IRS Approves Shifting Investment Income From High Tax State to Non-Tax State Without Having to Change Your Tax Residency
Dear Clients, Colleagues, and Friends,
Many of our readers live in a high income tax state and have been considering moving to a low or no income tax state. If you live in California as I do, you saw your state income tax rate retroactively rise by 30% to 13.3%. Many of the California residents are fed up and are getting ready to call “Mayflower Van Lines.”
If you live in one of the higher income tax states, such as CA, IL, NJ, and NY, to name a few, based on a very recent Internal Revenue Service Private Letter Ruling (PLR) 201310002, you can remain where you are and move your investment portfolio and the income it generates to Nevada, a zero income tax state.
This PLR, which was released on March 8, 2013, involved the formation of a Nevada Incomplete gift Non-Grantor trust or so-called NING Trust where the investment portfolio assets of the taxpayer were transferred to a Nevada asset protection trust and established in such a manner as to qualify for non-grantor trust status. Since the NING Trust will be treated as a NV resident for income tax purposes, and since NV is a non tax state, none of the taxable income earned in the NING Trust will be subject to tax in the state of the grantor of the trust, unless and until distributions are made to the trust beneficiaries. If the beneficiaries happen to reside in a low or no income tax state at the time of the distributions, the income tax treatment may be very well managed.
The differences between grantor and non-grantor trusts are as follows. For income tax purposes, a grantor trust is a “disregarded entity” and the income of the trust is reported on the grantor’s personal tax return. A non-grantor trust is treated as a separate taxpayer and reports the trust income separately. Thus, a non-grantor trust established in a non-tax state like Nevada will pay federal income tax on its investment income, but will not pay state income tax.
A brief example should help convey the potential savings of this plan. Assume a taxpayer had a five million dollar investment portfolio that earned a modest $250,000 (5%) income in interest, dividends, and capital gains each year. If that individual lived in a 10% income tax state, and the assets were held either personally or by a grantor trust, all income would ultimately wind up being attributed to the individual. Therefore, in addition to the Federal income tax, a state tax of $25,000 would be due. However, if that individual instead created a Nevada non-grantor trust to hold that investment portfolio, the trust would pay the Federal income tax on the accumulated income, but no state income tax would be due. Therefore, the taxpayer could reinvest the saved $25,000 back into his or her investments for additional growth.
It should be noted that one common tax advantage of the grantor trust is that it avoids the compressed Federal income tax brackets of the non-grantor trusts. Non-grantor trusts hit the maximum Federal income tax rate of 39.6% on any income above $11,950. Individuals and grantors of grantor trusts will not hit that rate until they have income above $400k as an individual taxpayer, or $450k if married. Therefore, a proper analysis should be made to determine whether the state tax savings through a NING Trust could potentially outweigh these compressed rates.
To engage in this income tax planning strategy, you must comply with several requirements. First, the trust must be a self-settled trust, which will allow the trustee to make distributions to the grantor. Secondly, as mentioned, this trust must be a non-grantor trust so that the state in which the grantor lives won’t be able to assert state income tax on income earned by the trust. Otherwise, as discussed, the income would “flow through” to the grantor. Lastly, in order to have the transfer of the portfolio deemed incomplete for gift tax purposes, the grantor must be given some form of power of appointment, and this is where the fine-tuning and the important guidance of PLR 201310002 comes into play. What was once unsettled ground, in terms of what power the grantor must retain in order for transfers to a trust to remain an incomplete gift, has now been determined by PLR 201310002. This PLR has confirmed that a transfer to a Nevada1 incomplete gift non-grantor (NING) Trust, using a lifetime special power of appointment, standard limited to distributions for Health, Education, Maintenance and Support, will be deemed incomplete for gift tax purposes. Moreover, this PLR has confirmed that the NING Trust is a non-grantor trust for income tax purposes. It is important to note that Nevada is the only state that has a specific statute that allows the lifetime power of appointment without allowing creditors to attack the assets of the trust.
So, for our readers who derive their income from investments and want to continue to enjoy the California warm weather and beautiful beaches, stay in California or your other high income tax state and just move your investments into a NING Trust to save state income taxes. In addition to the income tax benefits, your portfolio assets will enjoy unparalleled asset protection in these very litigious times. It is not a perfect solution (as you will still owe federal taxes), but it will help with those high tax states. Each year you delay doing this, the state income taxes you pay will not be able to be recaptured.
Contact the law firm if you want further information on the NING Trust or wish to have one created.
1 Nevada is the only jurisdiction where the IRS has expressly ruled the trust may be established to qualify in this fashion. It formerly ruled favorably in the case of a DE trust, but subsequently reversed its position.