Editor: Anthony S. Bakale, CPA, M.Tax
Estates, Trusts & Gifts
Recent developments in state law and income taxation have increased the importance of planning with trusts. Trust planning is a difficult area, as it involves technical rules under the Internal Revenue Code and Treasury regulations, and understanding the tax treatment of a trust often requires a detailed knowledge of state law beyond the familiarity of tax practitioners.
Yet, ample benefits can be achieved in thoughtful planning with trusts, because the planning can cater to human nature in many clients' desire to give away an asset with strings attached. Many wealthy clients have the means to make large gifts to family members and heirs but for a variety of reasons are not prepared to do so. Perhaps the recipients are not yet ready to receive large gifts. Perhaps the donor needs to retain access to trust funds for retirement needs while removing the property from a potentially taxable estate. Maybe the client really has no desire to part with any of his or her wealth but recognizes the need to safeguard it against creditors' claims. Regardless of the situation, clients love to learn about strategies for reducing taxes on their wealth and income, and tax practitioners can add value by opening a discussion on trust planning.
This item looks at a strategy that has received greater attention recently—an arrangement that can allow trust income to avoid state income taxes. This type of planning has developed over the last decade using what once were commonly referred to as Delaware incomplete nongrantor trusts (DINGs) (see, e.g., Letter Rulings 200502014, 200612002,and 200715005). This first wave of state income planning with trusts was based on Delaware law; thus the DING tag line. As explored below, after several years without guidance or rulings from the IRS on nongrantor incomplete gift trusts, more recent IRS private letter rulings have involved trusts established in Nevada (NINGs). Rather than shifting references to this style of trust depending on the state law involved, this item refers to DINGs in the sense of domestic incomplete nongrantor trusts. Herein, a DING trust refers to any irrevocable trust established under state law in the United States (i.e., not an offshore trust) that is not a grantor trust.
Federal Tax Concepts Involving Trusts
Subchapter J of the Code, including Secs. 671-678, basically provides that if certain powers are present in a trust agreement, the grantor of the trust will include all of its income, expenses, and tax attributes on the grantor's personal tax return. These are commonly known as grantor trusts and are treated for tax purposes as not separate and apart from the grantor. Transactions between a grantor and a grantor trust, such as a sale of property to the trust, are not recognized for income tax purposes. Grantor trusts can be revocable or irrevocable.
Many modern estate planning techniques intentionally create a grantor trust to facilitate shifting wealth out of a potentially taxable estate. However, as discussed below, the strategy in the recent private letter rulings, rather than seeking to accomplish grantor trust status, was to avoid grantor trust status. Specific grantor trust powers in the Code are described later.
The second concept in planning with trusts is whether a gift to the trust is a completed taxable gift for wealth transfer tax purposes or if the transfer is an incomplete gift. Bear in mind that most incomplete gifts are still, in the general sense, completed transfers of property to irrevocable trusts; i.e., the transfer of property to a trust really happened in entirety. But for tax purposes, the completed transfer to a trust can be deemed an incomplete gift due to the grantor's retaining certain powers over the trust. Specific rules in the Code and regulations address when a gift is complete or incomplete and thus whether the trust property is considered property of the grantor upon death (see Secs. 2036 and 2038 and Regs. Sec. 25.2511-2). The ultimate result of an incomplete gift is that the transfer is not subject to immediate federal gift tax (or use of the lifetime exemption), and the trust property is included in the grantor's taxable estate.
Whether a client should structure transfers to a trust as completed or incomplete gifts depends on the circumstances. While nongrantor trust status is imperative for DING trust planning, this planning can proceed with either option on the gift issue. If the client has little or no lifetime exemption from estate and gift taxes ($5.34 million for 2014 under Sec. 2010(c)(3)), then the transfers to trust need to be incomplete gifts to avoid liability for an immediate gift tax. In most situations, planning with a DING trust includes using incomplete gifts. As explained in an example below, it would take a very large transfer of assets to a trust to make the state income tax savings worth undertaking the planning. These large transfers of assets would most likely exceed the client's available gift tax exemption.
