The maneuvers are getting fresh scrutiny from officials in states including New York, which is losing an estimated $150 million a year through such tax avoidance. As fewer Americans pay the estate tax and top earners in New York and California owe more state income taxes, wealth planners say their clients are looking for new ways to escape those levies.
The asset shifts mirror steps corporations such as Google Inc. (GOOG) have taken across national borders to lower the taxes they pay. Within the U.S., some individuals who want to sell companies that they built move shares from home states to out-of-state trusts so the gains won’t be subject to state income taxes.
“I can’t sit with a client who has a substantial portfolio or is contemplating selling his business without putting the strategy on the table,” said William Lipkind, a New Jersey lawyer who said he’s been involved in 20 to 25 such transactions in the past year.
Lipkind said he’s moved as little as $700,000 and as much as $500 million. “You scratch your head and say, ’Why pay if we don’t have to?’”
States including Delaware and Nevada have waged a decades-long fight for wealthy Americans’ trusts, competing to write laws that make it easier to pass property across generations and protect assets from creditors. Nevada has no state income tax and Delaware’s tax doesn’t apply to out-of-state beneficiaries.
“The way that states go about taxing trusts is, shall we say, all over the map,” said Dick Nenno, managing director and trust counsel at Wilmington Trust, a Delaware-based subsidiary of M&T Bank Corp. (MTB) “And that creates some real planning opportunities.”
Using a Delaware Incomplete Non-Grantor Trust, or DING, wealthy residents of high-tax states take advantage of vague or conflicting definitions in state and federal laws. They can move assets just far enough out of their control so they aren’t liable for state income taxes without moving them far enough to trigger a 40 percent gift tax.
Because the trusts are private, there is no comprehensive data on how much money has moved across state borders in recent years or how much revenue the high-tax states are losing. Nevada figures show that trusts there hold $18 billion in assets, up from $8 billion in 2008.
Some high-tax states, such as New York, are seeking ways to stem the flow of money. A state tax commission, led by former Democratic Comptroller Carl McCall and investment banker Peter Solomon, last month recommended laws to limit the use of out-of-state trusts.
The New York Department of Taxation and Finance estimates that the proposed change would generate $150 million a year, or about a 0.4 percent increase in personal income tax collections. Those figures suggest annual income in out-of-state trusts of more than $1 billion and assets much bigger than that.
The use of out-of-state trusts isn’t a new strategy, especially for estate planning and asset protection. What’s changed in recent years is that wealth planners have become more focused on state income taxes.
“The state income taxes have become a huge issue,” said Lisa Featherngill, managing director of planning at Abbot Downing, the wealth-management subsidiary of Wells Fargo & Co.
Congress significantly narrowed the federal estate tax, making the per-person exemption higher, permanent and linked to inflation. Those changes make some more eager to minimize annual state taxes than focus on one-time estate tax savings.
The $5.34 million exemption in place for 2014 means that 1 in 726 people in the U.S. who die will owe federal estate taxes, compared with the 1 in 390 that would have paid taxes if Congress had set the exemption at $3.5 million, according to the nonpartisan Tax Policy Center in Washington.
At the same time, marginal state income tax rates have risen, particularly for top earners. For 2013, California applies a 13.3 percent tax rate on taxable income exceeding $1 million. The top state-and-local combined rate in New York City this year is 12.7 percent for income exceeding $1 million for individuals and $2.1 million for married couples.
Also, the federal government blessed the maneuvers in a ruling requested for a client by Lipkind, an attorney at Lampf, Lipkind, Prupis & Petigrow, P.C. in West Orange, New Jersey. The private letter ruling, released this year, ended a six-year hiatus on such decisions and ratified the Nevada counterpart of the DING, known as a NING.
“The only purpose of setting up these trusts, near as far as we can tell, is avoiding state tax,” said James Wetzler, a former New York state tax commissioner and a member of the state’s tax commission who criticizes the Internal Revenue Service. “I’m literally at a loss to understand why they would issue these rulings.”
That IRS ruling for a man with four sons, none of whom were named publicly, “resurrected this transaction from the ashes,” said Charles A. “Clary” Redd, a partner at Stinson Morrison Hecker LLP in St. Louis.
Steve Oshins, an attorney at Oshins & Associates LLC in Las Vegas, said he has moved billions of dollars in assets to Nevada, including some through NING trusts.
The DING and NING strategies illustrate how tax lawyers can exploit gaps in state and federal laws.
Trusts created by people before death typically come in two forms -- grantor trusts and non-grantor trusts.
The income generated by grantor trusts that isn’t distributed to beneficiaries is typically considered taxable income to the person who put the assets into the trust. The initial contribution of assets is, in many cases, considered a gift for estate tax purposes.
For example, records released during the 2012 presidential campaign showed that Mitt Romney used a grantor trust to pass wealth to his children, moving some assets before they rose in value and paying annual income taxes on trust earnings as a way of making an additional tax-free gift.
A non-grantor trust works the other way. The trust pays income taxes on any gains, with the top federal income tax bracket of 39.6 percent starting at $12,150 of income in 2014.
The NING and DING are hybrids, structured so the individual retains enough control to avoid gift tax and cedes enough control to avoid income tax.
“That’s like threading a needle being able to get both of those things at once,” Redd said.
The gift is considered incomplete, meaning that it hasn’t fully passed to heirs and isn’t subject to the U.S. gift tax. That’s because the person establishing the trust retains some ability to decide who gets how much money.
In the IRS ruling involving Lipkind’s client, the man with four sons has the sole power to use the money for the health, education or support of his children.
For income tax purposes, however, the trust is considered a non-grantor trust and pays its own taxes on undistributed income. That’s because the person establishing the trust gives up the ability to get money back from it without the agreement of a committee of family members.
The crucial fact is that the income tax liability belongs to the trust, not the individual.
That’s where state law comes in.
Nevada has no state income tax and Delaware doesn’t tax trusts unless the beneficiaries live in the state. New York’s tax law can’t touch the trusts if the trustees, tangible property and real estate are out of state and they receive no New York-sourced income.
The DING and NING don’t necessarily resolve estate planning challenges, because the money remains in the wealthy person’s estate. In the meantime, though, it can save significant state income taxes.
People considering these transactions have to weigh the potential federal tax costs of having the trust receive income instead of sending it to beneficiaries who may pay lower marginal tax rates. There are other limits, including taxes for residents of Connecticut and some other states, the loss of complete control over the assets and restrictions on how soon the assets can be sold after they’re transferred to the trust.
A study by two law professors examining data through 2003 found that about $100 billion had moved to states with the most generous laws for passing assets to heirs. States with an income tax on trust earnings didn’t see a significant increase in funds after changing other trust laws, the study found.
States such as Delaware, South Dakota, Nevada, and Alaska have become hubs for lawyers specializing in trusts and estates.
“It’s lobbying by local bankers and lawyers who are trying to attract business,” said Robert Sitkoff, a Harvard Law School professor and co-author of the study. “The initial payoff for the legislators is you’ve made happy an interest group, with all that entails.”
After that, he said, even without taxing the assets, the states have set up a “clean industry” of lawyers and related offices and the indirect revenues they bring, with few if any costs to the states.
Those lawyers and bankers then lure out-of-staters. Nenno sells Delaware’s century of trust-friendly law -- and lack of income taxes on non-residents.
A New York City resident with $1 million in capital gains would face a home-state bill topping $100,000, he said.
“If the trust is set up in Delaware, you avoid that $100,000-plus tax altogether,” Nenno said. “Perfectly legal.”
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