In recent years, estate planners and tax practitioners have begun to utilize incomplete gift non-grantor trusts, or ING trusts, with increased frequency. Although more traditionally used in the context of asset protection and state tax planning, ING trusts can also be effective tools for federal tax planning purposes, specifically by aligning taxpayers’ mismatched passive and non-passive income and losses. The use of ING trusts may unlock greater access to additional tax planning opportunities that taxpayers and investors previously disregarded due to their lack of passive income.

Converting the Character of Income

Using ING Trusts 

ING trusts are irrevocable trusts that are formed in tax-friendly states and have traditionally been used to minimize taxes at the state level, as well as provide certain asset protection benefits. As a non-grantor trust, an ING trust is a separate taxpayer from the trust’s grantor and is formed in a state that does not impose a state income tax. If properly structured, ING trusts make it possible to minimize state income taxes on the sale of certain assets.¹ This trust can also shield income from state income tax in certain cases.

While traditionally an effective tool in state tax planning, an often-overlooked aspect of ING trusts is their utility as a federal tax planning tool to create passive income allowing taxpayers to take advantage of additional tax incentives, such as solar investment tax credits.

If an individual taxpayer materially participates in a business, the income derived therefrom will be non-passive income to that taxpayer. If, however, the same taxpayer transfers a portion, up to all of the ownership of the business into an ING trust, a distinct and separate taxpayer, the income derived therefrom will be considered passive income to the trust, provided that the trust is so structured that it will be deemed not to materially participate in the business. Through administrative publications and judicial holdings, the IRS and courts have provided guidance for taxpayers to follow to ensure the ING trust is structured such that it meets these requirements as we will discuss here.

Why Use an ING Trust to Convert the Character of Income from Non-Passive to Passive? 

Many tax professionals go to great lengths attempting to convert passive activity losses to non-passive losses in order to utilize those losses (often from real estate activity and associated depreciation deductions) which are otherwise limited by the passive activity loss rules.  Another approach, however, that solves the same problem of misaligned income and losses, is to use an ING trust to recharacterize non-passive income into passive income, which can then absorb the previously limited losses. This approach also comes with an additional benefit – an ability to unlock access to opportunities to utilize additional tax incentives, including solar credits, that were previously unavailable to the taxpayer because they lacked the passive income necessary to take advantage of these tax credits and incentives. By utilizing an ING trust, these taxpayers can take advantage of a plethora of investment opportunities that were not previously feasible or available to them.

Applicable Law and Guidance: Overview 

The passive activity loss rules provided in Code Section 469 disallow the deduction of passive activity losses.² A passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate.2 To be deemed to materially participate in an activity, a taxpayer must participate in the trade or business on a regular, continuous, and substantial basis.³ More succinctly, income and losses derived from an activity in which the taxpayer materially participates are considered to generate non-passive income and/or non-passive losses.  Conversely, income and losses from an activity in which the taxpayer does not materially participate are considered passive income and passive losses respectively.

The passive activity loss rules provide that a taxpayer’s passive losses may only be claimed against passive income, and are limited to the extent of the taxpayer’s passive income.⁴ If a taxpayer has no passive income in the taxable year, no deduction for any passive activity losses will be allowed, and the passive loss will be carried forward indefinitely until such year that the taxpayer has passive income unto which it can be applied.⁵ Under these rules, taxpayers with non-passive income and passive losses in a taxable year could suffer an economic loss stemming from the passive activity, and yet still be subject to tax liability because the passive losses could not be deducted against non-passive income. An ING trust, with proper structural planning, can remedy this problem by converting the taxpayer’s non-passive income to passive income, thereby allowing the passive losses to be deducted, resulting in a lower tax liability.

ING Trusts: The Basics 

An ING trust is an irrevocable non-grantor trust that is a separate taxpayer from the trust grantor, with undistributed income produced by trust assets being taxed to the trust itself. An ING trust is designed to be an incomplete gift for federal gift tax purposes and the trust is also considered a resident of a state, generally with favorable trust state income tax laws. In this structure, taxpayers do not make a completed gift which is accompanied by additional gift taxes, and by establishing the trust in a state with no state income tax, this trust can allow taxpayers to minimize their state tax liability as well.

The fact that an ING trust is treated as a separate taxpayer from the grantor is important when considering federal tax consequences as well. If an individual taxpayer materially participates in a business, the income derived therefrom will be non-passive income to that taxpayer. If, however, the same taxpayer transfers the business into an ING trust, a distinct and separate taxpayer, the income derived therefrom will be passive income to the trust, providing that the trust is so structured that it will not be deemed to materially participate in the business. This conversion of income character unlocks multiple opportunities to reduce tax liability at the federal level. As discussed below, every ING trust, regardless of its use, must satisfy certain structural requirements, but an additional requirement must be met when using an ING trust in federal tax planning.

