A tool that can be part of an effective business exit strategy

The aim for most entrepreneurs who want to sell their business is to develop an exit plan on their own terms. They want to maximize value (or realize their desired value) and close the deal in the most tax-efficient manner. One way to help them accomplish this is by using a Nevada Incomplete Gift Non-Grantor Trust.

A Nevada Incomplete Gift Non-Grantor Trust is an irrevocable trust designed to reduce or eliminate potential state income taxes and capital gains taxes upon the sale of a business. Additionally, these trusts offer excellent asset protection for sellers. NINGs are typically used by business owners living in high-income-tax states who seek to minimize or eliminate their state income taxes. The NING exists as a form of tax arbitrage to save business owners the cost of state income and federal gift taxes but still permits future asset control by the settlor.

Preliminary planning for the sale of a closely held business

In an ideal situation, the planning process of selling a closely held business should be done a few years prior to the actual sale to maximize the advantage of the NING.

Business owners eager to get to their “number” hastily engage a business broker or investment banker, who then levies heavy percentage fees for aiding in the sale. I believe it’s important to have owners engage competent tax and legal professionals first, as presale planning is critical. Planning should take place prior to engaging a broker, drafting a letter of intent, or starting negotiations with a potential buyer.

The team

A CPA, an attorney and an investment banker are core advisors in business sales. The CPA typically has regular contact with the business, has reviewed or prepared the financials, and understands the business structure as well as its operations. The sale of a closely held company will require a few attorneys with different areas of specialization: a corporate/transactional attorney to structure and execute the transaction documents as well as an income tax attorney plus an estate planning attorney to minimize the seller’s income tax liability.

The owner of a closely held business usually has an accountant and an attorney, but it’s unlikely the owner has worked with an investment banker, business appraiser, or broker. For larger family businesses, choosing the right investment banker, after consultation with counsel, can be critical to maximizing the business sale price.

What is a NING Trust?

A Nevada Incomplete Gift Non-Grantor Trust is an irrevocable trust designed to reduce or eliminate the potential state income tax for high-income earners or on a significant capital gain incurred on the sale of an asset for business owners who live in a high-income-tax state. An irrevocable trust is a trust in which the assets placed are no longer owned by the grantor (business owner or seller). The trust has a separate tax ID number and is the entity that pays the income taxes. The trust is considered to be the owner of the assets. The proceeds or profits generated from any assets held in the trust are not taxable at the state level.

For example, Sally Founder owns a $5,000,000 investment portfolio that produces $600,000 of interest, dividends and capital gains per year. Assume that Sally’s home state has a 12.3% income tax rate but would not tax income from a trust created by Sally in Nevada. By transferring the investment portfolio to a Nevada Incomplete Non-Grantor Trust and by satisfying certain other technical requirements in the trust document, Sally could save $73,800 per year in state income tax (0.123 x $600,000). If Sally could reinvest the savings at 10%, Sally’s initial savings if reinvested would increase by $496,489 over a 20-year period. This amount increases as additional annual state tax savings are factored into the equation. Larger tax savings might also be achieved by taxpayers holding assets with large capital gains on low-basis assets.

Trust structure

Transactions using a NING should be structured carefully to satisfy the following requirements:

1. The trust must be established in a state that does not tax trust income.

2. The income from the trust must not be taxable by the founder’s (grantor’s) home state.

3. The trust must allow discretionary distributions to the grantor without making the trust a grantor trust.

4. Transfers into the trust must be incomplete gifts for federal gift tax purposes without having the trust become a grantor trust.

As noted previously, NING trusts are largely supported by a series of private letter rulings issued by the IRS. In order to use a NING, there are three critical points to consider.

First, any potential state tax reduction only applies to investment income-producing assets. It generally does not apply to compensation, to income from a trade or business, or to rents, royalties, or gains derived from ownership of tangible property. The second point is that the individual owner of the income-producing asset must transfer it into a special trust well in advance of any liquidation event. Third, that trust must be administered in Nevada (or a suitable state that has no income taxes and permits self-settled trusts).

1. Trust must be located in a state that doesn’t tax trust income

The incomplete gift non-grantor trust must be established in a state that: (1) will not tax trust income, (2) has a domestic asset protection trust statute, and (3) permits the settlor to retain a lifetime and testamentary nongeneral power of appointment. States that permit incomplete gift non-grantor trusts include Alaska, Delaware, Nevada, Ohio, South Dakota and Wyoming. It is important for a settlor to consider if their home state will deem the trust to be a resident trust.

For example, under California law, a trust is taxed on the income from intangible investment assets if a fiduciary (including a trustee) or a beneficiary (other than one whose interest in the trust is contingent) is resident in the state. Unlike tangible property, intangible investment assets not associated with a business domicile in a state with income taxes are deemed to be situated where the trust is administered. For NINGs, that is Nevada. The income from tangible property is traced to the location of the asset, while the income from intangible property — for example, the passive investments of a typical trust portfolio — is traced to the residence of the owner.

2. Trust not subject to tax in the settlor’s home state

Establishing the trust in one of the states listed above does not necessarily mean that the trust’s income will not be taxed by the grantor’s home state. Many states levy income tax on what they refer to as resident trusts. Resident trust definitions vary from state to state. For example, Connecticut, the District of Columbia, Illinois, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, Ohio, Oklahoma, Pennsylvania, Utah, Vermont, Virginia, West Virginia and Wisconsin treat trusts as resident trusts if the grantor/settlor was a state resident when the trust became irrevocable, regardless of where the trust is domiciled.

3. Discretionary distributions to the settlor

The trustee must be “adverse” to the settlor and have the power to make discretionary distributions to the settlor so that the settlor can receive the trust income. However, this must be accomplished without making the trust a grantor trust.

4. Incomplete gift

Most taxpayers who transfer assets to a NING do not want the transfer to be subject to gift tax. And while available, the taxpayer may not want to use their gift tax exemption. This is accomplished by: (1) giving the settlor a testamentary special power of appointment over the trust assets, and (2) requiring the consent of a distribution committee for any distributions to the settlor. The testamentary special power of appointment makes the transfer to the trust an incomplete gift, and the distribution committee consent requirement allows the trust to avoid grantor trust status.

Red flags for state tax authorities

State taxing authorities may audit and challenge NINGs that are hastily prepared and designed primarily to avoid incurring state income tax on a particular transaction, such as the disposition of a block of highly appreciated stock. State taxing authorities will examine the timing and dates on transaction documents as part of their assessment. They also may be on the lookout for issues such as funding a trust with assets that are certain or even highly likely to be sold shortly after the creation of the trust.

Subject to careful planning and execution, the NING is a powerful tax-planning tool useful for entrepreneurs and business owners contemplating the future sale of a closely held business, stock, or investment portfolio to eliminate or minimize state income tax. The benefits are especially appealing when the taxpayer’s home state is a high-income-tax state, such as California.

Investment income can be transferred into a NING, and state income tax on the investment income of assets held in the NING can be avoided. Taxpayers residing in states with high income taxes with large unrealized capital gains or a regular stream of ordinary income from an investment portfolio who have always wanted to find a way to eliminate or minimize their state income tax exposure without giving up the economic benefit of the underlying assets would benefit from using the NING.