A simple example can demonstrate the benefits of this trust planning. Imagine a high-net-worth client moving $10 million of investments to a DING trust established in a state that does not tax trust income. The interest, dividends, rents, royalties, and other investment income streams from the trust property generate an annual 5% return. The income is ordinary and taxed at the trust's marginal bracket, i.e., not long-term capital gains rate. The trust would realize $500,000 of income each year.
In this example, if the trust is a grantor trust (an irrevocable trust that includes certain powers under subchapter J of the Code), the $500,000 of income is taxed on the grantor's personal tax return for federal and state purposes. However, if the trust agreement includes no grantor trust powers, the trust itself reports the income. If the income is not distributed to the trust beneficiaries, the trust will pay tax on the net income, reported on Form 1041, U.S. Income Tax Return for Estates and Trusts.
For state purposes, the result can be dramatically different. If the grantor resides in a state with an income tax rate of 10%, such as is approximately the case in California, and income in the example is taxed to the grantor, the personal state income tax would be $50,000. If, however, a DING trust is successfully established in a state that does not tax trust income and the trust is beyond the tax reach of the grantor's state of residence, the state income tax on the trust income will be zero. Most clients would appreciate that type of tax savings. Keep in mind this result applies only as long as the trust income is not distributed to a trust beneficiary. Upon distribution of the income, the beneficiary would include the income in that beneficiary's personal tax return in his or her state of residence.
This simple example should not be interpreted to mean that this planning is easy and ripe for use by all clients with investment assets. The federal tax brackets of trusts must be taken into account. The highest current federal income tax bracket of 39.6% applies at $12,150 of taxable income for 2014, so most trusts with undistributed income will be in the highest federal bracket. If the grantor is not personally in or near the 39.6% tax bracket, the pursuit of state tax savings could generate increased federal income taxes that offset or exceed the state tax savings.
A caveat to this observation might be made in the case of a highly appreciated capital asset. Individuals in any tax bracket might benefit from a DING trust that sells an appreciated capital asset. If that asset can be transferred to a trust located in a nontaxing state, then a sale of the appreciated asset might avoid state income taxes on the gain. The federal income tax effects of transferring the assets to the trust will mostly be a wash, with trusts and individuals having the same long-term capital gain rates.
IRS Rulings on DING Trusts
Twice in the past year, the IRS issued a series of private letter rulings on proposed DING trust arrangements. The first series of identical rulings was issued in early 2013 (Letter Rulings 201310002 through 201310006). Another series of rulings was issued earlier this year, the only difference from the earlier set being a factual issue that guardians could represent minor beneficiaries on a trust committee, which did not significantly affect the IRS's tax analysis (Letter Rulings 201410001 through 201410010). The fact patterns concerning the trusts in the rulings were detailed and designed to satisfy a series of sometimes conflicting income and gift tax rules. In each ruling, the IRS concluded that the irrevocable trusts were not grantor trusts, and at the same time, the transfers of cash and property to the trusts by the grantor would be incomplete gifts.
The irrevocable trusts were established in Nevada, which does not tax the income of a nongrantor trust. It is not clear from the rulings in what state the grantor resided. There was an independent corporate trustee, but many trustee powers were reserved to family members. The children of the grantor served on a trust committee.
Three types of decisions could cause trust distributions. The trust committee could by majority vote direct the corporate trustee to distribute trust income and principal to the grantor or trust beneficiaries, if the grantor consented. The grantor could unilaterally and in a nonfiduciary capacity direct the corporate trustee to distribute trust principal to his descendants for purposes of a beneficiary's health, education, maintenance, and support. Also, upon unanimous vote of the trust committee not including the grantor, the committee could direct the trustee to distribute trust income or principal to the grantor or other beneficiaries. Other facts in the rulings addressed how replacement members of the trust committee were to be appointed and the disposition of the trust assets upon the grantor's death.
The IRS agreed with the requests of the taxpayer and ruled that (1) the trusts were not grantor trusts; (2) the grantor's transfers to the trusts were not completed gifts; (3) the votes of the committee to cause distributions to the grantor were not taxable gifts by the members of the committee; and (4) the votes of the committee to cause distributions to the other beneficiaries were not taxable gifts by the members of the committee.
