Earlier this year, California Gov. Gavin Newsom proposed legislation that gave estate planners pause: California residents could soon face taxes on the income and capital gains earned from their trusts domiciled in tax-free states like Delaware and Nevada.
Specifically, the proposal targets incomplete nongrantor (ING) trusts, which aim to eliminate state taxes on income and gains from certain assets, such as stocks or a closely held business.
"These trusts have been popular among wealthy residents of high-tax states like California, which collects 13.3% on capital gains from the highest earners—on top of the 23.8% they'd owe the federal government," says Austin Jarvis, director of trust, tax, and estate at the Schwab Center for Financial Research.
Some business owners, in particular, have found it beneficial to transfer their companies to ING trusts prior to selling. However, states are starting to crack down on what they see as blatant tax avoidance. New York passed a law similar to California's in 2014.
"Even if your state allows ING trusts, you can still run afoul of the law—and therefore face a tax bill—by implementing an ING trust strategy incorrectly," Austin says. That's because these irrevocable trusts are funded by an incomplete gift—meaning the assets remain part of the grantor's estate even though the trust acts as the owner for income tax purposes. "You have to make sure the trust document stipulates both of those things, which can seem at odds."
Ultimately, Austin says ING trusts generally work best for those who believe the tax savings are worth the trouble and the potential scrutiny by the IRS and state tax assessors.
"Anyone considering an ING trust should seek out estate and tax planners who have extensive experience in such strategies," Austin says, "because one wrong move could nullify the trust."
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