I. Tax & Asset Protection Benefits of PLR 201310002. New York imposes among the highest level of income tax of all states. New York City residents pay even more tax for the privilege of residing there. Income is taxed to the grantor of a grantor trust. Since income is taxed to the grantor of a grantor trust, it is axiomatic that a New York resident who creates a grantor trust with its situs in New York will be taxed at a high rate on trust income. New York also does not recognize the right of a person to create a self-settled spendthrift trust that will be beyond the reach of the settlor’s creditors.
¶ Assume New York resident owns assets with unrealized capital gain or assets which produce a high stream of annual income. If the assets are sold, or when the income is received, New York will take a large tax bite out of the sale or the annual income stream.
¶ Assume further that even if the trust is a New York “resident” trust, and therefore potentially subject to New York tax, that New York will not tax the trust because it meets the exception provided in Tax Law §605(b)(3)(D)(i): (i) All of the trustees are domiciled in another state; (ii) the entire trust corpus is located outside of New York and (iii) all income and gains are derived from out of state sources. Therefore, the New York resident trust (i.e., an inter vivos trust created by a New York resident) escapes taxation because it meets the exception in the exception in Tax Law §605(b)(3)(D)(i),
¶ Finally, assume that asset protection is an important objective of the settlor, since unknown future creditors may appear down the road and may be attracted to the scent of the grantor’s assets. How can taxes be reduced? How can gift tax be avoided? Finally, how can the assets be protected against claims of future unknown creditors?
III. Avoid Grantor Trust Status
& Protect The Trust Assets
First, how can grantor trust status be avoided so that trust income does not flow through to the New York resident and be taxed by New York? Treas. Reg. §1.677(a)-1(d), the first impediment, states that a trust is a grantor trust if the grantor’s creditors can reach trust assets under applicable state law. However, a few states, among them Nevada, Delaware, and Alaska now recognize the right of a settlor to create a self-settled spendthrift trust. If the trust were established as an irrevocable non-grantor trust in Nevada, a state that also imposes no income tax, New York would have no claim to tax the trust, provided the exception to resident trust taxation was met.
It should be noted, if not emphasized, that not all states employ the criteria utilized by New York in defining and taxing resident state trusts. Unlike New York, some states do not impose income tax based upon the residence of the grantor. In those states, the benefit of PLR 2013110002 would be more easily achieved. In New York, the New York resident trust would have to fall within the exception in Tax Law §605(b)(3)(D)(i). Nevertheless, for New York residents able to meet the exemption in Tax Law §605(b)(3)(D)(i), the ruling may be of considerable value. See “Income Tax Planning for New York Trusts,” Tax News & Comment, October 2012.]
IV. Facts in PLR 201310002
The facts in PLR 201310002 involve a situation where the grantor creates an irrevocable trust in which the grantor and his issue are discretionary beneficiaries. The trust provides that a corporate trustee distributes income and principal to the discretionary beneficiaries, consisting of the grantor and his issue.
For reason stated above, settling the trust in Nevada will avoid the application of Treas. Reg. §1.677(a)-1(d), and the trust will not automatically be a grantor trust, since self-settled spendthrift trusts are valid in Nevada. However, another vexing problem in avoiding the application of the grantor trust rules lies in IRC §674, which provides that the Grantor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment is controlled by the Grantor or a “nonadverse” party.
The facts in PLR 201310002 present a situation where the consent of an adverse party is required with respect to all distributions made during the grantor’s lifetime. IRC §672(a) provides that for the purpose of the grantor trust rules, the term “adverse party” means any person having a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.
If by now one is getting a sense of déjà vu, then that sense is correct. The situation involved in PLR 201310002 is the inverse of the familiar sale of assets to grantor trusts, which is a staple in estate planning. In sales to grantor trusts there is a complete transfer for transfer (gift, estate and GST) tax purposes, but an incomplete transfer for income tax purposes. Sales of assets to grantor trusts are generally made for estate tax purposes, as the asset is sold to the trust in exchange for an asset expected to appreciate less rapidly. The sale evades the capital gains tax because under Revenue Ruling 85-14, the sale by the grantor to a grantor trust has no income tax consequences.
In sharp contrast to sales to grantor trusts, transfers to the trusts contemplated in PLR 201310002 result in a complete transfer for income tax purposes, but an incomplete transfer for transfer tax purposes. Such trusts are referred to by tax and estate lawyers as “DING” trusts, or a “Delaware Incomplete Gift Non Grantor Trust,” or “NING” trusts, with Nevada substituted for Delaware.
The grantor trust provisions in IRC Sections 671 through 679 cast a wide net. How exactly does PLR 201310002 suggest the resolution of the problem of the self-spendthrift trust avoid being taxed as grantor trust for other reasons? Very carefully and very methodically. The facts in PLR 201310002 provide that a corporate trustee is required (i) to distribute income or principal at the direction of a ““distribution committee” or (ii) to distribute principal at the direction of the grantor.
In the facts of the ruling, the distribution committee consists of the grantor and his four children. At least two “eligible individuals” must at any time be serving as members of the distribution committee. The direction made by the distribution committee to the corporate trustee may be made in three ways:
Distribute income or principal upon direction of a majority of the distribution committee with the written consent of the Grantor. Note: The PLR expressly concludes that distributions pursuant to the Grantor-Consent Power can be made only with the consent of an adverse party, and thus the provision does not cause the trust to be a grantor trust. Thus, the PLR implicitly concludes that the distribution committee members are adverse to the grantor for purposes of the grantor trust rules.
Unanimous Member Power:
Distribute income or principal upon direction by all distribution committee members other than the Grantor. Note: the PLR expressly concludes that distributions pursuant to the Unanimous Member Power can be made only with the consent of an adverse party, and thus the provision does not cause the trust to be a grantor trust. Thus, the PLR implicitly concludes that the distribution committee members are adverse to the grantor for purposes of the grantor trust rules.
Grantor’s Sole Power:
Distribute principal to any of grantor’s issue (not to grantor, and not income) upon direction from grantor as grantor deems advisable in a nonfiduciary capacity to provide for the health, maintenance, support and education of the issue. Distributions can be directed in an unequal manner among potential beneficiaries. Note: Here, it would seem at first blush that the grantor has retained some power that might cause grantor trust problems. However, that bullet is dodged, as IRC §674(b)(5)(A) provides an exception to grantor trust status for a grantor who has retained the power to distribute corpus (i.e., principal) that is limited by a reasonably definite standard.
IV. Avoiding The Gift Tax
The DING or NING trust must also be structured to avoid gift tax, since the gift tax rate is now 40 percent once the lifetime exemption of $5 million is breached. The trust also needs to be irrevocable. Making an irrevocable trust incomplete for gift tax purposes is difficult, though possible. PLR 201310002 sanctions the use of a testamentary limited power of appointment to make the gift incomplete.
There is some concern that Chief Counsel Advisory 201208026 takes the position that the grantor’s retention of a testamentary power of appointment over a trust renders the remainder interest a completed gift, but not the term interest. If this is indeed the case, then the grantor would need to retain other powers in order to make the gift incomplete.
However, the retention of other powers could cause the ship to list, and fall back into the gravitational pull of the grantor trust provisions, defeating the raison d’etre for the trust. For now, the planning tool of using DING or NING trusts to avoid state income taxation and to protect assets seems viable, if for no reason other than the fact that PLR 201310002 approved of the technique and without discussing the possible application of CCA 201208026.