This article discusses the use of non-grantor trusts as an asset protection planning tool, while introducing the non-grantor trust as an income tax planning tool in order to reduce taxpayer’s exposure to state income and local taxation in jurisdictions with high income taxation (think New York, California, Massachusetts, et al). The executive summary is primarily geared to taxpayer’s large amounts of investment income.
The article geared is geared to high net worth individuals with large amounts of taxable income. The article also focuses on the personal tax planning of investment managers such as hedge funds and private equity managers who are frequently required to have all or most of personal liquid net worth invested in funds. A large percentage of funds and managers are based in states with high state income taxes- New York City (12.618%), California (10.55%), New Jersey (10.75%), Connecticut (6.5%) and Massachusetts (5.3% but 12% on short term capital gains).
Tax reform produced adverse results for managers that primarily generate short term capital gain income. The top marginal tax bracket increased to 39.6 percent for high income taxpayers for earned and short term capital gain income. The Obama Medicare tax adds an additional 3.8 percent on investment income for top income earners raising the top federal bracket to 43.4 percent. The phase out of personal exemptions and miscellaneous itemized deductions adds another 1-2 percent to the marginal rate. High income states such as New York and California add an additional 8-12% percent bringing taxpayers to a combined marginal tax bracket of 58 percent. Bottom line – hedge fund investors and managers may be paying higher taxes than ever before.
We also live in an era of unprecedented economic and political uncertainty. Add an increased likelihood of becoming a participant in the game of “litigation lottery”, i.e. getting sued, and pretty soon you may begin to sweat profusely. Ask yourself, will your creditors treat you fairly? The answer - not likely!
The Non-Grantor Trust is the lesser known cousin of its famous cousin, the Grantor Trust (whose days may also be numbered!). This article will show you how a non-grantor trust established in a favorable jurisdiction with no state income taxation and favorable asset protection rules can be an effective remedy for the taxation of certain categories of income in states with high income tax rates.
Nevada Asset Protection Trusts
Let me first admit to my bias in favor of offshore asset protection trusts. If you want to be as close to 100 percent certain that your asset protection trust can withstand your creditors’ challenges on your wealth, then a Cook Islands Asset Protection Trust is the way to go. The Cook Islands has a twenty five year perfect record against all creditors including large creditors such as the U.S. Government. Anyhow, that is a topic for a different article. The U.S. Constitutional issue of the Full Faith and Credit Clause with respect to domestic asset protection remains unanswered. It remains to be seen whether domestic self-settled trusts can withstand a constitutional challenged when a creditor from one state attempts to collect against an asset protection trust in Nevada, Delaware or South Dakota.
A number of domestic jurisdictions have adopted trust legislation that provides for asset protection. In my view, Nevada has the strongest legislation. Nevada’s asset protection has several things going for it:
(1) Two Year Statute of Limitations.
(2) For pre-existing creditors, the statute of limitations is the longer of two years from the date of the transfer to the trust or six months from the date the creditor discovered the transfer, or reasonably should have discovered the transfer waiting period for pre-existing creditors.
(3) Tacking – If a trust is moved from another jurisdiction to Nevada, the statute of limitations does not restart.
(4) Last In, First Out – For purposes of determining the statute of limitations, and multiple transfers to the trust, a transfer that is within the statue will not taint the entire trust for prior transfers where the statute has already expired.
(5) Decanting – A trustee may form another spendthrift trust without restarting a new statute of limitations period.
(6) Exceptional Creditors such as spousal and governmental claims – Nevada law does not exempt exceptional creditors from the favorable laws outlined above.
(7) Income Tax- Most importantly, Nevada does not tax trust income.
We need to cover a little ground before we jump into an example of the strategy. First, what is a so-called “grantor trust”? The Internal Revenue Code – Sections 671-679 provide the rules for grantor trusts. Grantor trusts have been the mainstay in advanced estate planning techniques largely since Chapter 14 (IRC Sec 2701-2704) largely paralyzed the use of “partnership freezes” and corporate reorganizations as estate freezing techniques.
Under the grantor trust rules, the trust settlor is considered the owner of trust assets for income tax purposes. As a result, all trust income and losses flow through the trust to the settlor. The trustee is able to accumulate assets within the trust without any depletion for income tax purposes. The grantor or settlor’s payment of the income tax liability is not considered an additional gift to the trust. At the same time, the trust assets are outside of the settlor’s taxable estate.
Trusts that are not taxed as grantor trusts are taxed as separate taxable entities. In general, marital trusts and most testamentary trusts are non-grantor trusts (“NGT”). Most asset protection trusts are also non-grantor trusts for income tax purposes. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket- $11, 200. A NGT is a trust that does not fall within any of the provisions of IRC Sec 671-679.