Grantor Trust Rules
A variety of different terms can be drafted into trust documents to create grantor trust status. While this status is often intentionally pursued in estate planning techniques, planning with DING trusts requires avoiding grantor trust status.
Subchapter J of the Code actually makes it much easier to opt into grantor trust status than to stay out of it. A trust is a grantor trust if it has one or more powers under Secs. 673-677. Therefore, each power that can cause grantor trust status must be carefully excluded from the trust agreement to be sure to create a nongrantor trust.
The most common type of grantor trust power is for the grantor to retain a power to revoke the trust (Sec. 676(a)). Revocable trusts are probably the most common type of trust, and they are all grantor trusts by virtue of that retained power. Obviously, DING trust planning cannot be done with a revocable trust.
As for irrevocable trusts, here are the most common grantor trust powers:
- The grantor retains a reversionary right to income and/or principal of the trust after a term of years or death of a life beneficiary, unless the present value of the reversionary interest is 5% or less of the initial transfer to the trust (Sec. 673(a)).
- The grantor or a person who is a "nonadverse" party retains a power to dispose of the trust assets without the consent of an "adverse" party (these terms are explained below) (Sec. 674(a)). That is the extent of the definition. It is easier to determine what is not a retained power of disposition, by reference to the exceptions in Sec. 674(b) and associated regulations. Common exceptions (i.e., these do not cause a grantor trust) include the grantor's power (1) to apply trust income to satisfy a legal support obligation; (2) to redirect by will at death the distribution terms among the beneficiaries (a testamentary power of appointment); (3) to exercise a power by will at death to add trust beneficiaries;and (4) to direct distributions of trust property subject to a "reasonably definite standard," such as for the health, education, and support of a beneficiary.
- The grantor has a power to purchase, exchange, or transact in property with the trust for less than full and adequate consideration (Sec. 675(1)).
- The grantor retains a power to remove and replace the trustee, unless that power is limited to independent trustees (Regs. Sec. 1.674(d)-2(a)). An independent trustee is one who is not related to or subordinate to the grantor (see Sec. 672(c)).
- The grantor has a power to borrow trust assets without adequate interest or security, unless similar terms are available to other persons (Sec. 675(2)).
- The grantor has a power in a nonfiduciary capacity (e.g., without regard to trustee duties to beneficiaries) to vote stock held in the trust, control investments of the trust, or reacquire trust assets in exchange for assets of equivalent value (Sec. 675(4)).
- The trustee has the sole power to distribute income to the grantor or the grantor's spouse, or to accumulate income for the future benefit of the grantor or spouse (Secs. 677(a)(1) and (2)).
- The trustee has the power to apply trust income to pay insurance premiums on a policy that insures the life of the grantor or grantor's spouse (Sec. 677(a)(3)).
- The trustee actually uses trust income to discharge a legal support obligation of the grantor or grantor's spouse (Sec. 677(b)).
These technical rules for determining grantor trust status demonstrate that the client must be very careful when retaining any kind of decision-making authority over irrevocable trust property or rights to income or principal from the trust. It is easy to cause grantor trust status, unless the grantor uniformly separates himself or herself from the management and benefit of the trust. To successfully establish a DING trust, the less attachment the grantor has to the trust after creation, the better.
The rub is that this result is not compatible with funding a trust with an incomplete gift. To have a gift that is not considered complete and subject to gift tax, some sort of retained power or control must be present for the grantor. This is a big reason the private letter rulings are so detailed and complicated. A fine line must be walked to simultaneously arrange a trust without grantor trust powers but to which gifts are not completed due to retained powers. The IRS rulings trace a path to that dual result.
Applying the Grantor Trust Rules to the Private Letter Rulings
In the IRS rulings, each power retained by the grantor over the trust agreements avoided grantor trust status. The key to get this result and avoid a power under Sec. 674 was that distributions directed by the grantor required the consent of "adverse parties," trust committee members who are beneficiaries and thus could be adversely affected by the distribution decision. Since the trust committee members (including the grantor's sons) were adverse parties and their votes were required (with one exception) for distributions, the trusts avoided grantor status. The exception was the grantor's sole power to distribute trust principal to beneficiaries, not himself or herself, for need, under a reasonably definite standard, which is not a grantor trust power (Sec. 674(b)(5)(A)).
