States Should Follow New York’s Lead and Shut Down Tax-Avoiding “ING Trusts”

For well over a decade, tax advisers have promoted a state income tax avoidance strategy called INGs — incomplete non-grantor trusts — among their wealthy clients. While INGs don’t enable wealthy people to avoid federal income taxes, their promoters promise that they can “avoid state income tax altogether” on income and gains from intangible property (financial assets such as stocks, bonds, and passive ownership shares in unincorporated businesses) that are transferred to a properly structured ING.^[2] Leaked IRS records reveal that half of the country’s wealthiest people use some type of trust for tax avoidance.^[3]

The ability of very wealthy people to leverage this complex tax avoidance scheme likely costs states significant amounts of revenue, especially in more affluent states such as California, Illinois, and Massachusetts. It also violates the principle that everyone who is financially capable of paying taxes should pay their fair share to support public services — especially those who have reaped the most benefit from the opportunities our nation affords. Fortunately, states can address the ING problem through a relatively simple fix to their tax codes, as New York has illustrated.

New York State officials became aware of ING trust abuse relatively soon after it arose and shut it down in 2014 by “decoupling” the state’s tax law from the Internal Revenue Code with respect to the classification of this type of trust. Other states should follow New York’s example promptly and put an end to the ING scheme, which allows very wealthy individuals to shirk their state income tax responsibilities while the rest of us fulfill ours.

Background: Grantor Trusts, Non-Grantor Trusts, and INGs

A trust is a legal relationship between three parties: a grantor, a trustee, and one or more beneficiaries. The grantor transfers property “in trust” to a trustee to manage it for the benefit of the beneficiaries. Children or grandchildren of the grantor are often beneficiaries; the grantor, who sets the terms of the trust, often is one as well. The trustee may be a professional service provider or a person the grantor knows and trusts.

Trusts have certain key advantages over outright gifts as a vehicle for transferring assets before death, such as the ability to require that the money be spent on the recipient’s education. They also have advantages over wills as a vehicle for transferring assets after death, such as avoiding the lengthy, costly, court-supervised probate process (which also publicly reveals the size and nature of the assets and who receives them). Some types of trusts can enable the grantor both to direct the transfer of wealth upon their death and to retain access to the trust’s assets, or the income they generate (dividends, capital gains, interest, royalties, etc.) while they are still alive, if they turn out to need more money than they had expected when establishing the trust.

For federal and state income tax purposes, however, in some cases a trust has its own tax-filing responsibility, just as if it were a legal entity.^[5]

There are two broad classifications of ordinary trusts under federal tax law:^[6]

• Grantor trust. If the grantor retained enough power over the property they transferred to the trust — to manage and dispose of it, even return it to themselves under some circumstances — that they should be treated as continuing to own it, the trust is likely to be classified as a grantor trust.^[7] Neither the federal government nor the states treat a grantor trust as a distinct taxable entity. Consequently, all trust income, whether or not it is distributed to beneficiaries, is reported on the grantor’s individual income tax return in the year in which it is realized.
• Non-grantor trust. If the grantor truly gave up control over the property when transferring it to the trust, the trust is classified as a non-grantor trust, because the grantor is no longer involved in managing the investment or distribution of the assets. Non-grantor trusts are considered separate, taxable entities under federal and state income tax laws.

Rules governing this distinction reflect the public policy concern that a grantor should be prevented from “avoiding tax by shifting income to other family members while still retaining an interest in or a power over the property placed in trust.”^[8] (See Appendix I for more detail on grantor and non-grantor trusts.)

The distinction between grantor and non-grantor trusts rests at the crux of a highly complex scheme that enables the wealthiest households to shelter huge sums of money from state taxation. INGs, a specific version of non-grantor trusts, are structured in a way that allows wealthy people to avoid paying state personal income tax on income left in the trust.^[9] Indeed, this is “the primary objective” of ING trusts, according to one estate planner.^[10]

The essential mechanism of the issue is that a wealthy person transfers cash, stocks, bonds, and other financial assets into an ING formed and administered in another state so that the annual earnings these assets generate are no longer taxable on their individual income tax forms. They nearly always locate the trust in a “tax haven” state that completely shields these trusts from taxation, such as Delaware, Nevada, South Dakota, and Wyoming. (See Appendix II for more detail on INGs.) This maneuver diverts large sums of money held by the country’s wealthiest people away from states where it could be taxed — especially more affluent states like California and Massachusetts, where many of these people live. And, as described in Appendix II, careful drafting of the trust agreement can enable the transfer of assets to the trust to be characterized as “incomplete,” achieving the vital aim of avoiding immediate liability for the federal gift tax — which otherwise would apply.

