Even with the increase in the overall cap on state and local tax deductions in last summer's tax and spending megabill, planning to minimize the effects of state-level income taxes remains essential.

Notably, the legislation includes phaseouts limiting the value of the expansion for higher-income taxpayers. Little can be done with respect to state-sourced income, but important planning opportunities exist for clients with investment assets such as dividends and interest that generate significant income.

This also applies to clients who expect to experience a liquidity event. Incomplete gift non-grantor trusts can be a valuable tool to shift taxes on investment income from an individual in a high-income tax state to the trust in a no-tax state. Despite the value of these complex structures, it's also important to exercise caution when using INGs to reduce taxes — and to understand the potential pitfalls.

INGs: The Basics

Because INGs are non-grantor trusts, they're taxed separately from the grantor and are treated as an entirely separate entity for income tax purposes. By establishing the trust in a state with no income taxes, the grantor can move the income from their high-tax home state. Delaware, Wyoming and Nevada are common locations for INGs.

While income on assets transferred to the trust is taxed to the trust, not to the grantor — essentially removing that income from the high-tax state — the assets remain in the grantor's estate for estate tax purposes. The "gift" of assets to the trust is intentionally rendered incomplete because the grantor retains certain powers over the trust. The grantor's estate and gift tax exemption and exclusions are not affected by the transfer of assets to the trust.

It's common for donors to retain the power to revest title in the property to themselves or be able to name new beneficiaries or change beneficiaries' interests. ING grantors often retain power to veto or approve trust distributions. These and other retained interests allow for non-grantor treatment — with the trust being taxed as an independent entity — while keeping the trust assets in the grantor's estate.

To ensure non-grantor trust treatment, authority over distributions is given to an adverse party because a grantor trust and the grantor are treated as a single taxpayer.

Potential Drawbacks

Taxpayers should understand that the ING strategy is useful for minimizing tax liability only with non-sourced income — typically, investment gains. INGs cannot be used as tax shelters for a taxpayer's wages or income for services performed by the taxpayer.

Similarly, the trusts cannot eliminate taxes on income that can be "sourced" to the taxpayer's home state. One such example is income from real estate investments within that home state.

Taxpayers should also evaluate state laws that apply to their home state. New York and California, for instance, have passed laws to treat INGs as grantor trusts for state tax purposes — essentially eliminating the state tax benefits of the trust.

As such, the ING strategy is most advantageous for clients expecting large capital gains and other liquidity events that cannot be "sourced" to their home states. Taxpayers with significant marketable securities or long-term stock holdings may find INGs particularly valuable.

ING owners should also be cautious about taking distributions from the trusts. The ING could be reclassified as a grantor trust under IRC Section 674 if the owner takes distributions without approval from an independent trustee or power-of-appointment committee.

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