In previous months, I’ve addressed tax advantages available to grantors who choose to situs their trusts in South Dakota. I’ve addressed using Domestic Asset Protection Trusts as a tax planning tool, using dynasty trusts to avoid paying federal estate taxes, and using community property trusts to obtain a complete step-up in basis for appreciated assets upon the first spouse’s death. This post will address two other tax advantages specific to South Dakota and how to utilize them.
One other tax advantage offered by South Dakota is a constitutional prohibition on inheritance tax. Article XI, Section 15 of the South Dakota Constitution states that “No tax may be levied on any inheritance, and the Legislature may not enact any law imposing such a tax.” To compare to surrounding states, Iowa and Nebraska both require an inheritance tax, and Minnesota imposes an estate tax. North Dakota does not currently impose an estate or inheritance tax, but it has no constitutional prohibition from enacting them.
Yet even with this constitutional protection, the most significant tax advantage offered by South Dakota is that it does not collect income tax. This fact, combined with all the other trust laws, is what makes South Dakota such an attractive jurisdiction to establish trusts originating from other states.
Why No Income Tax Is Important
For South Dakota residents who place assets in a South Dakota trust, not being taxed on the trust income is a given, regardless of whether it’s a grantor trust or non-grantor trust. It would make little sense to establish a trust in another state that imposes an income tax on its residents—unless, of course, the grantor simply doesn’t like money… But for residents from other states that have enacted a state income tax, grantors may place assets in a resident trust (a trust sitused and administered in a jurisdiction other than where the grantor or beneficiaries reside) in South Dakota in order to avoid paying income tax on the trust income. This is possible through either an irrevocable trust or an incomplete non-grantor trust residing in South Dakota.
In both of these types of trusts, the grantor gives up ownership of the trust income during the grantor’s life. So rather than income passing directly through to the grantor (which happens if the trust is a grantor trust, such as a revocable living trust), the income lies with the trust itself. If the trust is a resident of a state where there is no income tax, then the income produced by the trust assets is never taxed.
Incomplete Non-Grantor (ING) Trusts
While general irrevocable trusts can be used to avoid income taxes if the trust is a South Dakota resident, they will also result in gift tax consequences (i.e. reduction of the grantor’s unified credit and potential federal estate tax liability) and loss of the step-up in basis on the grantor’s death. But incomplete non-grantor trusts give grantors the best of both worlds. They avoid gift tax consequences and utilize a step-up in the grantor’s tax basis on the grantor’s death while still giving up ownership of the trust income during the grantor’s life.
In short, incomplete non-grantor trusts combine the benefits of a grantor trust (the step-up in basis and not having to pay gift tax) and a non-grantor trust (income is owned by the trust, not the grantor). So if the trust is a resident of South Dakota, the grantor will pay neither income tax nor gift tax.
This tax planning tool will be most beneficial for out-of-state grantors holding highly appreciated assets that would otherwise be taxed on the income derived from those assets. This will also be highly beneficial for those grantors who wish to retain control over how the trust assets are invested. Such grantors may engage in trading assets, etc., that would normally be a liquidating event subject to income taxation. But because the assets are owned by the trust in a state without income tax, nothing is subject to income taxation until a distribution is made from the trust to a beneficiary.
The IRS has issued Private Letter Rulings supporting this tax-saving technique, and individual states have begun supporting the use of resident trusts to avoid paying income tax in the grantor’s state of residence. In Fielding v. Commissioner of Revenue (Minn. 2018), the Minnesota Supreme Court held that the residence of the trust, and its consequential duty to pay income tax in the state of residence, depends on whether the trust, not the grantor, retains a minimum connection with the state. So even if a grantor lives in Minnesota, if the trust is administered elsewhere, and if trust assets don’t generate income within the state of Minnesota, then the trust is not a resident of that state sufficient to be taxed therein. For additional analysis of Fielding v. Commissioner, see my post on freeing trusts from Minnesota’s income tax.
To determine whether an incomplete non-grantor trust can be utilized as part of your comprehensive estate plan to minimize your tax liability, contact one of our Sioux Falls estate planning attorneys today.