Potential Scale of ING Tax Avoidance

The U.S. has over 700 billionaires,^[11] with a combined wealth of almost $5 trillion.^[12] The 1.3 million households who make up the wealthiest 1 percent (with net worth starting at $11 million apiece) have a combined wealth exceeding $45 trillion.^[13] Very wealthy individuals lower their taxes, in both legal and illegal ways, by accessing a “staggering amount of legal, planning and accounting firepower devoted to wealth defense.”^[14]

A great deal of federal tax avoidance by very wealthy individuals is accomplished using trusts established in tax haven states such as Delaware, Nevada, South Dakota, and Wyoming.^[15] “[T]he wealth held in the dynasty trusts of ultrarich families stands to reach $21 trillion between now and 2045,” according to one estimate;^[16] another study estimates that the top 1 percent avoid federal taxes on more than one-fifth of their income.^[17] Many very wealthy individuals use trusts to avoid state income taxes as well. (See text box, “What Makes a State a “Tax Haven” for ING Trusts?”)

The IRS data that can provide some insight into the potential scale of the use of INGs to avoid state income taxes are only available through tax year 2014. But these data suggest that, even as of that relatively early date in the evolution of INGs,^[18] they were already sheltering a substantial amount of income from state taxes.

As of 2014, more than 30,000 “complex” trusts^[19] — that is, trusts that do not distribute all their annual income to beneficiaries but instead accumulate at least some of it — had been established in Delaware, Nevada, South Dakota, and Wyoming combined. (See Table 1.) It is reasonable to assume that all ING trusts would fall into this category; there would be no point in setting up an ING if all the income was going to be paid out to beneficiaries, since the beneficiaries would then owe income tax on their payments in their states of residence. While many of the complex trusts in these four states likely are not INGs, the data provide some evidence that many of these trusts are, in fact, INGs being used as state income tax shelters by very rich people:

• For the four states combined, complex trusts reported $7.4 billion in 2014 income and distributed just 17.3 percent of it to beneficiaries, accumulating the remaining $6.1 billion. In the country as a whole, in contrast, the average complex trust distributed 54.4 percent of its 2014 income.
• For every 100,000 state residents, 1,162 complex trusts filing federal tax returns were established in Delaware, 714 in South Dakota, 669 in Wyoming, and 339 in Nevada. These figures for the first three states far exceed the nationwide figure of 463 complex trusts per 100,000 residents and provide compelling evidence of widespread use of trusts in these states by non-residents. And while complex trusts in all four states represented only 2.1 percent of such trusts nationally, they reported 8.2 percent of pre-distribution income of complex trusts and almost 15 percent of undistributed income.

Other IRS data provide additional evidence that a growing number of taxpayers have taken advantage of the ING tax shelter in these four states in more recent years:

• In 2021, income tax returns filed by trusts and estates combined reported $3.0 billion in federal income tax liability in Delaware, $3.1 billion in South Dakota, and $3.7 billion in Nevada — figures not that different from California ($3.9 billion) and New York ($3.5 billion), even though the three trust tax haven states have much smaller populations. (See Table 2.)

• Between 2009 (the first year for which these data are available) and 2021, the amount of federal income tax liability reported on estate and trust income tax returns rose by 438 percent in South Dakota, 558 percent in Delaware, 1,130 percent in Wyoming, and a whopping 2,089 percent in Nevada — well above the national increase of 335 percent.

The New York Solution

To date, the only state to end this indefensible and inequitable ING trust abuse is New York, which has 135 billionaires and a very large share of the nation’s highest-income 1 percent.^[20] In 2012, then-governor Andrew Cuomo established the New York State Tax Reform and Fairness Commission “to examine the equity aspect” of the state’s tax structure.^[21] The Commission asked tax law experts with the New York State Bar Association^[22] to analyze the ING issue and make policy recommendations.

