How You Can Avoid State Tax by Changing to a South Dakota Trust

People unfamiliar with trusts may mistakenly assume that trusts confer tax savings over what they would pay if they simply held assets in their own names. While this is almost certainly not the case—in fact, federal tax rates usually increase when you earn inside a trust—you can alter your trust’s tax treatment at the state level by switching the trust “situs.” The below discussion clarifies trust taxation and highlights several benefits of moving your trust situs to South Dakota.

What is Trust Situs?

First, some definitions: Situs comes from the Latin word for location (think “site”), and in our usage it refers to which state has the right to tax trust income. Next, discretionary distributions refer to payments made from the trust at the direction of the trustee. Where are discretionary distribution decisions being made by a trustee? That’s usually the trust situs for tax purposes.

So, for example, if you live in California and have set up your trust under California laws and make all trust distribution decisions in that state, then California is the obvious trust situs. However, if you were to relocate to, say, Arizona and start directing trust distributions there, then Arizona tax laws might begin to apply. While there is not a huge advantage to having Arizona state tax over California state tax (although there may be some), what if you could change from California to a state that had no state income tax?

You Can Avoid State Income Tax on Your Trust

You obviously want to pay as little tax on the trust earnings as possible, and there are a handful of states which do not charge a state income tax. South Dakota is one of them. To see how this might benefit you, if you have a trust located in a high-tax state like California, even if you haven’t distributed the income from the trust, the trust will have to pay state tax on that income for the year it was earned. But if the trust situs is switched to South Dakota, then there will not be state tax on the trust income. Only distributions will be taxed at the state rates applicable to the beneficiaries (and federally, of course). Any undistributed income and gains are shielded from state tax under this scenario.

South Dakota also has several trust-friendly provisions in the law that make it a consistent highest-ranked asset protection choice for trust situs, year after year. We will discuss these in more detail below. And the best part is that you can change your trust situs to South Dakota without having to move physically to South Dakota (though we’ve heard it’s nice). You simply have to appoint a South Dakota-based trust company to transfer situs.

Keep in mind that no US trust situs will get you out of US federal income tax. You must realize income at the federal level as it is received into the trust, whether from dividends, interest, or capital gains. And as stated above, trust tax rates increase at a faster rate than your personal income tax. For example, whereas a married couple filing jointly doesn’t incur the top marginal federal tax rate of 37% until they have adjusted gross income of over $600K, in a trust you hit the top rate after hitting only $12,500 (2018 numbers).

If you don’t already have a trust for estate planning purposes, keep the above tax penalty in mind. We would love to speak with you if you are considering whether a trust makes sense, but don’t pursue a trust just to save taxes, because it doesn’t work that way. But assuming you have or will establish a trust as part of your estate planning process, then using South Dakota as the situs, even if you do not live in South Dakota makes a lot of sense.

South Dakota Trusts Enjoy Trust-Friendly Laws

People choose a South Dakota trust jurisdiction for more than just the state tax savings. South Dakota has some of the friendliest laws for trusts available. Below are just a few provisions that can help you make the decision to choose this state for your trust situs.

Law against perpetuities repealed– A few years ago, South Dakota repealed the prohibition on “perpetual trusts,” which are trusts with no set termination dates. In most other states, you have to assign an expiration date to the trust, at which time the assets get liquidated and any gains in the portfolio realized so that taxes must be paid. Without this provision, you could conceivably create a trust which would last many generations—as long as assets are managed and spent prudently.

Trusts can remain private– In most states, the beneficiaries know they have a trust or find out when they reach the age where distributions can be made. But under a South Dakota Trust, you can keep the existence of a trust quiet longer. Many wealthy families worry about the impact of a large trust fund on their heirs. “Trust fund babies” have a reputation for being lazy, entitled, addicted, etc., because they know they have money waiting for them and don’t need to work hard in life to succeed.

Trust privacy can help maintain a work incentive in heirs and allow distributions to take place closer to the time that the beneficiary is mature enough to handle it. The decision of when to inform beneficiaries of their assets is made by the then-current trust protector. You can outline how you would want this handled in your trust documents when working with your attorney.