The General Structural Requirements

of ING Trusts  

ING trusts provide multiple tax planning opportunities, but to take advantage of these opportunities, they must be properly structured. First, the ING trust must be established in a state with favorable trust income tax laws. Second, the grantor must retain a limited power of appointment over the trust assets or there may be unintended federal tax consequences. Third, for the trust to maintain its non-grantor status, the trust instrument must establish a distribution committee comprised of trust beneficiaries other than the grantor.

To maximize state tax benefits, ING trusts must be formed in a state that has no fiduciary state income tax as well as Domestic Asset Protection Trust statutes. Together, these two requirements exclude the option to establish an ING trust in most states. For this reason, almost all ING trusts are formed in either Nevada or Delaware. 

Transfers to an ING trust are intended to be incomplete gifts for federal gift tax purposes. To ensure the transfer is not recharacterized as a completed gift that is accompanied by additional gift tax consequences, the grantor must retain sufficient power over the trust assets. A gift is considered complete when the grantor has so parted with dominion and control that he has no power to change its disposition.⁶ The grantor may therefore ensure the gift is considered incomplete by retaining a limited power of appointment over the trust assets.

Contrary to the above requirement that the grantor retains sufficient control over the trust assets for gift tax purposes, the grantor must also relinquish a certain amount of control over the trust assets to ensure the trust remains a non-grantor trust that is a separate taxpayer from the grantor. A grantor is considered the owner of any portion of a trust in which the beneficial enjoyment of the principal or the income is subject to a power of disposition, exercisable by the grantor or a non-adverse party, without the consent of any adverse party.⁷ To ensure the grantor is not deemed an owner of any portion of the trust and the trust remains an entirely separate taxpayer, the ING trust instrument must establish a distribution committee comprised of the trust beneficiaries other than the grantor. This committee makes distributions decisions by either unanimous vote or majority vote plus the vote of the grantor. The distribution committee is an adverse party under Code Section 672(a) and will therefore ensure the ING trust remains a non-grantor trust that is a separate taxpayer from the grantor.

Additional Federal Requirements and Guidance 

For the income of an ING trust to be characterized as passive income, the trust (generally through its fiduciaries) may not materially participate in the income-producing activity. To ensure an ING trust is not deemed to materially participate in an activity, an additional requirement for ING trusts used in federal tax planning is that the appointed trustee(s) may be neither an owner nor an employee of the business transferred into the trust.

The Internal Revenue Code and treasury regulations provide little guidance on how to determine if a trust materially participates in an activity, but through administrative publications and court holdings, the IRS and courts have laid a clear foundation for taxpayers to follow to ensure that the ING trust can navigate to avoid being deemed to materially participate in an activity and thus produces passive income.

The IRS’s position is that income from an ING trust is per se passive,⁸ although this interpretation has been rejected by courts in at least two cases.⁹ In both cases, the IRS argued that only the activities of the trustees should be considered in determining material participation, and the activities of a trust’s employees should be disregarded when determining if the trust materially participated in an activity. The IRS further argued that the activities of trustees who are also employees of the trust should be disregarded because it is impossible to differentiate between activities performed as an employee and those performed as a trustee.

The courts disagreed with the IRS in both cases. In Mattie K. Carter Trust, the District Court held that the activities of both the trustee and the trust’s employees are to be considered in determining whether the trust materially participated in an activity. Similarly, in Frank Argona Trust, the U.S. Tax Court found that trustees’ activities as employees should be considered when determining material participation of a trust in an activity. Despite the courts’ rulings in these cases, the IRS has not changed its position that income from an ING trust is per se passive.3

The courts’ decisions in these 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 grantor of an ING trust must simply appoint a trustee who is neither an owner nor an employee of the business transferred into the trust. Doing so will ensure that income that was non-passive to the individual taxpayer will be passive to the ING trust, unlocking multiple opportunities for tax planning at the federal level.

Conclusion 

ING trusts provide multiple tax planning opportunities at the federal level, including minimizing tax liability by allowing the deduction of previously disallowed passive activity losses. ING trusts accomplish this feat by transforming the character of a taxpayer’s active income into passive income. To take advantage of this opportunity, a taxpayer who actively participates in a business should consider transferring his or her business(s) into an ING trust that is properly structured. For federal tax purposes specifically, the grantor must appoint a trustee who is neither an owner nor an employee of the business. Doing so will ensure the trust does not materially participate under Section 469 and will thus produce passive income unto which the taxpayer’s passive losses may be applied.

References: [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(a)(1) [3] I.R.C. § 469(h)(1) [4] I.R.C. § 469(d)(1) [5] I.R.C. § 469(b) [6] 26 CFR § 25.2511-2(b) [7] I.R.C. § 674(a) [8] IRS National Office Technical Advice Memorandum 200733023, issued in response to Mattie K. Carter Trust v. United States. [9] 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).