Academic journal article Vanderbilt Law Review

Strange Bedfellows: The Federal Constitution, Out-of-State Nongrantor Accumulation Trusts, and the Complete Avoidance of State Income Taxation

Academic journal article Vanderbilt Law Review

Strange Bedfellows: The Federal Constitution, Out-of-State Nongrantor Accumulation Trusts, and the Complete Avoidance of State Income Taxation

Article excerpt

I. Introduction

Presently the maximum rate of federal taxation of taxable income is 39.6 percent.1 With the Medicare surtax on investment income of 3.8 percent,2 the federal tax rate can exceed forty-three percent. The state3 tax in states such as California4 and New York5 can easily exceed twelve percent. The combined federal-state share of taxable income can, thus, be fifty-five percent or more.6 Even when a state has a relatively benign rate of income taxation, a sale of a highly appreciated asset can result in a significant state tax burden in absolute dollars that is added to the federal tax due.7

In light of the foregoing, it should come as no surprise that taxpayers have been incentivized to pursue strategies that reduce or eliminate the overall take of Government. For the individual with investment income, one such option is the use of an out-of-state, nongrantor accumulation trust that avoids all states' income taxes. In particular, a Nevada Incomplete Gift Nongrantor Trust ("NING") has recently received considerable attention and actually garnered IRS approval.8

The NING is designed to be an independent taxpayer for tax purposes, separate and apart from the settlor. This is crucial, because if the settlor retains certain strings of control, the trust is likely to be regarded as a "grantor trust."9 In such case, the trust is ignored for income tax purposes-the settlor10 is deemed still in effective control. As a consequence, all income, even if accumulated in trust, will be attributed to the settlor.

The grantor trust rules set forth in the Internal Revenue Code have been, with just a few exceptions, enacted as part of state income tax laws. Accordingly, there will be no state tax savings if the trust is treated as a grantor trust. To avoid grantor trust status, the NING is drafted so that strings of control, notably the power to make distributions, are either held exclusively by beneficiaries with substantial interests, such as members of settlor's family, or shared by the settlor and these beneficiaries. These beneficiaries are deemed "adverse parties" vis-à-vis the settlor under both the Code and state tax laws that mirror the Code's grantor trust provisions. The assumption is that adverse parties, being economically self-interested, will not approve distributions to the settlor that have the effect of diminishing their own interests in the trust.* 11 Because of these adverse interests, the NING is a nongrantor trust rather than a grantor trust. On the other hand, in reality, the settlor retains practical control in many of these situations because adverse parties, especially younger family members, are likely to comply with the perceived or stated wishes of the settlor.12

The nuanced drafting that avoids grantor trust status for income tax purposes is not the end of the story. The settlor's retention of strings of control may also impact the NING's treatment under the federal gift tax. Indeed, a properly crafted NING is something of a sleight of hand, a successful navigation of a Scylla and Charybdis of tax law-giving up sufficient strings of control so the settlor is not taxed on the income, while not giving up too many strings of control so that the transfer of assets to the trustee is a taxable transfer under the federal gift tax.

Fortunately, a tax arbitrage opportunity exists for sophisticated planners. The federal income tax and the federal gift tax are not in pari materia on the question of the quantum of control that results in a transfer's being deemed complete or not.13 The NING capitalizes on this arbitrage opportunity by denying the settlor sufficient strings of control so that the trust is a nongrantor trust for federal income tax purposes, but preserves for the settlor certain strings of control that are only pertinent to the federal gift tax. These strings of control make the transfer incomplete and, thus, not a taxable gift for federal gift tax purposes.14

Even then, the NING is not for everyone. …

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