In an increasingly adverse tax environment, taxpayers and their advisors are planning creatively to mitigate their liability exposure. One tool that a taxpayer can use is a Delaware incomplete non-grantor (DING) trust. DING trusts are sitused in jurisdictions that don’t tax the income and capital gains of a non-grantor trust.1 Individual taxpayers who are domiciled in states with high income tax rates use DING trusts to avoid state income tax imposed by their respective domiciles. In addition, a DING trust provides heightened asset protection advantages for a grantor and his family.
DING trusts were quite popular from 2001 until 2007. In 2001, the Internal Revenue Service issued a favorable DING trust private letter ruling, but in 2007, it began publicly reconsidering its position. It noted, in IR-2007-127, that the DING trust rulings from 2001 were potentially in conflict with Revenue Rulings 76-503 and 77-158. This public announcement had a chilling effect on the use of DING trusts, due to uncertainty about the IRS’ position.2
On March 8, 2013, the IRS released a series of PLRs that resuscitated planning options for DING trusts. In PLRs 201310002–201310008 (collectively the 2013 PLRs), the IRS blessed a particular type of DING trust structure, resulting in favorable income and gift tax treatment for the taxpayer.
This development means that DING trusts can be used to mitigate the state income tax consequences arising from the sale of artwork. Here’s how.
In designing a DING trust, an advisor must ensure that it’s not classified as a grantor trust for income tax purposes. Otherwise, it would most likely be taxed to the grantor for state income tax purposes as well, defeating the primary purpose of the trust. Additionally, the client’s advisor must draft the trust appropriately, so that a transfer to the DING trust isn’t considered a completed gift. Otherwise, the transfer would be subject to a 40 percent federal gift tax. Because the DING trust assets will be includible in the grantor’s estate, proper planning must be implemented to mitigate any estate tax consequences.
According to the 2013 PLRs, other key features of a DING trust include:
1. Trust distributions can benefit the grantor and other family members during the grantor’s life.
2. A corporate trustee distributes income or principal at the direction of a distribution committee or principal on the direction from the grantor.
3. The distribution committee must always have two eligible individuals serving as committee members.
4. Eligible individuals are the grantor’s descendants and, if such a descendant is a minor, his legal guardian.
5. The DING trust provides for a distribution committee comprised of members of the grantor’s family who have the authority to make trust distributions to the grantor and to the other beneficiaries, including the members of the distribution committee. The grantor can’t be a member of the committee.
6. The 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.
7. In brief, the trust can provide for the following consent powers:
a) Grantor consent power—Distribute income or principal on direction of a majority of the distribution committee with consent by the grantor;
b) Unanimous member power—Distribute income or principal on direction by all distribution committee members other than the grantor; and
c) Grantor’s sole power—Distribute principal and not income to any of the grantor’s issue on direction from the grantor in a non-fiduciary capacity to provide for the health, maintenance, support and education of his issue.
DING Trust Asset
A DING trust is particularly attractive for two types of taxpayers: (1) an individual who holds portfolios that generate a substantial amount of income; and (2) an individual who anticipates a disposition of highly appreciated assets with a low basis. While DING trusts have been commonly used to structure the sale of highly appreciated intangibles, such as securities and closely held business interests without state income tax liability, they can also be used for the same purpose in connection with sales of highly appreciated artwork.
It’s important for an advisor to closely examine the laws of the grantor’s domicile with respect to non-resident trusts.3 Different states impose trust taxation based on different considerations, such as the domicile of the grantor, the residence of the trustee or a combination of both.4 For example, in New Jersey, a nonresident trust isn’t taxable if there are no New Jersey trustees, assets or sources income.5 New Jersey source income includes income derived from real and tangible personal property located in New Jersey. Accordingly, if the artwork is located in New Jersey and sold in New Jersey, then it’s likely characterized as New Jersey source income and subject to New Jersey state income tax.
