Good workers do good work in S.D.’s trusts. Let’s not ruin that, Mr. Doeden
This is the last in a series of five interconnected essays. The first installment can be read here. The second installment can be found here. The third is located here. The fourth, here.
“Trust” is becoming a word like probate, a term folks dislike. That’s unfortunate.
Few ordinary citizens have a great grasp of what a typical probate looks like. They may have heard stories about a probate that goes on forever and costs the heirs a ton of money to resolve because of family infighting, an attorney who overbilled, or creditors which swarmed around the estate like flies.
There’s room to criticize probate, but at least in South Dakota, it’s a pretty efficient system for winding up a decedent’s affairs, getting final taxes paid, and distributing assets to heirs.
Assessing any legal process ought to utilize a birds-eye analysis of costs and benefits instead of focusing on a bad outcome or two. Just because one ambulance runs into a school bus does not mean that we should get rid of ambulances.
Trusts are the same way. You may have heard stories about a few bad apples abusing trusts to shelter ill-gotten proceeds or to launder criminal enterprise funds. The Pandora Papers generated negative trust-press.
Indeed, some ne’er-do-wells have misused trusts. But just because some criminals deposit their profits into bank accounts doesn’t mean we ought to eliminate banks.
Most folks are a lot more familiar with bank accounts than trust accounts. A prior essay here described trusts and how they work. They’re not as complicated as one might think.
Trusts can accomplish a multitude of legitimate aims. One of the perfectly legal things that trusts can be used for is to save taxes. Saving taxes with trusts has the sound of something nefarious.
I want to give an example of how a wealthy citizen might use a perpetual trust in South Dakota to save taxes and what that looks like:
“Hal Hypothetical” is from Murdo. He’s not a billionaire, but his frugal living has paid off. Until recently, he had a net worth of $20 million; he’s a widower and permanently estranged from his two adult children (that’s a long story). He gets along well with his two adult grandchildren, however, and recently, he made gifts of just a hair over $7.5 million to each of them. So, today, his remaining net worth is $5 million. No one feels sorry for the super-wealthy, but they do have problems that we don’t have.
Hal has a federal transfer tax problem: Congress imposes an estate/gift tax and a generation skipping transfer (GST) tax (whether lifetime or testamentary gifts) above a certain magnitude (collectively, “transfer taxes.”
Now Hal would like to make another gift to his grandchildren. He’s got a pile of stock in a certain company that has done well. He purchased it more than two decades ago for $100,000. It has appreciated to $938,000 and just issued an extraordinary dividend of $100,000. Hal would like to make a gift of the stock and its recent dividend to his grandchildren (both of whom live in California) for Christmas.
He visits with his local attorney to see if he can make the gift in a tax efficient manner, taking advantage of South Dakota’s trust law and tax benefits. Here’s what that looks like:
Hal gifts the stock and dividends to a “dynasty trust” drafted by his attorney. The trust names his local bank as trustee and the grandchildren as beneficiaries. The trustee will distribute funds to the grandchildren as needed and make discretionary distributions to them and their descendantsm for as long as the money holds out and there are living descendants to benefit.
Before we examine the tax savings, let’s review the taxes that won’t be avoided:
Hal’s Income Tax on the $100,000 Dividend. “Hal” is in the highest tax bracket and will pay about $40,000 on this year’s dividend when he files his 1040 next April.
Hal’s Transfer Tax. Hal’s gift triggers both the federal gift and GST tax. Hal will file a form 709 and pay these taxes by April 15, too. The tax bill? $800,000.
Capital Gains Tax. The trustee will likely sell the stock and diversify the portfolio. Doing so will trigger capital gains tax on the gain of $838,000 (the current value of the stock, $938,000, minus what Hal originally acquired it for, $100,000. The tax bill for realizing these gains will be about $168,000 and charged to the trust.
Ordinary Trust Income Tax. The new investments which the trust invests in will produce additional income in the form of dividend and interest. If the trustee distributes this income to the beneficiaries, they’ll pay state and federal income taxes on them. If the trustee elects to accumulate the income in the trust, the trust will pay federal income taxes. Either way, the income gets taxed. For as long as the trust exists, it will report (on a form 1041) and pay federal income taxes every year (unless the income is taxed to the beneficiaries).
If you do the math, we’re looking at taxes exceeding $1 million in connection with a $1 million gift. Is this what tax avoidance trusts look like? Where’s the tax savings, for heaven’s sake?!
Glad you asked. Here are the tax savings:
GST Savings. Instead of just making a gift to his grandkids outright, Hal gifted to the trustee of a trust for their benefit. Thus structured, the trust assets won’t be subject to estate taxes in the grandchildren’s estates – or their future descendants’ estates. Because the trust is administered in South Dakota, it – like a corporation – can continue as long as it has utility to the beneficiaries – indefinitely or, if you prefer, perpetually. Such is a dynasty trust, which many states don’t permit.
California Income Tax Savings. Recall that the grandchildren are Californians. California imposes a state income tax. To the extent that the trustee accumulates income rather than distributing it, no California state income tax will be due by virtue of the trust’s income, just federal income tax.
Future Appreciation Transfer Tax Savings. Although a grandpa, Hal is a relatively young man. He’s 70. Had he not made the gift of the stock at Christmas, he would have lived an additional 15 years and upon his death, the stock would have doubled to $2 million. If he had left that same stock to his grandkids in his will, it would have generated a combined estate/GST tax of $1.6 million. Instead, by gifting the stock before it had further appreciated, he saved $800,000.
If you’re someone who thinks that the taxes saved by this kind of planning are outrageous, that Hal and his trust should pay even more taxes, then you and I must agree to disagree.
In my view, this kind of trust planning benefits South Dakotans – and out-of-staters – who object to paying more than their fair share. Hal Hypothetical’s dynasty trust is no more a tax avoidance scheme than taking a standard deduction or claiming a tax break by virtue of charitable contributions. It’s permitted by Congress. It’s by-the-rules planning. South Dakota has, over the last 30 years, cultivated a legal infrastructure and tax-friendly environment which encourages affluent taxpayers (with their foresight and professional advisors’ acumen) to benefit from our state’s lawmakers’ prudence.
We’ve become an attractive jurisdiction for trusts; the best in the world, actually. In exchange, South Dakota gains some good jobs; good workers doing good work in the trust industry. A quiet industry which is well-regulated by our Division of Banking.
Let’s not ruin that, Mr. Doeden. Let’s not spoil a good thing. For us, or for others. The feds are already extracting plenty or wealth. We need not enable the feds to tax us, or the affluent, one penny more than they already are. To add a new state tax on trusts is a bad idea.
Thomas E. Simmons is a professor at the University of South Dakota Knudson School of Law in Vermillion. The foregoing views and opinions are those of the writer and not those of the University of South Dakota, its Knudson School of Law, or the South Dakota Board of Regents.
Photo: public domain, wikimedia commons
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