There are many ways to reduce income taxes after selling a business. But those with the luxury and foresight to plan enjoy even more options. For instance, some entrepreneurs with deals in sight might consider an Incomplete Non-Grantor (“ING”) trust. The strategy is designed to eliminate state income taxes on sales proceeds, but it isn’t for everyone. Ultimately, its appeal rests on careful structuring and a thorough understanding of the trade-offs.
DINGs, WINGs, and NINGs
While these acronyms might sound like silverware hitting the floor, they’re actually powerful tools for an eventual business exit. A Delaware Incomplete Non-Grantor Trust (DING), a Nevada Incomplete Non-Grantor Trust (NING), or a Wyoming Incomplete Non-Grantor Trust (WING) are just three avenues for business owners and their families to secure substantial state income tax savings—provided the trust vehicles are properly structured.1
How do ING trusts work? A business owner living in a high-tax-rate state establishes a non-grantor trust—one that’s treated as a separate income taxpayer—in a state that does not tax the trust’s retained income (e.g., Delaware, Nevada, Wyoming, etc.). Notably, the trust must have two critical features:
- the gift must be “incomplete” so that the entrepreneur is treated as owning the trust assets for estate and gift tax purposes, and
- the trust must be a “non-grantor trust” so that the entrepreneur isn’t treated as owning the trust assets for income tax purposes.
This combination allows the grantor to achieve a favorable state income tax outcome without making a taxable gift (Display).
Trust Powers: Knowing When to Hold or Fold
To ensure the transfer to the trust will be considered incomplete for gift tax purposes, the grantor must reserve sufficient power over the transferred assets. Typically, the grantor will retain a power to direct the trustee to distribute the trust’s assets to others.2 If properly structured, the mere existence of this “limited power of appointment” will make the grantor’s gift to the trust incomplete. Relinquishment of the grantor’s power of appointment would complete the gift; for that reason, in most cases, the power will remain in effect during the grantor’s lifetime.
For income tax purposes, limitations on the grantor’s ability to receive distributions of trust assets help ensure qualification as a non-grantor trust.3 Among other provisions, the trust instrument typically will prohibit any distribution to the grantor without consent of a “distribution committee” consisting of a subset of, or all, current beneficiaries.
If the trust meets both requirements—the gift to the trust is incomplete, but the trust is not a grantor trust—then undistributed trust income should avoid state income tax, while distributed income will be subject to income tax in the beneficiary’s home state. Either way, an ING trust is still subject to federal income tax (whether income is accumulated in the trust or distributed to beneficiaries). And, if income is accumulated, the trust must pay those federal income taxes under highly compressed trust tax brackets.
Case Study: Exploring Exit Options
Consider the Riveras, a 60-year-old couple who are planning to sell their business for $30 million. Like many entrepreneurs, most of their wealth is tied up in their business. However, they have set aside $2.5 million in marketable investments, including a $1.5 million retirement account. While they enjoy living in their current state, the prospect of losing 10% (i.e., $3 million) of their sale proceeds to state and local taxes concerns them. The Riveras want to maximize their after-tax proceeds since they’ll rely on the funds to sustain their annual living expenses of $250,000, adjusted for inflation, over their lifetimes. Could an ING trust provide a meaningful tax benefit? Or would establishing a spousal lifetime access trust (a “SLAT”) prove more effective?
To answer these questions, let’s analyze four different scenarios:
The results of our modeling surprised the Riveras (Display). They’re clearly able to sustain their lifestyle for 30 years, but in the absence of any planning, will likely owe significant estate taxes (Scenario A). Scenario B (giving $10 million to an ING) achieves a somewhat better outcome by generating an immediate state income tax savings of $620,000. But that extra savings increases the size of their taxable estate, which drives their future estate tax liability higher. Conversely, Scenario C (completed gift to a non-ING trust) not only saves them $620,000 in income taxes but also removes future growth of the trust’s assets from their estate for federal estate tax purposes.
Lastly, and perhaps unexpectedly, Scenario D (the SLAT) confers the greatest benefit of all. While the SLAT yields no income tax savings, the family’s wealth is significantly enhanced by shifting federal, state, and local income taxes from the trust to the Riveras personally. This depletes their estate and, in this case, completely eliminates their potential estate tax liability—mainly due to the grantor’s ability to pay the SLAT’s income taxes without those payments being treated as additional gifts to the trust for federal gift tax purposes.4 Without this income tax burden, the SLAT accumulates $16.3 million more wealth than the taxable trusts (Scenarios B and C) over a 30-year period. All in all, the family is better off by $13.5 million (29% more wealth) after 30 years compared to the “no planning” scenario.
An Optimal Solution?
In general, establishing an ING Trust makes the most sense when the grantor:
- Lives in a high-income-tax-rate state;
- Is in the top-marginal-income-tax bracket for federal income tax purposes;
- Has already used her or his full federal gift and estate tax exclusion (currently $12.06 million); and
- Has appreciated assets (like business interests) to contribute that would benefit from a step-up in cost basis at the grantor’s death.
Yet before proceeding, there are several considerations business owners and their advisors must weigh, including:
- Availability: This strategy may not be legally accessible in a given entrepreneur’s state of residence. Some states assert the right to tax tangible assets (e.g., real estate, businesses, etc.), notwithstanding ownership by an out-of-state trust. Others (e.g., New York) disallow ING trusts entirely. California has proposed tax law changes that may make ING trusts less effective, and other states may follow.
- Trade-Offs: As the case study shows, the ING trust can provide substantial income tax savings on an initial sale, but (i) will require the trust to be taxed at extremely condensed federal income tax brackets on undistributed income; and (ii) will not provide any estate tax relief.
- Oversight: An ING trust requires an individual or corporate trustee domiciled in the tax-favored state. A corporate trustee charges administration fees, which must be factored into the strategy’s net value. After sale of the business, the ING trust’s future federal income taxes may be mitigated by (i) distributing, rather than retaining, trust accounting income; and (ii) adopting tax-efficient investment strategies, such as tax-loss harvesting, and “wrapping” high-returning, tax-inefficient investments in one or more low-cost private placement life insurance (PPLI) policies.
Tax planning prior to a business sale can be complicated and is best undertaken well in advance of the closing date. If you are contemplating an exit, talk to your Bernstein Financial Advisor now to explore which planning strategies might benefit you.
- Andrew Bishop, CFA
- Director—Wealth Strategies Group
- Robert Dietz, CFA
- National Director, Tax Research—Investment & Wealth Strategies
- Thomas Pauloski
- Senior National Director, Institute for Trust and Estate Planning—Wealth Strategies Group
1 Trust income tax laws vary from state to state, so state income tax savings may not be achieved in every situation. For example, some states assert the right to tax a trust forever if the grantor was a resident of that state at the time the trust became irrevocable.
2 Treas. Reg. Sec. 25.2511-2(b).
3 See Sections 671-679 of the Internal Revenue Code.
4 Rev. Rul. 2004-64, 2004-2 C.B. 7, 2004.