Incomplete non-grantor trusts are separate taxpayers for income tax purposes and are structured so that most transfers to and distributions from these trusts are incomplete gifts for federal gift tax purposes. They’re frequently formed in states with favorable laws regarding the income taxation of trusts, such as Delaware; hence, they’re often referred to as DING (Delaware incomplete non-grantor) trusts. The DING trust will be included in the grantor’s estate, and the trust assets should receive a corresponding step-up in basis at death. Residents of states with high income taxes often create DING trusts to help minimize state income taxes. Further, these trusts can be beneficial for taxpayers who wish to preserve their unified lifetime gift and estate tax credit for future planning and for those who have previously used the entirety of their unified credit.
In 2013, the Internal Revenue Service issued a series of favorable private letter rulings approving the terms of an incomplete non-grantor trust.1 Just last week, the IRS issued another PLR with facts and rulings similar to those of the 2013 PLRs. These series of rulings indicate that the IRS is developing a more positive attitude towards properly structured DING trusts; however, as discussed later in this article, some states are starting to crack down on the use of these trusts.
Proposed Trust Terms
In PLR 201430005 (July 25, 2014), the grantor proposed creating an irrevocable trust for the benefit of himself, his descendants and four adult individuals. During the grantor’s life, the beneficiaries of the trust would be the grantor and the four adult individuals. A trust company was to be appointed as trustee and could distribute income and principal during the grantor’s life only in the three following scenarios.
First, the trustee was required to distribute trust income and principal to one or more of the beneficiaries as directed by a majority of the members of the distribution committee with the written consent of the grantor (the grantor’s consent power). Second, the trustee was required to distribute trust income and principal to one or more of the beneficiaries as directed by all the members of the distribution committee (the unanimous member power). Finally, the grantor had the power, in a nonfiduciary capacity, to direct the trustee to distribute trust principal (but not income) to any one or more of the beneficiaries (other than the grantor, his creditors, his estate or the creditors of his estate) as the grantor deemed advisable for his descendants’ health, education, maintenance or support (the grantor’s sole power).
The distribution committee was to be initially comprised of the four adult beneficiaries other than the grantor. Under the terms of the proposed trust, the distribution committee must always consist of least two members who are also trust beneficiaries, other than the grantor. If at any time the distribution committee doesn’t consist of at least two such members, the vacancy must be filled by the eldest adult descendant of the grantor who’s willing and able to act. If there’s no such descendant, the distribution committee will cease to exist. Furthermore, the distribution committee will cease to exist at the time of the grantor’s death.
The terms of the proposed trust gave the grantor a limited testamentary power of appointment (POA). Following the grantor’s death, to the extent this POA wasn’t fully exercised, the remaining trust income and principal was to be divided into two equal parts. One half was to be distributed in equal shares to the four named adult beneficiaries who survived him. The other half was to be divided into shares, per stirpes, for the grantor’s descendants and held in further trust for such descendants.
Non-Grantor Trust
The IRS first held that the proposed trust qualified as a non-grantor trust. The IRS didn’t provide any reasoned analysis but simply stated that Internal Revenue Code Sections 673, 674, 676, 677 and 678 were inapplicable to the facts at hand. The IRS noted that the application of IRC Section 675 was a question of fact to be answered during the examination of the parties’ federal income tax returns. Therefore, the trust would be treated as a separate taxpayer, and neither the grantor nor any other person would be treated as the owner of the trust property for federal income tax purposes.
Incomplete Gift by the Grantor
IRC Section 2501(a)(1) imposes a tax on each transfer of property by gift during the calendar year. Under Section 2511(a), the gift tax applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect and whether the property is real or personal, tangible or intangible. Further, Treasury Regulations Section 25.2511-2(b) provides that a gift is complete if the donor has “so parted with dominion and control as to leave in the donor no power to change its disposition.” The IRS analyzed each of the dispositive powers granted to the grantor and the distribution committee in turn to determine whether these powers will cause the initial transfer to the trust to be a completed gift for gift tax purposes.
The IRS first addressed the grantor’s consent power. Under Treas. Regs. Section 25.2511-2(e), a donor is considered to have retained a power to change the disposition of property if such power is exercisable by the donor together with persons not having a substantial adverse interest in the disposition of such property. While Treas. Regs. Section 25.2511-2(e) doesn’t define “substantial adverse interest,” Treas. Regs. Section 25.2514-3(b)(2) provides that a taker in default of a POA has an interest adverse to the exercise of such power. Section 25.2514-3(b)(2) further states “a co-holder of a power has an adverse interest where he may possess the power after the possessor’s death and may exercise it at that time in favor of himself, his creditors, his estate, or the creditors of his estate.” Here, the IRS determined that the distribution committee members didn’t have a substantial adverse interest to the grantor for gift tax purposes. Specifically, they weren’t takers in default; instead, they were merely co-holders of this power. Further, as the distribution committee ceased to exist on the grantor’s death, its members didn’t have a substantial adverse interest because they would no longer possess the power to direct distributions after his death. Therefore, as the distribution committee members didn’t have a substantial adverse interest to the grantor, the IRS held that the grantor’s consent power wouldn’t cause the initial transfer to the trust to be a completed gift.
