Greenbaum Rowe Smith & Davis Newsletter

Avoiding New Jersey Income Tax with a Delaware Non-Grantor Trust

By Peter D. Crawford, Jr., Esq.

On June 28, 2004, New Jersey's already high personal income taxes climbed still higher, when Governor James McGreevey signed into law the so-called "Millionaire's Tax." Before that date, single New Jerseyans were already paying tax at a rate of 6.37% on their annual income over $75,000. The "Millionaire's Tax" increased the tax rate on annual income over $500,000 to 8.97%. This new bracket gave New Jersey the distinction of having the fifth highest personal income tax rate among the fifty states.

Since the enactment of the "Millionaire's Tax," New Jersey's successful entrepreneurs have struggled to find ways to reduce their tax liability. According to the Wall Street Journal, some have even decamped to other states.

The good news is that it is possible to avoid New Jersey income taxes on some types of income without uprooting yourself and your business from New Jersey.

Consider the following example. Roger incorporated a business in New Jersey in 2002, investing $50,000 of his own capital. From 2002 to 2006, the business grew rapidly but had no taxable income. In 2007, Roger is approached by a multinational company, which wants to buy his stock in the business for $5,050,000. If the sale goes through, Roger will realize a capital gain of $5,000,000 (the $5,050,000 sale proceeds less his original investment of $50,000).

If the federal income tax rate applicable to the gain is 15%, Roger can expect to pay $750,000 in federal income tax on his capital gain. There is no way of avoiding this tax.

The New Jersey income tax on the first $500,000 of Roger's gain will be imposed at graduated rates of between 1.4% and 6.37%; the remaining $4,500,000 of his gain will be taxed at 8.97%. The total New Jersey tax due will be about $433,000.

Could Roger have avoided paying $433,000 in New Jersey taxes? It appears he could. When he incorporated his business, he could have transferred all his stock to a "Delaware Non-Grantor Trust."

A Delaware Non-Grantor Trust is nothing more than a trust administered in the State of Delaware that limits the grantor's rights and powers to such an extent that the trust is recognized as a taxpayer separate from the grantor. ("Grantor" simply means the creator of the trust; in our example, Roger would be the "grantor.")

If Roger's goal was to maintain as much control over the Delaware Non-Grantor Trust as possible without jeopardizing its tax advantages, he might include the following provisions in the trust:
  • He would name a bank or trust company in the State of Delaware or an individual resident of Delaware as trustee.


  • He could give himself and two trust beneficiaries the power, by majority vote, to compel the trustee to make distributions from the trust to any one or more of Roger, Roger's descendants, and any other beneficiaries.


  • If Roger dies while the trust is still in force, he could give himself the power to determine how the remaining trust property is divided among his spouse and descendants.
If Roger established a trust with the above terms, it should be regarded for tax purposes as a nonresident of New Jersey. Nonresidents pay New Jersey tax only on their "New Jersey source income." Since gain from the sale of stock is not considered "New Jersey source income," the trust would not pay any New Jersey income tax on its $5,000,000 gain from the sale of its stock in Roger's business. (This assumes the trust is established at the inception of the business; if it were established after sale negotiations begin, New Jersey may have a basis to tax the gain.)

Although the trust would be regarded as a resident of Delaware, due to a quirk in Delaware's tax law, it would not pay any Delaware income tax on its $5,000,000 gain either. Delaware only taxes the capital gains of a resident trust if one of the trust's beneficiaries is a resident in Delaware. Thus, if Roger can avoid naming any Delaware residents as beneficiaries, he can avoid any Delaware tax on the trust's capital gain.

Suppose Roger wishes to enjoy some of the bounty of his good fortune. Is it possible for him to withdraw funds from the trust and still avoid state income tax on his $5,000,000 capital gain? Yes, provided that he waits until the tax year following the sale to make the withdrawal. If a trust distributes funds to a New Jersey resident in a particular tax year, New Jersey may tax that resident on a portion of the trust income for the year. But New Jersey does not "look back" to a prior year to see if the trust has untaxed income. Thus, if Roger waits until 2008 to withdraw funds, New Jersey may be able to tax Roger on the trust's investment income for 2008 but it cannot look back to 2007 and tax the $5,000,000 gain.

If you think you could use a Delaware Non-Grantor Trust in your business, you need not go to Delaware. There are attorneys and bank officers in New Jersey who can help you establish such a trust.

Peter D. Crawford, Jr. is a partner in the firm's Tax, Trusts & Estates Department. He is admitted to practice in New Jersey, Pennsylvania and Massachusetts.