LLG Blog

Thursday, August 16, 2018

Understanding the Tax Angles of Self-Settled Trusts



NINGs, DINGs and WINGs may sound like characters in a new Pixar animated film. In reality, they’re the names bestowed on certain self-settled trusts (sometimes referred to as nongrantor trusts) in states providing a favorable tax environment for these trusts. The acronyms stand for Nevada Incomplete-gift Nongrantor Gift (NING) trusts, Delaware Incomplete-gift Nongrantor Gift (DING) trusts and Wyoming Incomplete-gift Nongrantor Gift (WING) trusts, respectively

If you’re noticing a trend — none of these three states impose an income tax on its residents — it’s no coincidence. The use of NINGs, WINGs and DINGs is tied directly to tax savings on the state level for high-income individuals.

Current tax landscape

Despite tax cuts implemented by the Tax Cuts and Jobs Act (TCJA), effective for 2018 through 2025, high wage earners can still face a hefty income tax bill. The TCJA reduces the top tax rate from 39.6% to 37% and retains the maximum 20% tax rate on long-term capital gains and the additional 3.8% net investment income tax (NIIT) on investment earnings. But that’s only part of the equation.

Most states add their own income tax to the tax burden. In fact, in California this extra tax can reach double-digit rates. Thus, you might easily pay close to 50 cents on the dollar in combined state and federal income taxes — not even taking other taxes into account.

At the same time, the TCJA doubled the federal gift and estate tax exemption from $5 million to $10 million, indexed to $11.18 million in 2018. Currently, a married couple can effectively shelter up to $22.36 million from estate tax.

Of course, a few states still impose death and inheritance taxes, but the general trend is moving away from these taxes. For instance, in New Jersey, a state known for high income taxes, the death tax was recently repealed, effective in 2018. 

One way to avoid high income taxes in your home state is to simply move to a low- or no-tax state. This has helped fuel a migration to states like Florida and Texas. But that may be drastic step for some, especially if you’re not ready to retire or want to remain closer to family.

Tax savings with self-settled trusts

Cue the introduction to NINGs, DINGs and WINGs. With these trust types, the main thrust is to shift tax liability for earnings for assets to the state where the trust is created — namely, Nevada, Delaware or Wyoming. Because the trust is a nongrantor trust, the earnings are taxable to the trust entity itself. As a result, you may avoid a big income tax bill in the state where you reside.

For example, a California resident, John, has a $5 million portfolio. For simplicity, let’s say that he’s held all of his securities longer than one year (so that they qualify for long-term capital gain treatment) and the initial cost was $1 million.

If John sells off his entire portfolio in 2018, he recognizes a $4 million gain taxed at the 20% federal rate, not counting the NIIT. In addition, with the top 13.3% rate in California, he could owe another $532,000 on the $4 million gain.

This harsh state tax result could be avoided if John sets up a NING, DING or WING trust and transfers the $5 million in assets to it. There’s no state income tax to worry about. In this case, he saves more than $500,000 in state income tax, even though he lives in California.

Gift and estate tax issues

Because the transfer of assets to the trust is considered an incomplete gift, no federal gift tax return has to be filed with the IRS. This also means that there’s erosion of the lifetime gift tax exemption, which is unified with the estate tax exemption. But then the assets will be included in the taxpayer’s taxable estate upon death.

As discussed above, this isn’t usually a problem due to the generous gift and estate tax exemption. Furthermore, the taxpayer’s heirs can benefit from a step-up in basis in the securities, thereby reducing income tax liability on any future sales. It’s a win-win-win situation.

Turn to a professional

Bear in mind that self-settled trusts are complex arrangements. Various IRS private letter rulings have established subtle differences for NINGs, DINGs and WINGs that should be addressed beforehand. Needless to say, this isn’t a do-it-yourself proposition: consult with your estate planning advisor to learn whether this trust type is right for you.

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