The Revival of the “DING Trust” – Is it Here to Stay?
June 12, 2013
Individuals continue to proactively seek an approach to manage and mitigate potential federal and state income tax exposure, as tax reform over the last several years has produced adverse results, especially for those living in high income tax states generating ordinary income and short-term gains.
Beginning in 2013, the top federal marginal income tax rate is 39.6% for high income taxpayers with earned income and short term gains, which does not include an additional tax rate increase of approximately 1% for the phase out of personal exemptions and itemized deductions. The Medicare tax also adds an additional 3.8% tax on top of the federal tax for investment income generated by the high earners. Those residing in high tax states such as New York and California can count on a combined federal and state marginal income tax rate of up to 56% in certain instances.
The Internal Revenue Service (“IRS”) recently resurrected a state income tax planning strategy that been on hold and has not been ruled upon for at least five years, involving what has been known as the “DING Trust” (Delaware Incomplete Non-Grantor trust).
The 2013 private letter rulings, issued by the IRS, indicate a willingness to again issue rulings with respect to this type of trust offering insight into proper structuring. As described below, the DING trust has been subject to rulings issued over five years ago that have been subject to practitioner criticism, and almost suffered extinction with the advent of Internal Revenue Code Section 2511(c) which provided that a transfer to a non-grantor trust would be treated as a completed gift. Fortunately, the American Taxpayer Relief Act of 2012 made the repeal under the 2010 Tax Relief Unemployment Insurance Reauthorization and Job Creation Act permanent.
By utilizing a DING trust, an individual is able to transfer high-income producing assets to a trust without triggering federal or state gift tax (in the case of Connecticut resident) while mitigating state income tax with regard to the assets transferred. The trusts are designed to shift state income tax from the grantor’s domicile state to a trust located in a jurisdiction that does not tax trust income, accumulated income and capital gains, with the added benefit of providing asset protection to the grantor and family. Trust jurisdictions used have included Delaware, Nevada, and Alaska.
This type of trust is often appealing to an individual who holds significant income generating portfolios or anticipate a liquidity event of highly appreciated assets, resides in a high tax state that will not tax a non-grantor trust domiciled in such a low or no income state, and is looking for asset protection in the future.
Currently, New York and New Jersey will not tax a trust’s income if it has no resident trustees, assets located in the jurisdiction, or state sourced income. An investment portfolio held in a DING trust should be exempt from New York and New Jersey state and local income tax if the trustee is a non-New York resident or non-New Jersey resident, respectively. California will tax trust income if the trust has at least one resident trustee and no non-contingent beneficiary resident in California.
To illustrate the concept, assume a married resident of New York City expecting a $15 million gain from the sale of stock in a closely held business. The individual is considering transferring the stock into a DING trust created in Nevada. All gain will be considered net investment income for purposes of the Medicare tax. Capital gains will be taxed at 20%, a combined New York state and city income tax rate of 12.8%, and Nevada state fiduciary income tax rate of 0%.
|No Trust||With DING Trust|
|Gain from Sale of stock||15,000,000||15,000,000|
|Federal Capital Gains Tax (20%)||(3,000,000)||(3,000,000)|
|Medicare Tax (3.8% over applicable threshold)||(560,500)||(569,546)|
|Combined New York Taxes (12.8%)||(1,920,000)||0|
The funding of the DING trust is designed to be an incomplete gift so the trust assets will be includible in the grantor’s estate at death. Other complimentary estate planning strategies should be considered to reduce the grantor’s taxable estate, including perhaps setting up an insurance trust to secure life insurance that can be used to fund the estate tax on death.
In considering the design of the trust, it is extremely important to consider the balance of the state income tax savings against the federal income tax resulting from the income being taxed in the trust as opposed to an individual, especially given compressed trust rate brackets and the 3.8% Medicare tax on investment income. Drafting the trust with flexibility enables the trustee to make distributions to those beneficiaries in a lower income tax bracket in the future, thus being able to minimize both federal and state income taxation.
A thorough review of the state trust laws and income tax rules should be undertaken before implementing the plan in order to have the desired state income tax consequences, as many states assert taxation based on a grantor’s domicile, the trustee’s domicile, location of the assets, place of administration, or a combination of these factors, as mentioned above. Private letter rulings may only be relied upon by those requesting the rulings. Those who execute a strategy using the DING trust may be well advised to obtain their own private letter ruling.
The key goal in structuring the DING trust is to avoid the trust being classified as a grantor trust and to avoid a completed gift upon the funding of the trust. The trust is irrevocable and must be domiciled in a state that authorizes self-settled spendthrift trusts; otherwise the grantor’s creditors could potentially attach the trust assets creating grantor trust status for federal income tax purposes. Other key areas for consideration include the following:
- Trust distributions can benefit the trust settlor and other family members during the grantor’s life -- this is especially helpful if the grantor wants to avoid unforeseen cash flow issues in the future;
- Trust can create a distribution committee comprised of members of the grantor’s family having the authority to make trust distributions to the grantor and to the other beneficiaries including the members of the distribution committee. The grantor cannot be a member of the committee.
- Trust can provide the grantor with the power to consent to the trust distributions, and the grantor can have a limited testamentary power of appointment over the trust assets.
Over the last decade, the IRS has issued rulings involving the DING trust having similar facts but criticized by practitioners. A particular criticism involved whether the grantor retaining a lifetime power to appoint assets with the consent of a distribution committee would create an incomplete gift and non-grantor trust status. For gift tax purposes, the IRS ruled that a gift was incomplete on the basis that the distribution committee was not adverse to the grantor. But on the same facts, ruled that for income tax purposes the trust is not a grantor trust since the distribution committee members held adverse interests with respect to the settlor.
In the 2013 PLR, the IRS ruled that the funding of an irrevocable trust was an incomplete gift; a gift from the trust should not be treated as a gift from the members of the distribution committee, and classified the trust as a non-grantor trust with the following essential provisions:
- Grantor consent power -- Distribute income or principal upon direction of a majority of the distribution committee with consent by the Grantor;
- Unanimous member power -- Distribute income or principal upon direction by all distribution committee members other than the Grantor; and
- Grantor’s sole power -- Distribute principal and not income to any of the Grantor’s issue upon direction from the Grantor in a non -fiduciary capacity to provide for the health, maintenance, support, and education of his issue.
With the rise in federal income tax rates, state income tax planning for those residing in high-tax jurisdictions such as New York, New Jersey, and California is more prevalent. The DING trust, if properly structured, can be used as a tool in a comprehensive financial plan which can be helpful in mitigating income tax for those holding income generating portfolios or anticipating a liquidity event. Individuals considering this strategy should seek counsel especially due to the fluctuations in state law and the specific guidelines set forth by the Internal Revenue Service. These trusts do not provide for federal estate tax savings they work best when combined with a well-thought out estate plan.