For a number of years it was possible to set up a type of asset protection trust in Delaware, whereby, pursuant to the terms of the trust and particular state law, the trust would not be deemed a grantor trust for income tax purposes and the transfer of assets to such trust would not be considered completed gifts for gift tax purposes. Hence the name, Delaware Incomplete Non-Grantor or DING trust.
This trust vehicle, while designed primarily for asset protection, proved very useful in assisting residents of high tax states in totally avoiding state and local tax related to intangible property. Certain states, like New York and New Jersey, do not tax out of state trusts provided there are no in-state fiduciaries and no in-state assets. Thus, a resident of New York City with a state and local tax burden of ~13% could transfer stocks and bonds to a DING trust where the related income would escape local taxation because Delaware has no income tax. The trust would, however, owe federal income tax on its income. In later periods the NYC resident could take a distribution from the DING trust (subject to the approval by a distribution committee – more on that later), and New York would view that as a distribution of trust corpus which is not taxable.
DING trusts were gaining popularity up until 2007 when the IRS began to question the gift tax implications. You see, taxpayers like the state and local tax benefits of DING trusts but not at the expense of gift tax. For years the IRS was willing to issue private letter rulings to taxpayers that the transfer of assets to properly structured DING trusts would not constitute a completed gift and thus no gift tax would be incurred. Note, gift tax would be implicated if assets of the trust were later distributed to beneficiaries other than the settlor. In July 2013, the IRS finally issued another favorable private letter ruling regarding this type of trust structure. However, this particular trust was established under Nevada law rather than Delaware law and thus the moniker “NING”.
The IRS reasoning behind both the new ruling as well as the older breed is that the settlor retains certain incidents of ownership with respect to the trust property but yet the settlor may only remove trust property if beneficiaries adverse to the settlor agree. Each of these types of trusts must have a distribution committee that is made up of trust beneficiaries other than the settlor. In this way the committee is adverse to the settlor because any distribution from the trust to the settlor reduces the ultimate allocation to the other beneficiaries. Therefore, the trust is not a grantor trust but also transfers of property to the trust are an incomplete gift.
This puts the trust in a sort of no-man’s land for state tax purposes. The trust is a separate taxpayer from the settlor (it’s not a grantor trust) and yet transfers of assets (even appreciated assets) to the trust are not taxable for either income or gift tax purposes. This unique circumstance permits intangible assets to be freely shifted out of high tax states and into low or no tax states. Provided, of course, that such high tax state has chosen not to tax out of state trusts (like NY and NJ). Unfortunately for Connecticut residents, this does not work. Connecticut taxes out of state trusts as a domestic trust if created by a state resident regardless of the existence of any in-state fiduciaries or assets. For a New York or New Jersey resident with substantial securities holdings the benefits of a NING trust must be considered. A hedge fund manager living in New York City would be paying ~13% state and local tax on income earned through the management fee as well as the carried interest. The equity interests in both the management company and the GP entity could easily be transferred to a NING trust and the entire 13% tax burden would cease. Moreover, investors with appreciated holdings definitely want to consider migrating such assets out of state well prior to disposition as the state and local tax liability related to the pre-existing gain can be avoided upon sale.
If you have questions related to DING or NING trusts please contact your regular WithumSmith+Brown partner.
- Tony Tuths