The IRS next analyzed the grantor’s sole power. Treas. Regs. Section 25.2511-2(c) provides in part that a gift is incomplete if and to the extent the donor retains the power to change the beneficial interests, unless such power is a fiduciary power limited by a fixed and ascertainable standard. Here, the grantor’s sole power was a nonfiduciary power to distribute trust principal (but not income) to the beneficiaries other than himself. The grantor had the power to distribute trust principal equally or unequally among such beneficiaries, including all to one to the exclusion of the others. The IRS determined that this limited lifetime POA therefore wouldn’t cause the initial transfer to the trust to be a completed gift under Section 25.2511-2(c).
Further, the IRS considered whether the grantor’s limited testamentary POA will cause his initial transfer to the trust to be a completed gift. Treas. Regs. Section 25.2511-2(b) gives an example in which the donor transferred property to a trust and retained a testamentary power to appoint the remainder among his descendants. This regulation concludes that the donor’s testamentary POA causes his gift to the trust to be incomplete. Here, pursuant to Section 25.2511-2(b), the IRS concluded that the grantor’s limited testamentary POA will cause the initial funding of the trust to be an incomplete gift for gift tax purposes, but only with respect to the remainder.
Finally, the IRS addressed the unanimous member power. In Goldstein v. Commissioner,2 the grantor of a trust retained the power to change the beneficiaries, and the trustees had the power to distribute any part or all of the trust property to one or more of the beneficiaries. The Tax Court held that the grantor’s power to change the beneficiaries caused his transfer to the trust to be incomplete for gift tax purposes, even though the grantor’s power could be defeated by the trustees’ decision to distribute all the trust property outright to one or more of the beneficiaries. Here, as in Goldstein, the unanimous member power isn’t a condition precedent to the grantor’s exercise of his retained powers; rather, the grantor will retain these powers until the distribution committee directs the trustee to distribute the entirety of the trust funds. Therefore, the IRS held that this power won’t cause the grantor’s initial transfer of property to the trust to be a completed gift for federal gift tax purposes.
Incomplete Gifts by Distribution Committee Members
The IRS next considered whether distributions directed by the distribution committee will be completed gifts by the members of such committee. First, the IRS determined that a distribution of property to the grantor under the direction of the distribution committee wouldn’t be a completed gift by any of the members of this committee; instead, such a distribution would be a return to the grantor of his property.
Second, the IRS analyzed whether a distribution directed by the distribution committee to a beneficiary other than the grantor would be an exercise of a general POA and would, therefore, constitute a completed gift by the members of this committee. Pursuant to IRC Section 2514(b), the exercise of a general POA is a transfer of property by the individual possessing such power.
Under the proposed terms of the trust, the distribution committee could direct distributions pursuant to the grantor’s consent power. IRC Section 2514(c)(3)(A) provides that if a POA is exercisable by the possessor only in conjunction with the creator of such power, such power isn’t a general POA. Here, the distribution committee’s power to direct distributions under the grantor’s consent power could be exercised only in conjunction with the grantor, the creator of this power. Therefore, the IRS concluded that a distribution to a beneficiary other than the grantor pursuant to the grantor’s consent power wouldn’t cause the members of the distribution committee to have general POAs under Section 2514(c)(3)(A) and would, therefore, be an incomplete gift.
The distribution committee also could direct distributions pursuant to the unanimous member power. Section 2514(c)(3)(B) provides that if a POA is exercisable by the possessor only in conjunction with a person having a substantial interest in the property subject to the power that’s adverse to the exercise of the power in favor of the possessor, such power isn’t a general POA. For these purposes, a co-holder of a power is considered to have an adverse interest under Section 25.2514-3(b)(2), cited above. Here, the IRS determined that the distribution committee members had substantial adverse interests, presumably because they were all trust beneficiaries. On the death of one of the committee members, the remaining members would continue to serve and would continue to possess the power to direct distributions to themselves as beneficiaries during the grantor’s life. Therefore, the IRS held that a distribution to a beneficiary other than the grantor pursuant to the unanimous member power wouldn’t cause the members of the distribution committee to have general POAs under Section 2514(c)(3)(B) and the corresponding regulations and would, therefore, be an incomplete gift.
State Tax Considerations
Practitioners should continue to be cognizant of the income tax laws of the state where the grantor resides. For instance, earlier this year, New York Governor Andrew Cuomo signed the New York State 2014-2015 Budget into law. This budget incorporates a number of significant state tax changes, including a revision to the income tax treatment of incomplete non-grantor trusts. Specifically, under the new law, incomplete non-grantor trusts created by New York residents will be deemed to be grantor trusts for New York purposes. Therefore, New York residents may no longer wish to plan with incomplete non-grantor trusts, because they’re now required to pay New York State (and New York City) personal income tax on the income earned on or after Jan. 1, 2014 by these trusts.
Endnotes
- See PLR 201310002 – 201310006 (released March 8, 2013).
- Goldstein v. Commissioner, 37 T.C. 897 (1962).