The essential trust provisions necessary to classify a trust as a NGT include retention of a power by the settlor to name new trust beneficiaries, or to change the interest of trust beneficiaries except as limited by a special power of appointment (ascertainable standard). The settlor’s transfer to a trust with this power renders the transfer an incomplete gift for gift tax purposes. A second method to avoid grantor trust treatment is to require the consent of an adverse party on any trust distributions under IRC Sec 672(a).
Income Taxation of Trust Income within a Non-Grantor
Believe or not, the legal question of a State’s right to tax trust income has been litigated a lot including at the U.S. Supreme Court level several times. The constitutional restraint on a State’s ability to tax trust income centers on the 14th Amendment Due Process and the Commerce Clause. Most of the States focus on these five criteria below:
(1 ) Was the trust was created by the Will of a testator who lived in the state at death?;
(2) Did the settlor of an inter vivos trust live in the State?;
(3) Is the trust administered in the State;
(4) Does one or more trustees live or do business in the State?;
(5) Does one or more beneficiaries live in the state?
Here is a brief summary for how trust income taxation works out for our key states:
(1) New York (NY) -NY will not tax a trust’s income if it has no NY trustees, no NY assets, and no NY source of income. Intangible property such as investment portfolio assets should be exempt from NY state and local income taxation in a Nevada Trust. Most investment partnerships and LLCs are based in Delaware. The manager’s personal investment in the fund should be exempt from taxation, but not the management fee.
Carried interest is likely to be taxed at ordinary rates in the future, but arguably should not be taxable in NY if represented by a separate class of limited partnership interest and held in a Nevada Trust.
(2) New Jersey (NJ)- NJ will not tax a trust’s income if it has no NJ trustees, no NJ assets, and no NJ source of income.
(3) Connecticut (CT) – CT will not tax a trust’s income if it has no CT trustees, no CT assets, and no CT source of income.
(4) California (CA) – CA taxes trust income if the trust has at least one trustee resident and one non-contingent beneficiary in CA.
(5) Massachusetts (MA) – MA will not tax a trust’s income if it has no MA trustees, no MA assets, and no MA source of income.
Joe Smith, age 50, is a managing director of a hedge fund, Acme Asset Management. The general partner of Acme is a Delaware LLC, Acme Management. The funds are Delaware limited partnerships. Acme has a domestic fund and offshore fund that invest through a master feeder structure. Acme is the investment advisor to the funds.
The funds have approximately $1 billion of assets under management. Acme earns a management fee of two percent and a performance fee of 20% of profits. The fund has consistently been earning an investment return of ten percent per annum net of all fees. All of the fund’s income is short term capital gain income taxed at ordinary rates.
Smith is a resident of New York City. Smith has a personal net worth of $40 million. He has generated most of this wealth over the last ten years due to the success of his funds. Joe is married with two children. His personal investment as a limited partner in the fund is $20 million.
As of January 2013, Joe will be in a combined marginal tax bracket of 55.6% - Federal (43%) and New York City (12.62%). His combined New York City taxation will be approximately $252, 400. He will not be able to deduct his state taxes on his federal return due to the application of the alternative minimum tax (AMT).
Joe is deeply concerned about his litigation exposure to creditors as well as his state and city income tax liability. He would like to position his assets in a domestic asset protection trust for creditor protection as well minimize his state income tax exposure.
Joe is the settlor of a new Nevada Trust. The trustee is Premier Trust Company which has its offices in Nevada. The trust is an irrevocable trust. Joe transfers his limited partnership assets in the Acme funds to the trust. The transfer to the trust is not a complete gift for gift tax purposes. The gift is not complete because Joe retains a testamentary special power of appointment that allows him to change the trust’s beneficiaries at his death.
Joe is a discretionary beneficiary of the trust as well as his wife and children. In this case, the trust income is expected to accumulate for a number of years as Joe has other sources of earned income to meet his personal income needs. None of the trust assets are located in New York. None of the trustee or trust operations come into contact with New York. The fund has no New York sourced income.
Following the transfer of the LP, the trustee will be the owner of the LP interest. The trust will meet the requirements under New York with respect to the state taxation of trust income. The projected state tax savings are $250,000 per year. The future value of these tax savings over a ten year period at ten percent is $3.95 million.
A lot of attention is given to tax planning for federal taxes at both the income and estate tax level with far less attention being given to state and local tax planning. Many clients live in states where income and estate tax planning is of equal importance at the state level.
A NGT that provides asset protection and income tax benefits is an excellent solution for clients in a high tax jurisdiction to reduce this exposure. Nevada is an excellent state for both considerations. This solution is not well known for tax planning purposes. Additionally, the urgency of asset protection planning is another significant factor that can be addressed through this solution.
As we move forward into new territory with regard to higher taxes, consider adding this solution to your arsenal of techniques to help your taxes lower taxes.
 See Treas. Reg. 2011-2(c)