million asset he originally acquired at a $1 million cost basis. He wants to sell it, but lives in a state where the tax is 10%.

If he puts the asset in a DING trust and then sells it, he avoids a state-tax bill of $900,000. He would still owe $2,142,000 in federal tax, assuming the top capital-gains rate of 20% plus the 3.8% surtax on net investment income. The assets remaining after the federal tax bill was paid would be $7,858,000 compared with $6,958,000 if it weren’t in a DING trust.

To pull this off, a little legal maneuvering is needed, because the trust has to accomplish two things. It has to be designed so that the individual gives up enough control of the asset to not be considered an owner under federal income-tax rules; that nonowner status is indicated by “nongrantor.” But the individual must retain enough control of the asset so as not to trigger gift taxes.

A gift is considered “incomplete” if the person giving it retains some level of control. With a DING, NING or WING, the individual usually sits on a committee of beneficiaries that has the power to change or direct the distribution of the assets, including making distributions back to him or herself.

Advisers say people contemplating the creation of such trusts should think about timing. If an asset put into a trust is immediately sold and the money distributed back to the person forming it, that is likely to raise red flags with state tax authorities as a sham. But setting up a trust, selling the assets a few years down the road and then distributing them some time after that is less likely to raise negative attention, especially if the person obtains a private-letter ruling from the IRS.

Click here to access the full article on The Wall Street Journal.

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