In 2013 the Internal Revenue Service (“Service”) issued several private letter rulings (“PLRs”) sanctioning the use of a state income tax planning strategy known as the Delaware Incomplete Non-Grantor trust—or the “DING” trust. DING trusts are designed to lower the state income tax burden on high-income producing assets, avoid the application of the federal gift tax rules, and provide asset protection to the grantor and family. Such trusts are not exclusive to Delaware—the trust may be sitused in multiple jurisdictions that achieve the same goals stated above, such as Alaska or Nevada (the “NING”).
The PLRs were issued after a long period of silence that followed an IRS news release stating that the Service was rethinking the gift tax consequences of a DING trust—the silence chilled the estate and tax practitioner community. The five recently issued PLRs provide a breath of fresh air and signify that the Service is willing to issue rulings on such trusts. In addition, the PLRs provide some guidelines for drafting a successful DING trust.
Facts of PLRs 20131002-201310006
The PLRs all had identical facts. Grantor created an irrevocable trust of which Grantor and his issue were discretionary beneficiaries. There was a corporate trustee who was required to distribute income or principal at the direction of a distribution committee, or solely principal at the direction of the Grantor. The distribution committee consisted of
Grantor and his four sons.
At all times at least two “eligible individuals” must be members of the distribution committee, which consists of the adult issue of the Grantor. Any vacancy on the Distribution committee must be filled by the eldest of Grantor’s issue other than the then-serving committee members. The distribution committee ceases to exist upon Grantor’s death.
There were three methods by which a distribution from the trust could be made: the “Grantor Consent Power,” the “Unanimous Member Power,” and the “Grantor’s Sole Power.” Under the “Grantor Consent Power” the trustee must distribute income or principal upon the direction of a majority of the distribution committee members with the written consent of the grantor. Under the “Unanimous Member Power” the trustee must distribute income or principal upon the direction by all distribution committee members other than the grantor. Under the “Grantor’s Sole Power” the trustee must distribute principal (and not income) to any of Grantor’s issue (and not to the Grantor) upon direction from the Grantor as the Grantor deems advisable in a nonfiduciary capacity to provide for the health, maintenance, support and education of his issue. In addition to this sole power, Grantor also holds a limited testamentary power of appointment.
Rationale of PLRs 20131002-201310006
The PLRs provided four rulings. First, the trust is not a grantor trust. Second, the transfer by Grantor of the assets to the trust is not considered a completed gift for federal tax purposes. Third, distributions made by the distribution committee to the Grantor will not be considered a gift made by the distribution committee members for federal tax purposes. Last, for federal tax purposes, there is no completed gift by the distribution committee members upon making a distribution to another beneficiary other than the Grantor.
The Internal Revenue Code (“Code”) will classify a trust as a Grantor Trust if the Grantor retains certain powers over the trust. The result of a Grantor Trust is that the Grantor is treated as the owner of the trust and that the income of the trust will be taxable to the Grantor (and not the trust). In the facts presented, the trust is not a Grantor Trust predominately because any distributions of income or principal require the consent of an adverse party. Additionally, Grantor’s Sole Power avoids Grantor Trust status because the Grantor may only distribute principal (and not income), and such distributions are limited by a reasonably definite standard (health, maintenance, support and education).
The ruling that the transfer to the trust is an incomplete gift is important because, depending on the size of the gift and the grantor’s gifting history, the transfer could result in a forty percent (40%) tax imposed on the value transferred. Broadly speaking, despite the PLRs not providing much analysis, the transfers to the trusts are not considered gifts by the Grantor because Grantor is considered to have sufficient dominion and control over the assets after the transfer to the trust, as is evidenced by the Grantor’s consent power and limited testamentary power of appointment. Juxtaposed, distributions are not considered gifts by distribution committee members other than Grantor because such members do not have sufficient dominion and control over the assets transferred (e.g., at least two “eligible individuals” provide sufficient adversity to divest each beneficiary of dominion and control). It should be noted that, since the transfer is considered an incomplete gift, the value of the trust will be includible in Grantor’s estate for estate tax purposes.
The State Tax Benefit
Some states impose little if no tax on the accumulated income and capital gains of assets held in trust. Thus, where the Grantor lives in a state that imposes marginally higher taxes on income-producing assets held in trust, the Grantor can shift the state income tax burden, avoid a gift for federal tax purposes, and retain the added benefit of asset protection. This can be very appealing to a client who anticipates a liquidity event of highly appreciated assets or who has a significant income-generating portfolio. The benefits are best seen with an illustration.
A client anticipates a $10 million dollar gain attributable to highly appreciated stock. The client is married, files her taxes jointly, and lives in a state that imposes a 10% tax on accumulated earnings and capital gains. Additionally, gain attributable to the stock is subject federal long-term capital gains tax at 20% as well as the 3.8% Medicare tax imposed on net investment income.
It should quickly be noted that the disparity between the NIIT imposed in the two scenarios above exists because of how the assets are held. When held by an individual who is married filing jointly, the tax is imposed on the net investment income that exceeds $250,000; when held in trust, the tax is imposed on net investment income that exceeds $12,150.
The tax benefits of a DING seem clear—when a client lives in a high-tax State and has a high income-producing asset, the DING trust can be a powerful tax minimization solution. However, DING trusts are not for every client and every situation, and considerations must also be given proper weight.
Some Other Considerations
Compressed Trust Tax Rates. You should weigh the potential state income tax savings against the client’s federal income tax bracket. Because accumulated earnings and capital gains would be subject to the compressed marginal trust income tax brackets, and presuming your client is not subject to the highest individual marginal income tax bracket, the additional federal income tax imposed on trust income may be greater than the state tax benefit.
Distribution Committee Considerations. At its core, there must be a proper family dynamic for an effective distribution committee to be implemented. In the absence of enough people, or in the presence of even the slightest bit of existing adversity, a DING trust may cause more headache to the grantor than the economic benefit is worth. Simply put, the grantor must have sufficient trust in each distribution committee member and be confident that such members have the proper business acumen and sophistication to carry out a DING trust’s purpose.
State Law. It is imperative that you undertake a thorough review of state trust and income tax law. Depending on the state, a trust may be taxed on the accumulated earnings and capital gains based on the domicile of the grantor, the domicile of the trustee, the location of the assets, or place of the trust’s administration, or a combination of these factors. In the absence of such a review, the desired state tax benefit could be lost. Consequently, you would be well-advised to seek counsel due to the fluctuations and differences in state law.
Given the guidance of the recent PLRs, the DING trust is indeed a viable option to consider for state tax minimization purposes. The PLRs should give adequate comfort that structuring a DING trust will not result in a taxable gift for federal purposes.
By: Jim Duggan, JD, MBA