The NY Bar’s report confirmed the problem with INGs: “We agree with the Commission’s view that DING Trusts [ING trusts established in Delaware] created by New York State grantors should be subject to New York State income tax, given that DING Trusts appear to be primarily established to avoid state income taxation.”^[23] The report explained that:

• INGs “allow for the gift-tax-free transfer of unlimited amounts of property to trusts that are treated as taxpayers separate from the grantor for Federal income tax purposes.”
• An ING’s “state income tax [avoidance] benefits are achieved only if the trust is a non-grantor trust for tax purposes.”
• A “significant amount of income” is sheltered in these tax avoidance vehicles, based on data collected by New York’s tax department.^[24]

The report also addressed an even “more aggressive” use of INGs, which could be called the “stash-and-sell” scheme. Consider an individual who owns property (such as stock) that has appreciated in value and who intends to sell it at a very large gain. Unlike individuals selling more modest appreciated property, who must pay tax on their capital gain in the year it is realized, someone with access to ING planning could transfer their stock to their ING and, after a relatively short delay (aimed at fending off a possible challenge from the IRS under its “step transaction doctrine”),^[25] informally direct the ING’s trustee to sell the stock. With a cleverly structured ING, they would owe no federal gift tax on the transfer, and the ING trust would owe no New York income tax on the capital gain.

The NY Bar report offered an elegant solution to the ING problem. Noting that “the ING Trust would not achieve the desired state income tax avoidance if it were characterized as a grantor trust,” it proposed to characterize INGs as grantor trusts for state purposes — even though they are treated as non-grantor trusts for federal purposes — simply by “decoupling from the Internal Revenue Code with respect to this specific issue.”^[26]

State legislative decoupling is easy and common, so it is unsurprising that the New York State legislature adopted this approach. States generally follow the federal Internal Revenue Code except when they choose to decouple from specific federal rules they prefer to address in their own way. Section 612(a) of the New York tax law establishes that New York personal income tax generally follows federal law; Section 612(b) then provides a long list of New York-specific decoupling “modifications.” In 2014, acting on the NY Bar’s report, the legislature added a new sub-subsection (41) to Section 612(b) that shuts down ING-based tax avoidance:

Sec. 612(b) Modifications increasing federal adjusted gross income. There shall be added to federal adjusted gross income:

. . . (41) In the case of a taxpayer who transferred property to an incomplete gift non-grantor trust, the income of the trust, less any deductions of the trust, to the extent such income and deductions of such trust would be taken into account in computing the taxpayer’s federal taxable income if such trust in its entirety were treated as a grantor trust for federal tax purposes.^[27]

In other words, the income of the ING trust is attributed to the New York resident grantor, not the trust.

Replicating the New York Solution

With the simple addition of INGs to its long list of statutory decoupling “modifications,” New York solved its ING problem in 2014. In the eight years since then, however, no other state has followed its lead. Other states — particularly those with larger numbers of people in the top 1 percent and progressive tax codes — also should end personal income tax avoidance among very wealthy individuals by terminating ING trust abuse.

California’s Unfinished Business

Some 186 billionaires currently live in California, more than any other state,^[28] and the wealth of the state’s 30 wealthiest people as of October 2021 exceeded $1 trillion.^[29] California’s top personal income tax rate of 13.3 percent is the highest in the country, and neighboring Nevada is one of the top tax havens for locating an ING trust.^[30] All this adds up to serious vulnerability to ING trust abuse.

In 2020 the California Franchise Tax Board (FTB) explained at a public stakeholder meeting that California had the same tax problem that New York had before decoupling.^[31] As in New York, California’s vulnerability to ING trust abuse reflects the fact that California “conforms, with modification” to the federal tax treatment of trusts, “including the treatment of the ING trust as a separate legal entity and taxpayer.”^[32]

Also like New York, California could eliminate ING trust abuse simply by decoupling from the federal treatment, explained the FTB. “New York had a similar issue” and “enacted legislation eliminating the ING trust problem by … add[ing] the net income of an ING trust to the adjusted gross income of the New York resident [grantor], as if the trust was a grantor trust.” That is, New York “[s]evered the connection between the federal and state rules” governing ING trusts. “Our proposal suggests a similar approach,” explained the FTB.^[33] In January 2023, California Governor Gavin Newsom included in his proposed fiscal year 2024 budget package a fix for the ING trust problem modeled on the New York approach.^[34] Legislators would be wise to adopt it without delay.

Other States Should Also Act

Vulnerability to ING trust abuse extends beyond California to include nearly every state that has not turned itself into a tax haven.

