Adversity, Inconsistency, and the Incomplete Nongrantor Trust

Abstract

Federal tax considerations have traditionally played a prominent role in the planning and drafting of family trusts. State taxes, by comparison, have received far less attention. Since 2001, however, sophisticated estate planners have developed a specialized form of trust, known as an "incomplete nongrantor" (ING) trust, which purports to avoid state fiduciary income taxes on accumulated trust income. Unlike most tax-driven trusts, the ING trust is not designed to reduce federal tax liability. Nevertheless, its efficacy depends on a threshold determination of federal tax consequences. To ensure that the ING trust is respected as a taxable entity separate from the grantor, the grantor must scrupulously eschew any interest or power that might give rise to deemed ownership under the grantor trust rules; in other words, the transfer must be complete for federal income tax purposes. This is easily accomplished if the trust is irrevocable and the grantor is willing to relinquish any prospect of beneficial enjoyment or control. The grantor, however, typically wishes to retain sufficient control over the trust to make the transfer wholly incomplete for federal gift tax purposes. In theory, a transfer may be treated as complete for income tax purposes and incomplete for gift tax purposes. With careful planning, a trust may be designed to avoid the gift tax as well as the grantor trust rules, but no judicial decision or revenue ruling to date directly confirms that an ING trust successfully achieves this feat. Instead, proponents have relied on a series of private letter rulings from the Internal Revenue Service to support their analysis of the trust's federal tax consequences. Closer scrutiny of that analysis reveals gaps and contradictions which call into question the viability of the ING trust as a planning technique.