Estate planning Q&A: South Dakota trusts and tax savings

South Dakota trusts can be utilized as a way to reduce state income taxes. While these trusts can offer certain benefits, they also come with important limitations and risks that aren’t always highlighted in the headlines.

This Q&A is designed to explain what South Dakota trusts are, how they work, and what you should consider before deciding if this strategy is right for you.

What is a South Dakota trust and why do people use them?

It is a type of irrevocable trust set up in South Dakota (or another state with no state income tax, such as Alaska, Wyoming, or Nevada) that is treated as a separate taxpayer from the person who funds it (i.e., a “nongrantor trust”). Taxpayers often use these trusts to try to avoid state income taxes on investment income, especially when they live in high-tax states like New York or California. In general, you can set up a trust in South Dakota, even though you don’t live there, by having the trust document contain certain terms (such as designating a South Dakota trustee and providing that South Dakota law governs the trust) and having the trust hold certain assets such that it is a “resident” of South Dakota for state income tax purposes.

If I set up a South Dakota trust, will it automatically avoid state income taxes on all my income?

Not necessarily. Even if your trust is based in South Dakota, states where the income is actually earned, like New York or California, can still tax the trust’s share of income from investments or businesses located in those states. This is especially true for income that “flows through” from partnerships, LLCs, or S corporations that operate in those states. The trust’s location in South Dakota may not shield it from taxes on income sourced to other states. Nongrantor trusts can be subject to state taxation based on residency factors that are closely connected with a state. A close connection or nexus with a given state is created by either the fiduciary’s/trustee’s residence, beneficiary’s residence, settlor’s residence at the time the trust became irrevocable or the location of the administration of the trust. In short, if you establish a South Dakota trust intending to avoid all state taxation but nexus is created with another state, the trust will be subject to tax obligations in that state.

Are there states that specifically restrict this planning?

Yes. New York has laws that prevent certain nongrantor trust strategies, and California has broad rules that can pull trust income back into its tax net if the grantor, beneficiaries, or income have ties to the state.

What are the key advantages of this type of planning?

• Potential savings on state income taxes for income not sourced to another state.
• Strong asset protection features offered by South Dakota trust law.
• Ability to create long-term or “dynasty” trusts that can last for generations.
• Privacy benefits and favorable trust administration rules in South Dakota.

Note: States other than South Dakota may provide these same advantages.

What are the limitations or downsides?

• Income earned in other states may still be taxed there.
• Some states impose throwback taxes on distributions to resident beneficiaries, imposing additional income tax and interest on those beneficiaries.
• To qualify as a nongrantor trust, the grantor must give up certain powers and control.
• Can be complex and costly. Requires independent trustees, valuations, and ongoing compliance.
• The strategy can come with audit risk. High-tax states aggressively challenge these strategies.
• Risk of future state legislation that eliminates the tax benefits from this strategy.
• Depending on how the trust is structured, there may be estate or gift tax implications, including the filing of a gift tax return for the year the trust is established.
• Potential for double taxation if states deny credits for taxes paid elsewhere or assert nexus based on trust residency factors.

Is this planning right for you?

This strategy is not a one-size-fits-all solution. It works only in specific circumstances and requires careful planning. If you live in a high-tax state, or a state that will impose tax based on the residency of the settlor, or have income sourced to multiple states, the benefits may be limited. Before considering this approach, talk to a qualified tax advisor who can review your situation, explain the risks, and help you weigh the costs against the potential savings.