The IRS rulings provided various reasons for concluding the grantor did not make completed gifts. Significantly, the IRS concluded that for purposes of Regs. Sec. 25.2511-2(e), the sons on the trust committee were not adverse parties. The sons were adverse parties for purposes of the grantor trust rules on that issue. Thus, the rulings appear to confirm that, with a carefully drafted trust agreement, the same persons can be adverse and nonadverse for different tests. In addition, the grantor held a testamentary power of appointment over the trust assets, with the ability to redirect the distribution terms at his death. The IRS confirmed its position in Chief Counsel Advice 201208026 that such a limited power causes an incomplete gift of the remainder interest in the trust. The other powers held by the grantor in the letter rulings then led to incomplete gift results on the lifetime interests, as well.
Great care will be needed when planning in this area. Each taxpayer will have to analyze how closely the fact patterns in these rulings must be duplicated to achieve nongrantor trust, incomplete gift status. However, for the right clients, the tax savings make the challenge a worthwhile topic.
Using a DING Trust for Asset Protection
A client might also be interested in establishing a self-settled asset protection trust. These trusts have become more common in their domestic variety as various states enact legislation that allows for self-settled spendthrift trusts. These are trusts that upend the traditional law in the United States that a person could not defeat creditors by transferring property to a trust of which that person was a beneficiary.
A growing number of states have passed legislation changing that traditional rule. So, in Alaska, Delaware, Nevada, Ohio, South Dakota, and many other jurisdictions, asset protection can be achieved by funding a trust for one's own benefit. A detailed analysis of this area of law is beyond the scope of this item, but the intersection of domestic asset protection trusts (DAPTs) with DING trusts merits a moment of attention. The very nature of asset protection planning with a self-settled trust is that the grantor of a trust wants to remain a beneficiary of the trust while maintaining minimal rights to future distributions. So, for the most part, asset protection trust structures are consistent with DING trust structures, i.e., no grantor trust powers.
The important issue to work through is whether the transfers to the trust will not be completed gifts for federal estate and gift tax purposes. In general, a trust formed in a state that does not tax trust income and that has domestic asset protection legislation could be an alternative for this type of combined planning. Bear in mind there are a host of legal issues to work through, such as analyzing whether the resident of a state that does not have these favorable laws can take advantage of a trust that is formed in such a state without challenge by state taxing authorities and creditors seeking payment of a court judgment.
Potential State Responses
Given the growing interest in DING trust planning, it is not out of the realm of reason that state lawmakers will take note of the development. A flood of income-producing property being transferred to trusts located in Delaware, Nevada, and the like will eventually have an impact on the tax receipts of other states that rely on trust income tax revenue.
Thus, it is noteworthy that New York state has recently proposed changes to its state trust laws. Included in Gov. Andrew Cuomo's budget bill for the next biennium and effective April 1, 2014, the state's treatment of grantor and nongrantor trusts was "decoupled" from federal tax law. New York extendedthe classification of what is a grantor trust, for state tax purposes, to include the kind of irrevocable trusts that are being created by New York residents under Delaware and Nevada law. If the trust is a grantor trust, the plan fails.
More broadly, a subcommittee of the Multistate Tax Commission intends to explore whether uniform rules should be put in place for consistent treatment of determining the residency of a trust. It is the very presence of inconsistency on trust situs and trust taxation across the states that can create opportunities for knowledgeable tax practitioners to assist clients in minimizing their families' tax burdens-call it trust law arbitrage.
The takeaway from these developments is that, while it is worthwhile for high-income and high-net-worth clients to explore DING trust planning, they must do so with possible law changes in mind. Trust agreements will need to be drafted and implemented with terms that account for law changes that could render the trust arrangement useless, or worse, that increase taxes for the family.
Anthony Bakale is with Cohen & Co. Ltd., Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.