State Tax Planning and the Importance of Selecting Proper Trust Jurisdiction

Given recent changes in the federal tax code, state tax planning and selecting the proper U.S. trust jurisdiction in the planning process is more important now than ever. Establishing a trust in a state that does not have an income tax, such as South Dakota, provides a compelling potential tax planning opportunity for trustees and beneficiaries. State capital gains on low cost basis assets may be avoided upon sale, trust assets can grow free of state income tax over multiple generations, and federal estate tax can be avoided forever in dynasty trust states such as South Dakota.


INCOMPLETE NON-GRANTOR TRUSTS

The Incomplete Non-Grantor Trust (“ING”) is a powerful vehicle that potentially eliminates state income and capital gain tax while taking advantage of Domestic Asset Protection. Essentially, it is an incomplete gift that never leaves the settlor’s estate which means there is no gift tax and the trust has a Non-Grantor status, meaning the income is taxed at the trust level. By establishing the trust in a no income tax state like South Dakota, a settlor can potentially eliminate state capital gains tax, which is particularly compelling for low cost basis assets.

When to use the Incomplete Non-Grantor Trust

  • Asset with significant appreciation, such as low cost basis stock.
  • To avoid state income tax on subsequent liquidity when created in a jurisdiction that does not have a state income tax, such as South Dakota.
  • To avoid future state income tax on undistributed investment income.
  • Strong recent PLR support.

Example of the Tax Savings Associated with an Incomplete Non-Grantor Trust

  • Closely held business with fair market value significantly over basis with a gain in excess of $20 million.
  • Transfer of closely held stock into an Incomplete Non-Grantor Trust created in jurisdiction with no income tax.
  • No gift tax consequence.
  • Assuming home state has a 13.3% (CA) income tax rate = $2.66 million state tax savings.
  • Assuming an estimated future investment portfolio of $16 million earning a conservative 4% undistributed total return, continued state tax savings of $38,400 per year.

UNDISTRIBUTED TRUST INCOME

Undistributed trust income retained in a trust is typically taxed in most states at the applicable income tax levels of that state. However, establishing a trust in a state that does not have an income tax, such as South Dakota, provides a potential tax planning opportunity for trustees and beneficiaries whereby trust assets can grow free of state income tax over multiple generations.

Resident Trust

A Resident Trust is a trust with situs and trust administration in a jurisdiction other than where the settlor, beneficiaries, or co-trustees reside. State appellate case law across the nation is supporting the proposition that it is unconstitutional (violation of both the Commerce Clause and Due Process) for a state to tax undistributed retained trust income in a resident trust.

  • Pennsylvania, North Carolina, and New Jersey each have appellate court case law, indicating that taxing retained income in a resident trust is a violation of the Commerce Clause of the United States Constitution and Due Process.
  • This recent case law makes a compelling argument for the movement of trusts to states like South Dakota, where there is no state income tax.
  • Trusts established in a state without a state income tax may avoid taxation on undistributed retained trust income, which clearly has a very substantial impact on the value of trust assets over subsequent generations, particularly in high tax states like California and New Jersey.

These state tax planning opportunities, available by simply selecting a no tax jurisdiction like South Dakota, are particularly compelling when considered in conjunction with the fact that South Dakota…

  • Is generally regarded by most practitioners and academics, including Steve Oshins, as being the best Dynasty Trust state in the nation.
  • Unequivocally has the most robust privacy laws in the country, as pointed out by an article appearing in the January 2018 edition of Trusts & Estates Magazine comparing U.S. trust jurisdictions wherein the author noted, “Of the top tier trust jurisdictions, South Dakota has the best trust privacy laws.”
  • Is one of only two states with a Community Property Trust, a compelling tax planning tool for spouses.
  • Is the only state in the country with the Family Advisor, referred to as a “Trust Protector Light.”
  • Has one of the lowest insurance premium tax in the nation at 8 basis points, which applies to policies held both by a trust directly AND within an LLC, unlike Delaware which taxes policies at 200 basis held within an LLC.

For more information about these, and other powerful trust planning tools, please contact us via our contact page.