South Dakota Trusts and Carried Interest State Tax Planning
Establishing a non-grantor irrevocable trust in certain favorable states has long been a pillar of tax and estate planning for high-net-worth individuals and families. One of the most popular states to establish such a trust is South Dakota, which offers notable legal protections and tax advantages without a residency requirement other than having a South Dakota Trustee (usually a bank or trust company). Other popular jurisdictions to establish trusts include Wyoming, Nevada and Alaska.
Carried interest, “carry” or “promote” refers to the share of a fund’s profits—typically 20%—that is allocated and paid to managers. It typically represents a significant portion of a private-equity employee’s compensation. In recent years, many private-equity professionals have embraced South Dakota trusts to reduce or eliminate state and local income tax[1] on carried-interest income, with the added benefit of removing assets and their appreciation from their taxable estate for estate tax purposes. In addition to providing these significant tax benefits, South Dakota allows trusts to hold assets indefinitely (known as perpetual or dynasty trusts); offers strong asset protection from lawsuits, creditors, and divorcing spouses, and seals trust records indefinitely, delivering enhanced privacy when compared with trusts based in other states.
If the benefits of South Dakota trusts are so significant, why isn’t everyone using them? These structures are complex and require careful consideration within the context of a complete estate plan. Some things to know:
State income tax benefits are not available to Illinois residents. Illinois taxes trusts based on the residency of the grantor who has established the trust. Even if an Illinois resident establishes an irrevocable non-grantor trust under South Dakota law, there is still a “nexus” for Illinois income taxation due to the grantor residing in the State of Illinois. While this result may seem onerous, there have been some successful strategies to eliminate Illinois income taxation once the grantor, the Trustee and the beneficiaries of the trust no longer have a connection to Illinois.
Your residency impacts how much you could benefit. South Dakota trusts provide tax advantages at the state and local level, so individuals based in states with high marginal income tax rates — such as California at 12.3% and New York at 10.9% (plus up to another 3.876% in New York City) will benefit the most. Those based in states with lower income tax rates will still benefit, but the tax savings will be less dramatic.
These trusts have estate and gift tax implications. Transferring carried interests without also transferring a corresponding proportion of one’s capital investment can trigger complex federal estate and gift tax implications under Internal Revenue Code Section 2701. A sophisticated trusts & estates advisor should carefully review any plans to create a South Dakota or other non-grantor irrevocable trust.
Some states could challenge these trusts in the future. Not all states recognize the bona fides of non-grantor irrevocable trusts with these benefits. It remains to be seen whether states with meaningful enforcement resources (i.e., California and New York) could challenge these arrangements in an attempt to recoup lost state tax revenue from residents using South Dakota trusts.
Questions about whether a South Dakota trust should become part of your tax and estate planning strategy? Reach out to Robert Garner, Stephen Pratt, or another member of LP’s Tax Planning Group or Trusts & Estates Group.
[1] Carried interest income is generally (but not always) taxable at capital gains rates for federal income tax purposes. A topic for another day.