DINGs, DAPTs, and tax planning with self-settled trusts.

• Author: Swartz, Scott
• Position: Delaware incomplete nongrantor trusts, domestic asset protection trusts

Recent developments in state law and income taxation have increased the importance of planning with trusts. Trust planning is a difficult area, as it involves technical rules under the Internal Revenue Code and Treasury regulations, and understanding the tax treatment of a trust often requires a detailed knowledge of state law beyond the familiarity of tax practitioners.

Yet, ample benefits can be achieved in thoughtful planning with trusts, because the planning can cater to human nature in many clients' desire to give away an asset with strings attached. Many wealthy clients have the means to make large gifts to family members and heirs but for a variety of reasons are not prepared to do so. Perhaps the recipients are not yet ready to receive large gifts. Perhaps the donor needs to retain access to trust funds for retirement needs while removing the property from a potentially taxable estate. Maybe the client really has no desire to part with any of his or her wealth but recognizes the need to safeguard it against creditors' claims. Regardless of the situation, clients love to learn about strategies for reducing taxes on their wealth and income, and tax practitioners can add value by opening a discussion on trust planning.

This item looks at a strategy that has received greater attention recently--an arrangement that can allow trust income to avoid state income taxes. This type of planning has developed over the last decade using what once were commonly referred to as Delaware incomplete nongrantor trusts (DINGs) (see, e.g., Letter Rulings 200502014,200612002, and 200715005). This first wave of state income planning with trusts was based on Delaware law; thus the DING tag line. As explored below, after several years without guidance or rulings from the IRS on nongrantor incomplete gift trusts, more recent IRS private letter rulings have involved trusts established in Nevada (NINGs). Rather than shifting references to this style of trust depending on the state law involved, this item refers to DINGs in the sense of domestic incomplete nongrantor trusts. Herein, a DING trust refers to any irrevocable trust established under state law in the United States (i.e., not an offshore trust) that is not a grantor trust.

Federal Tax Concepts Involving Trusts

Subchapter J of the Code, including Secs. 671-678, basically provides that if certain powers are present in a trust agreement, the grantor of the trust will include all of its income, expenses, and tax attributes on the grantor's personal tax return. These are commonly known as grantor trusts and are treated for tax purposes as not separate and apart from the grantor. Transactions between a grantor and a grantor trust, such as a sale of property to the trust, are not recognized for income tax purposes. Grantor trusts can be revocable or irrevocable.

Many modern estate planning techniques intentionally create a grantor trust to facilitate shifting wealth out of a potentially taxable estate. However, as discussed below, the strategy in the recent private letter rulings, rather than seeking to accomplish grantor trust status, was to avoid grantor trust status. Specific grantor trust powers in the Code are described later.

The second concept in planning with trusts is whether a gift to the trust is a completed taxable gift for wealth transfer tax purposes or if the transfer is an incomplete gift. Bear in mind that most incomplete gifts are still, in the general sense, completed transfers of property to irrevocable trusts; i.e., the transfer of property to a trust really happened in entirety. But for tax purposes, the completed transfer to a trust can be deemed an incomplete gift due to the grantor's retaining certain powers over the trust. Specific rules in the Code and regulations address when a gift is complete or incomplete and thus whether the trust property is considered property of the grantor upon death (see Secs. 2036 and 2038 and Regs. Sec. 25.2511-2). The ultimate result of an incomplete gift is that the transfer is not subject to immediate federal gift tax (or use of the lifetime exemption), and the trust property is included in the grantor's taxable estate.

Whether a client should structure transfers to a trust as completed or incomplete gifts depends on the circumstances. While nongrantor trust status is...