Protection from creditors– Under South Dakota law, a creditor cannot force trust distributions to satisfy a claim. They have to wait until assets get distributed to the beneficiary and then go after the beneficiary for payment. Given that a trust can be perpetual as well, you can easily see how much protection a South Dakota Trust can offer wealthy families. As an aside, South Dakota also permits a transfer of marital property to a “Domestic Asset Protection Trust,” which potentially can bar claims on the trust assets for alimony. (Contact us if you wish more information about this provision.)

Portability of Community Property Basis Rules– This one takes a little explaining. If you live in a community property state, then the tax basis of your assets enjoys a “step up” when one spouse predeceases the other. For example, if a husband and wife jointly own stock, for which they paid $50,000 and it is now worth $1 million, there is an embedded taxable gain of $950,000 that could incur a very healthy tax bill if they were to sell the position. However, if one of the spouses passed away before the other, then the basis would be “reset” to $1 million (or whatever the value was at the date of death or valuation date). This is referred to as a “step up” in basis. That means all the tax liability on $950,000 just vanished. The surviving spouse will never have to pay it. A South Dakota trust can be drafted to recognize community property rules with respect to basis step-up.

“Decanting” to a New Trust– Laws can change. But legal costs to amend trust tend to be on the low side in South Dakota. Some changes can even be made without an attorney’s involvement at all. However, when significant changes to the trust are called for, South Dakota makes it relatively easy to create a new trust and “decant” the previous trust assets into the new trust. Think of it as starting over with a clean slate. Some states make this difficult and expensive, but for South Dakota trusts, it can be much simpler.

How Do I Move My Trust to South Dakota?

The above discussion is for general information purposes only. But if after reading it you have decided to pursue a South Dakota trust, it’s really quite easy. But note that there is a trustee fee involved. By working with Alpha Fiduciary as manager of your trust assets, you would appoint a South Dakota trust company as trustee to administer the trust terms and handle distributions.

Working through Alpha Fiduciary and one of our trust company partners can add a lot of value, as you now know you have a professional trustee looking after the trust to ensure you stay in line with the terms and avoid setting yourself up for problems with the beneficiaries later. The trust officer can advise on any trust terms that might need to change or be added, but once all the paperwork is finished, you have a South Dakota trust!

In addition to professional trust management, you will enjoy professional asset management that matches your investment strategy with your trust’s goals, both for income beneficiaries and remainder beneficiaries. We take pride in reviewing your situation carefully and guiding you as a fiduciary advisor. We do not earn commissions or referral fees from the products or trust companies we recommend. And our initial review is always complimentary.

Why not call us today to talk about your individual situation in more detail? We can answer your initial questions and help you get the trust established through our network of professional estate attorneys and South Dakota trust companies. The sooner you act, the more you could potentially save on taxes by making this move, so call us now!

About Arthur Doglione

Arthur is an industry veteran with more than 20 years of experience working with high-net-worth clients. He has an extensive background in wealth management with particular expertise in portfolio management. Before establishing Alpha Fiduciary, Art was a Senior Vice President with Merrill Lynch where he built his practice to be the largest of Merrill Lynch’s Arizona territory.

Art founded Alpha Fiduciary in 2006 and has completed two acquisitions since then. The firm currently serves clients across many states as a fee-only Registered Investment Advisor (RIA).

Art founded Alpha Fiduciary as a fiduciary advisory firm. This means it has a responsibility to its clients first and foremost.

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About Arthur Doglione

Arthur is an industry veteran with more than 20 years of experience working with high-net-worth clients. He has an extensive background in wealth management with particular expertise in portfolio management. Before establishing Alpha Fiduciary, Art was a Senior Vice President with Merrill Lynch where he built his practice to be the largest of Merrill Lynch’s Arizona territory.Art founded Alpha Fiduciary in 2006 and has completed two acquisitions since then. The firm currently serves clients across many states as a fee-only Registered Investment Advisor (RIA).Art founded Alpha Fiduciary as a fiduciary advisory firm. This means it has a responsibility to its clients first and foremost.