Illinois, home to 26 billionaires whose combined wealth exceeds $100 billion, would benefit from adopting the New York solution. So would Massachusetts and Nebraska, each of which hosts billionaire wealth of more than $100 billion. Resident billionaires enjoy more than $50 billion of combined wealth in each of six other states — Connecticut, Michigan, Oregon, Pennsylvania, Virginia, and Wisconsin — which are also highly vulnerable to ING abuse. Hawai’i, New Jersey, and North Carolina each host a billionaire class controlling more than $20 billion.^[35] And, of course, INGs are also attractive tax shelters for wealthy families with assets below $1 billion.

Moreover, the estimate above may be far too low. The true amount of wealth concentrated among very wealthy individuals is hard to determine because their trust arrangements are often entirely secret, with no way for regulators or tax authorities to trace who owns what and how much it is worth.^[36] On rare occasions, some information becomes public when a whistleblower leaks documents from firms in the “wealth defense” industry. This happened in the Pandora Papers leak, which showed that many wealthy people hide money in offshore accounts to avoid taxation.^[37] These leaks, however, present only partial pictures.

Currently there is no way to accurately estimate states’ revenue losses due to ING trust abuse, but the data that are available, including estimates of the size of billionaire fortunes and of the large proportion of very wealthy individuals who engage in tax avoidance, suggest that those losses are considerable. ING trusts enable this group to dodge their state personal income tax obligations, but states can shut down this abuse by applying the New York solution.

Appendix I: Grantor and Non-Grantor Trusts

A grantor trust is not a taxable legal entity; the trust property, though “transferred” by the grantor, is treated as still owned by the grantor. Consequently, all trust income — regardless of whether it is distributed to beneficiaries — is reported on the grantor’s individual income tax return in the year in which it is realized.

A non-grantor trust, in contrast, is a trust over which the grantor no longer has meaningful control — for example, to revoke the trust arrangement, require distributions to the grantor, or change beneficiaries. As a consequence of that complete gift of property, the non-grantor trust is treated for tax purposes as if it were a legal entity independent of the grantor, as the owner of the trust property, and as a taxpayer in its own right. The trust agreement may direct the trustee to distribute the income flowing from that property to beneficiaries, direct the trustee to let the income accumulate in the trust, or leave that decision up to the trustee’s discretion. But if the trust accumulates income in a given year, it must pay tax on that income, and if it distributes income to beneficiaries, they are taxed on that income. (The trust then gets a deduction so there is no double taxation.)^[38]

State income tax laws generally follow federal tax law. For the taxation of trust income, as for the taxation of corporate and individual income, most states take as their starting point the Internal Revenue Code and related regulations, rulings, and court decisions. If a trust is a non-grantor trust for federal tax purposes, almost all states deem it a non-grantor trust, too.^[39] However, each state can decouple by statute from a variety of specific federal rules and substitute its own. This decoupling concept is central to the New York solution to the ING problem.

An individual, corporation, or trust is subject to a state’s income tax only if there is a sufficient “nexus” (connection) between it and the state to satisfy jurisdictional standards that limit state power to impose tax on that entity. In-state residency is the connection that matters in the context of grantor trusts. If the grantor of a grantor trust is resident in the state, every year they must include on their individual tax return all their income from whatever geographic source, including any trust income attributable to them.

Non-grantor trusts are also treated as having a “residence” for tax purposes, but because they are legal entities and not human beings, determining the state of residence is less straightforward.^[40] State rules for determining a non-grantor trust’s state of residency vary widely;^[41] relevant factors include whether: (1) the trustee is an in-state resident; (2) the beneficiary is an in-state resident; (3) the grantor is an in-state resident (or was when it became a non-grantor trust);^[42] (4) the trust is administered in state; (5) the trust owns real estate or other tangible property in state; and (6) the trust agreement says it’s governed by the state’s law.

Residence rules are an essential ingredient of many schemes to avoid state personal income tax. A handful of states do not impose any individual or trust-level income tax on their residents; these states function as tax havens for ING trusts.^[43]

Appendix II: The ING Trust Problem

Most states impose personal income tax on their residents’ investment income (like dividends and interest) earned during the year on their intangible assets (like stocks and bonds). But an ING provides very wealthy individuals with a vehicle to escape their state personal income tax obligations on this income when they leave it in the trust.^[44] Indeed, state personal income tax avoidance is “the primary objective” of ING trusts, according to one estate planner.^[45]

How INGs Work

INGs manipulate three fundamental elements of state personal income taxation: (1) the identity of the taxpayer; (2) the state’s taxing jurisdiction over that taxpayer (nexus); and (3) the taxpayer’s ownership of the income (the tax base).