Arguably, if the artwork is kept in a storage site outside of New Jersey and the sale transaction takes place outside of New Jersey, then its disposition shouldn’t result in New Jersey source income (not to mention New Jersey state sales tax liability). It would be prudent to have all the paperwork pertaining to the artwork, such as insurance and storage address, located outside of New Jersey as well. Advisors for DING trust clients should also counsel their clients on the “old-and-cold” approach—that is, the artwork should be transferred to the DING trust a significant period of time prior to its disposition to avoid a step-transaction doctrine argument by the state authority. Domiciliaries of each state must conduct an independent analysis of their respective state’s income tax laws to determine the consequences of the sale of tangible personal property, such as artwork within a DING trust of which he’s the settlor.
Finally, advisors must also ensure that the income from the disposition of the asset doesn’t give rise to source income of the trust’s jurisdiction. Otherwise, there’s exposure to the trust jurisdiction’s income tax laws.
To illustrate the tax savings afforded by a DING trust, assume that a married resident of New Jersey is expecting a $5 million gain from the sale of highly appreciated artwork. Furthermore, the individual isn’t planning on engaging in an Internal Revenue Code Section 1031 like-kind exchange transaction to defer federal and state income taxes.6 The individual is considering transferring the stock into a DING trust created in Delaware. All gain will be considered net investment income for purposes of the Medicare tax. Capital gains will be taxed at the collectibles tax rate of 28 percent, a New Jersey state income tax rate of 8.97 percent and incur no state fiduciary income tax. “State Income Tax Benefit,” p. 33, shows an estimate of the state income tax savings afforded by a DING trust in this example.
In considering the design of the trust, it’s extremely important to balance 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 percent 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 minimizing both federal and state income taxation.
A properly designed DING trust can be a powerful tool in mitigating the effect of state income tax liability resulting from the sale of appreciated artwork. In planning for a DING trust, a taxpayer must examine state trust laws, as well as the income tax law of his own domicile, to assure that the desired income tax result may be achieved. Many states impose tax based on a grantor’s domicile, the trustee’s domicile, location of the assets, place of administration or a combination of these factors. For the purposes of the federal income, estate and gift taxes, taxpayers are well advised to apply for a PLR, as the PLRs discussed in this article may only be relied on by those requesting the ruling.
1. While Delaware is a possible choice of jurisdiction for such a trust, it’s by no means the only one. Other options include: Alaska, Nevada, South Dakota and Wyoming.
2. Delaware incomplete non-grantor (DING) trusts almost became obsolete with the introduction of Internal Revenue Code Section 2511(c), which provided that a transfer to a non-grantor trust would be treated as a completed gift. The American Taxpayer Relief Act of 2012 made permanent the repeal of this section under the 2010 Tax Relief Unemployment Insurance Reauthorization and Job Creation Act.
3. For a more thorough treatment of state tax laws and income taxation of nonresident trusts, see Richard Nenno, “Planning to Minimize or Avoid State Income Tax on Trusts,” ACTEC Journal (2008); Charles Platt and Richard Nenno, “New York State Income Taxation of Nongrantor Trusts: Rules and Opportunities,” Tax Management Estates, Gifts and Trusts Journal (2012); and Richard Nenno, “State Income Taxation of Trustees: Some Updates,” Tax Management Memorandum (June 2013).
4. As of April 1, 2014, the New York State tax law has been amended to impose a tax on the distribution of income from a nonresident trust to a New York State beneficiary.
5. See NJSA 54A:1-2(o)(2)-(3). Although an inter vivos trust set up by an individual who was a New Jersey domiciliary at the time of the transfer to a trust is considered a New Jersey resident trust, the New Jersey 2013 Fiduciary Income Tax Return instructions provide in relevant part that:
If a resident trust . . . does not have any assets in New Jersey or income from New Jersey sources, and does not have any trustees . . . in New Jersey, it is not subject to New Jersey tax. However, a New Jersey Gross Income Tax Fiduciary Return should be filed with a statement enclosed certifying the trust’s . . . exempt status.
6. For more information on how to defer income taxes in the context of sales of art, see K. Eli Akhavan, “Artfully Deferring Taxes,” Probate & Property
(July/August 2012) and K. Eli Akhavan, “Brushstrokes of Art Planning,” Trusts & Estates (August 2012), at p. 23.