In recent years, estate planners and tax practitioners have been utilizing incomplete non-grantor trusts, or ING trusts, with increased frequency. The most common use of ING trusts has been to minimize state income taxes, but an often-overlooked aspect of ING trusts is their effectiveness as a tax planning tool at the federal level. ING trusts provide taxpayers and investors a variety of new opportunities that they may have previously disregarded due to their lack of passive income.
This article will provide a broad overview of ING trusts and their traditional use as a state tax planning tool, but it will primarily provide a basic illustration on how ING trusts can facilitate tax planning at the federal level. Specifically, this article will show how ING trusts can be used to convert active income to passive income, which opens the door for different planning options to minimize a taxpayer’s federal tax liability.
The Traditional Use of an ING Trust: Minimizing State Income Taxes
ING trusts have primarily been used to minimize state income taxes. An ING trust is designed to be an incomplete gift for federal gift tax purposes and a resident of a state with favorable trust income tax laws, typically Nevada or Delaware. This structure allows taxpayers to avoid the gift tax consequences that accompany a completed gift, and by establishing the trust in a state with no state trust income tax, allows taxpayers to minimize their state tax liability. Because of this, typical users of ING trusts are taxpayers who live in states with a high state income tax who are selling certain assets that will produce a large capital gain. By transferring these assets into a properly structured ING trust prior to disposition, these taxpayers are able to minimize their state tax liability.[1] Note that in addition to complying with different states’ trust income statutes, there are a litany of structural requirements an ING trust must always satisfy to effectively accomplish this goal, and some states, such as New York and California, have implemented statutes to prevent the typical avoidance of state income taxes using ING trusts.
The Overlooked Utility of an ING Trust: Federal Tax Planning
While an effective tool in state tax planning, an often-overlooked aspect of ING trusts is their utility in facilitating federal tax planning. Under Code Section 469 and the accompanying regulations and case law, ING trusts are invaluable tax planning tools at the federal level. Taxpayers can use ING trusts to convert active income to passive income, thereby allowing them to absorb passive activity losses they may have, as well as utilize various other tax incentives.
ING Trusts Can Help Taxpayers Avoid Limitations Imposed by Passive Activity Loss Rules
ING trusts can facilitate federal tax planning by converting the character of a taxpayer’s income from active to passive. Code Section 469 defines passive activity as any activity in which a taxpayer does not materially participate[2], and the Code allows passive activity losses and passive activity credits to be applied only against passive activity income.[3] By converting the character of a taxpayer’s income from active to passive, ING trusts allow a taxpayer’s otherwise unused passive activity losses to be absorbed and opens the door for the taxpayer to utilize otherwise unusable passive activity tax credits.
How ING Trusts Can Convert the Character of Income
The IRS’s position is that income from an ING trust is per se passive,[4] although this interpretation has been rejected by courts in at least two cases.[5] The courts’ decisions in those cases allow ING trusts the flexibility of determining the character of their income as passive or active based on the identity and participation of the trustee. To comply with both the IRS’s position and courts’ holdings on material participation of trusts, the taxpayer grantor must simply appoint a trustee who is neither an owner nor an employee of the business transferred into trust. Doing so will ensure that income that was active to the individual taxpayer will be passive to the ING trust, allowing formerly unusable passive activity losses and passive activity credits to be absorbed.
Why Use an ING Trust to Convert the Character of Income?
Many tax professionals spend much of their time and effort attempting to convert passive activity losses to active in order to utilize these losses that are limited by the passive activity loss rules. Instead, competent tax professionals taking an active approach in tax mitigation can implement ING trusts to provide a better avenue for their clients to utilize these losses by transforming the character of income from active to passive, with respect to which passive activity losses can be utilized. At the same time, using an ING trust to convert income to passive unlocks opportunities to use other tax incentives, such as solar investment tax credits, which generally have only been able to be used by large C corporations or other large entities with passive income.
In addition, some taxpayers may disregard certain investment opportunities, such as solar investments, because they lack the passive income necessary to take full advantage of the tax credits derived from the investment. By utilizing an ING trust, these taxpayers can take advantage of a plethora of investment opportunities that were not previously feasible to them.
Conclusion
In conclusion, incomplete non-grantor trusts have become a popular planning tool to avoid state income tax, but an often-overlooked aspect of ING trusts is their ability to facilitate tax planning at the federal level. ING trusts provide taxpayers with new opportunities to take advantage of various tax incentives and minimize their federal tax liability.
[1] Income earned by tangible assets, such as a business or real estate, is sourced to the state in which that asset is located, and state income tax on this income cannot be avoided using an ING trust.
[2] I.R.C. § 469(c)(1).
[3] I.R.C. § 469(d)(1).
[4] IRS National Office Technical Advice Memorandum 200733023, issued in response to Mattie K. Carter Trust v. United States.
[5] Mattie K. Carter Trust v. United States, NO. 4:02-CV-154-A (N.D. Tex. Apr. 11, 2003); Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (U.S.T.C. Mar. 27, 2014).