First, for the scheme to work, the ING — not the grantor — must be the taxpayer. A non-grantor trust is treated as a taxable entity separate from its grantor, and relinquishing control is central to qualification as a non-grantor trust. If the grantor does not make a complete gift of their property to the ING, then the ING is a grantor trust, and the grantor remains the taxpayer and is liable for tax on the trust’s income.

Second, the ING must be subject to the taxing power of a tax haven state, not the grantor’s home state. That way, when the ING earns and retains^[46] income from its intangible property,^[47] this income will not be subject to state personal income tax. A trust’s nexus with a state is determined by its residence, which a skilled attorney, accountant, or trust company officer can easily manipulate. If the trustee (an individual or service firm) is resident in a state with no income tax on trusts or no income tax at all; if the trustee administers trust operations in that state; and if the trust is governed by that state’s laws, then the ING is a resident taxpayer in the tax haven.^[48]

Third, the grantor’s tax base must be shifted to the ING. The tax base is the accumulated (that is, undistributed) income produced by the grantor’s intangible property. The grantor transfers that property to the ING as part of the process of qualifying it as a non-grantor trust.

Federal Gift Tax Poses Obstacle but Can Be Overcome

There is one significant disincentive to pursuing the ING strategy: the federal gift tax, which levies its top 40 percent rate on most of the assets a grantor would wish to transfer to their ING.

The gift tax is imposed on the value of all gifts an individual makes during their life,^[49] and transfers of property to a non-grantor trust typically count as gifts as soon as they are made. The Internal Revenue Code provides a lifetime exemption amount that can be given away tax free (the current amounts are roughly $12 million for individuals and $24 million for couples), but most very wealthy gift-givers will far surpass their exemption. This 40 percent tax would more than offset the state personal income tax advantages of an ING unless the grantor can avoid the federal gift tax consequences of transferring assets to the ING.^[50]

The problem appears unresolvable initially, since the legal requirement for obtaining non-grantor trust status (namely, that the property transfer must be “complete”) conflicts with the requirement for escaping the federal gift tax (that the property transfer must be “incomplete” and thus not really a gift after all).

The solution is for the grantor to tell the IRS that the property transfer is both “complete” and “incomplete,”^[51] using carefully drafted trust provisions that skirt close to faking the facts.^[52] A common way to walk this tightrope when drafting the trust agreement is, first, to give the grantor ongoing “strings of control” — like the power to make payouts to beneficiaries for their health and education. This makes the grantor’s gift to the trust “incomplete” for gift tax purposes, and thus not a taxable gift. Second, the agreement should condition this grantor payout power on approval by a “distribution committee” composed of some of the beneficiaries and sometimes even the grantor. This retains the trust’s non-grantor status, since it means the grantor’s power over the trust is not unlimited.^[53]

INGs Can Also Enable Very Wealthy Individuals to Avoid Creditors

“‘[T]ax havens aren’t primarily for tax avoidance. They offer something even more appealing and dangerous, which is law avoidance in general,” writes Brooke Harrington.^[54] She continues: “What high-net-worth individuals buy in this system is the right to pick and choose the laws that govern them.”^[55] ING trusts are one example, since they can enable very rich individuals to escape the laws that require everyone else to pay their debts.

Creditor avoidance is easy for wealthy people with INGs; indeed, it is a required element under federal law for creating INGs. Under federal tax rules, “the possibility that trust assets can be accessed to cover claims of creditors of the [grantor] makes the trust a ‘grantor trust’”— not an ING.^[56] That’s because the IRS treats creditor access to trust property as an economic benefit for the grantor, as it would be for a grantor who desired to control enough property in the trust to satisfy their debts. Retaining that benefit constitutes retention of “control” by the grantor.

With creditor avoidance a necessary element for qualifying a trust as an ING, tax havens stand ready to oblige. Led by Nevada and South Dakota, more than a dozen states have enacted legislation authorizing “domestic asset protection trusts” (DAPTs) that enable tax dodgers to evade their creditors as well.^[57]