Advantages of the incomplete non-grantor trust
- The grantor desires to establish an irrevocable trust without giving up a basis adjustment for trust assets at death and without using his federal gift tax exclusion or paying gift tax.
- Assets held in an incomplete non-grantor trust at death (including appreciation from current value) are included in the grantor’s gross estate, and basis is adjusted to the date of death or alternate valuation date value.
- Transfers to the trust are not completed gifts and no applicable exclusion is applied at the time of the transfer to the trust.
- The grantor resides in a high income tax rate jurisdiction and is sensitive to state and local income tax burdens.
- A trust properly established as a separate taxpayer in Delaware or Nevada is not subject to income taxes in the grantor’s home state, provided there is no trust nexus with the home state (such as a resident trustee/advisor) and no state-sourced income, and the home state does not determine trust residence based on the grantor’s domicile.
- The grantor has substantial assets outside the trust and wants to preserve a “nest egg” for his family and/or himself.
- Trust assets may be protected from creditors of the grantor and beneficiaries as permitted under applicable state and federal law.
Avoiding A Completed Gift
In order to avoid a completed gift and the potential gift tax consequences, i.e., the use of exclusion or payment of gift taxes, it is critical for the grantor to reserve sufficient power over the trust assets. Also, the place of administration of the trust and/or the presence of tangible assets or commercial activity in the state can affect trust residence for state tax purposes.
For example, grantors who live in high income tax states that base the residence of a trust exclusively on the residence or domicile of the grantor may not receive a state tax benefit from incomplete non-grantor trusts, since the trust will be treated as a resident of the high income tax state where the grantor resides even if it is also treated as resident in another state. Also, some states, such as California, tax certain accumulations in out-of-state trusts upon distribution to in-state beneficiaries.
Red flags for state tax authorities
State taxing authorities may challenge abusive transactions that are designed primarily to avoid incurring state income tax on a particular transaction, such as the disposition of a block of highly appreciated stock.
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