Selecting the proper trust jurisdiction in the planning process is essential for several reasons. However, one of the most compelling and directly measurable benefits is in the area of trust taxation. Below are specific planning areas that leverage South Dakota’s no state income tax status in a way that could result in substantial tax savings, extending over multiple generations.
A South Dakota Dynasty Trust is a very powerful planning tool that preserves family wealth over generations because it avoids federal estate taxation in perpetuity. Driven by state law, South Dakota law allowed for the first Dynasty Trust in the nation in 1983 by abolishing the rule against perpetuities. Therefore, unlike many states that have merely amended the rule against perpetuities to extend the time when a trust must terminate, the South Dakota Dynasty Trust avoids federal taxation on trust assets forever because there is never a termination of the trust resulting in a distribution of trust assets.
Dynasty Trusts are not available in all states and are not created equally. Nevada attorney, Steve Oshins, produces an annual rankings chart of Dynasty Trust states from across the country. South Dakota is, for the 7th consecutive year, ranked as being the top Dynasty Trust state in the nation while Delaware, long considered a top tier trust jurisdiction, is currently in the 8th position. Click here for Attorney Steve Oshins’ “7th Annual Dynasty Trust State Rankings Chart” for a more detailed and objective comparison of the Dynasty Trust states.
Community Property Trusts
The South Dakota Community Property Special Spousal Trust may be a revocable or irrevocable trust created by one or both spouses with both spouses as beneficiaries to avoid taxation, because it treats the property as community property at the death of the first spouse, applying a 100% step-up in basis at date of death of the first spouse.
The South Dakota Community Property Special Spousal Trust:
- Avoids federal capital gains taxation of marital/trust assets when subsequently sold. (In non-community property states, the step-up in basis at date of death is only 50%, which means that taxes would be owed on the remaining 50% of the cost basis of the marital property when sold.)
- Creates a powerful tax move that has the potential to result in compelling federal and state tax savings over subsequent generations by combining its benefits with the federal estate tax benefits of a Dynasty Trust, in a jurisdiction that does not have an income tax, such as South Dakota.
- May also be created, in appropriate cases, to take advantage of South Dakota’s Directed Trust laws, delivering more control to settlors and Domestic Asset Protection Trust laws for enhanced protection from creditors.
Click here for more information on the South Dakota Community Property Special Spousal Trust, including a video on this powerful new legislation.
Incomplete Non-Grantor Trust (“ING”)
An Incomplete Non-Grantor Trust (“ING”) is a powerful vehicle that potentially eliminates state income/capital gain tax while taking advantage of Domestic Asset Protection. It is an incomplete gift that never leaves the settlor’s estate, which means there is no gift tax, and it has a Non-Grantor status, meaning the income is taxed at the trust level.
When to use the Incomplete Non-Grantor Trust
- Asset with significant appreciation, such as low cost basis stock.
- Avoids state income tax on subsequent liquidity event if created in a jurisdiction that does not have a state income tax, such as South Dakota.
- Avoids future state income tax on undistributed investment income.
- PLR requests with the IRS recommended (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 6% income tax rate = $1.2 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.
For more information on Incomplete Non-Grantor Trusts, click here for an article appearing in Trusts & Estates Magazine written by NYC Attorney, William Lipkind. Mr. Lipkind is nationally recognized for his progressive trust planning strategies and is generally regarded as an expert relative to the ING Trust Strategy, having obtained several favorable Private Letter Rulings from the IRS on this and other tax planning strategies.
State Taxation of Trusts
Undistributed trust income retained in a trust is typically taxed in most states at the applicable income tax levels of that state. However, situsing 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 whereby trust assets can grow free of state income tax over multiple generations.
Resident Trust – No Taxation on Undistributed Income
A Resident Trust is a trust with situs and trust administration in a jurisdiction other than where the settlor, beneficiaries, or co-trustees reside. The United States Supreme Court and state courts across the nation have held that it is unconstitutional (violation of both the Commerce Clause and Due Process) for a state to tax undistributed, non-sourced trust income in a resident trust, affirming and confirming that significant state tax savings can be realized by simply selecting a top tier, no-income tax state like South Dakota in the planning process.
- In the Kaestner case, the Supreme Court struck down North Carolina’s attempt to tax undistributed income of a Resident Trust properly sitused and administered in a no income tax state, like South Dakota. (Domicile of beneficiary not sufficient to establish nexus for taxation.)
- The Supreme Court denied cert in Fielding, upholding the Minnesota Supreme Court’s decision also striking down that state’s attempt to tax undistributed trust income within a resident trust. (Domicile of settlor not sufficient to establish nexus for taxation.)
- Pennsylvania, Minnesota, and New Jersey each have appellate court case law, indicating that taxing undistributed income in a resident trust is a violation of the Commerce Clause of the United States Constitution and Due Process.
- Supreme Court and state appellate case law makes a compelling argument for the movement of trusts into states like South Dakota, where there is no state income tax.
- Trusts with situs in states without a state income tax would avoid taxation on undistributed retained trust income, which has a very substantial impact on the value of trust assets over subsequent generations, particularly in high tax states like California, New York, North Carolina, and New Jersey.
Click here for a video discussion on the Kaestner case and how it affirms the power of state tax planning using trusts.
Click here for a video on how this taxation is applied to various trusts around the country.
Insurance Premium Tax
An Insurance Premium Tax is a tax that is levied upon insurers, both domestic and foreign, for the privilege of engaging in the business of providing insurance in the state.
- Most states in the country have an Insurance Premium Tax between 150 and 250 basis points. For example, Nevada’s tax is 350 basis points and Delaware’s tax is 200 basis points.
- South Dakota has one of the lowest Insurance Premium Tax in the country at 8 basis points, meaning that the purchase of insurance through a South Dakota trust will result in substantial tax savings.
Contact us for more information regarding Trust Taxation and for a specific analysis of how South Dakota law can benefit your situation.