Perpetual trusts are inter vivos or testamentary trust that hold significant assets and last for at least the period of the rule against perpetuities of the governing state law or, if there is no such rule, forever. Clients often use perpetual trust for their $1 million exemption from the federal generation-skipping transfer tax (GSTT). This article first describes the tax and non-tax characteristics of perpetual trusts. The article then focuses on perpetual trusts under South Dakota law, which is well suited to the establishment and maintenance of perpetual trusts because the state has no rule against perpetuities or state income tax
What Is A Perpetual Trust
The primary purpose of a perpetual trust is to create a large fund that will be available for future generations of the trustor's family. Although only the drafting lawyer's imagination limits the substantive terms of the trust, a perpetual trust typically gives its trustees complete discretion about whether, when and how much income or principal, or both, to distribute to the beneficiaries. The beneficiaries often are the descendants of the trustor as a class. The trustor usually does not reserve any interest or power over the trust. Some trustors, however, reserve a limited power to remove trustees, although trustors more often vest removal and replacement powers in an advisory committee or a trust protector. The protector or committee members are typically individuals unrelated to the trustor and may have broader powers, including the addition or deletion of beneficiaries and amendment of the trust.
Wealthy clients often give $1 million during their lifetimes to a perpetual trust to obtain the maximum advantage of their GSTT exemptions. Many lawyers also advise married couples to use perpetual trusts to provide for the continuation of a credit shelter after the death of the surviving spouse. The couples' children will be discretionary income and principal beneficiaries during their lifetimes. The trust will typically give the children nongeneral testamentary powers of appointment over their shares of the trust principal. The trust instrument may also give the children a "five and five" power of withdrawal. If the trustee makes a distribution to a child, or the child exercises a right of withdrawal, a waste of the trustors' GSTT exemption allocated to the trust will result. The remaining assets of the trust not appointed for distributed will be held in discretionary trusts for successive generations of the deceased parents' descendants and will provide efficient leverage of the GSTT exemption.
Why Use A Perpetual Trust?
The federal and many state transfer tax systems attempt to impose a transfer tax on assets as they pass from one generation to the next. A person can eliminate transfer taxes at each generation yet still make assets available to family members in a succeeding generation by creating a trust for his or her family over which the younger generations have little control but from which they receive economic benefits. Thus, the longer the trust, the greater the theoretical benefits.
Distributions from a perpetual trust to the trustors' grandchildren and more remote descendants may trigger the GSTT. Code § 2631, however, allows each person an exemption from the GSTT of $1 million; this amount will be indexed for inflation starting in 1999. If a person places his or her GSTT exemption amount in a perpetual trust and allocates GSTT exemption to the trust, he or she will incur gift tax to the extent that the gift exceeds the available unified credit exemption equivalent, which currently is $25,000. If, however, the person limits the gift to the perpetual trust to the amount of his or her available unified credit exemption equivalent and allocates that much GSTT exemption to the trust, the person could avoid a gift tax on the creation of the trust.
The significance of perpetual trusts is highlighted by the fact that if there is a gift tax on the transfer to the trust, that will be the last transfer tax ever paid on the assets of a properly structured trust. If there is no gift tax because the trustor gave only his or her unified credit exemption equivalent, a transfer tax will never be paid on the assets of the trust.
The impact of these facts in dollars is graphically demonstrated when one considers that $1 million invested for 85 years at a 5% current yield, appreciating at a rate of 7% per year and sold and reinvested at a rate of 20% per year, will produce a value of $1.9 billion at the end of the 85 year period, assuming no distributions of income or principal and no payment of transfer taxes. The reason for the large principal amount at the end of 85 years is that the trust assets have not been subjected to transfer taxes for three generations. It may be possible for the trust to grow even larger if the trustee invests in life insurance or minority positions in family entities at a discounted value or engages in deferred payment purchases of family assets.
Given the attractiveness of the perpetual trust and the fact that trusts are mobile, lawyers and their clients should consider in which state to establish a perpetual trust. Alaska, Delaware, Idaho, Illinois, South Dakota and Wisconsin have no rule against perpetuities. In addition, Alaska and South Dakota have no state fiduciary income tax, making those states even more favorable for a perpetual trust under certain circumstances. Recent changes in the laws of many states and the current proliferation of new state laws (e.g., in Alaska and Delaware) have generated increased interest in perpetual trusts. The laws of some states are more favorable to perpetual trusts that others. No one state law is best, however, and laws that are favorable today may not be the best choice tomorrow because of legislative activity in other states. The law of one state may be the best choice to accomplish one purpose of the trust, such as asset protection from creditors, while the law of another state may be best to accomplish a different purpose, such as creation of a private trust company.
Why South Dakota?
Perhaps most important, the South Dakota legislature and state administrative officers have attempted to crate a very favorable business climate that encourages the use of perpetual trusts. For example, South Dakota abrogated the common law rule against perpetuities in 1983. SDCL 43-5-8 ("the common law rule against perpetuities is not in force in this state"). Thus, trusts, the validity of which is governed by South Dakota law, literally can last forever; there is never any need to vest interests in or make any distributions to anyone. As a result, transfer taxes need never be incurred on the trust assets following the initial transfer to the trust.
Another attraction is that there is not and never has been any individual or trust state income tax in South Dakota to erode the trust principal. In the earlier example, an 85 year trust could accumulate up to $1.9 billion from a $1 million initial contribution. If a New York resident created an identical trust at the same time under New York law and based on the same assumptions, the New York trust would accumulate only $488 million. See Pierce H. McDowell III, The Dynasty Trust: Protective Armor for Generations to Come, Tr. & Est. 47-54 (Oct. 1993). As discussed below, however, lawyers and their clients should note that, even though South Dakota does not have an income tax, the state of the trustor's domicile may tax the undistributed income and gains of a South Dakota perpetual trust.
Creating Situs In A Favorable State
Lawyers have considerable freedom to choose the law of the state that will govern the validity, construction and administration of the trust. In Wilmington Trust Co. v. Wilmington Trust Co., 24 A.2d 309, 313 (Del. 1942), the Delaware Supreme Court noted that
Contracting parties, within definite limits, have some rights of choice in the selection of the jurisdiction under whose law their contract is to be governed…. [T]here seems to be no good reason why [a trustor's] intent should not be respected by the courts, if the selected jurisdiction has a material connection with the transaction.
The Restatement (Second) of Conflicts of Laws § 268-270 (1971) expresses the same philosophy that a court will uphold a trustor's selection of the law governing a trust if, under the law of the state selected, the trust would be valid, even though the law of the trustor's domicile would not recognize the trust as valid.
South Dakota's version of the Uniform Probate Code (SDCL 29A-2-703) provides that the local law of the state selected by the transferor in the governing instrument controls its meaning and legal effect, unless the application of that law is contrary to South Dakota public policy. Therefore, the South Dakota legislature has expressly recognized the freedom of a trustor to choose applicable law in the governing instrument.
But lawyers should be aware of decisions such as Rudow v. Fogel, 426 N.E.2d 155 (Mass. Ct. App. 1981), in which the court held that the trust instrument's choice of governing law was only one criterion for determining what law governs the trust. In Allstate Insurance Co. v. Hague, 449 U.S. 302 (1981), the Supreme Court indicated that constitutional due process and full faith and credit principles would prevent enforcement of a provision choosing a foreign state's law if the only contact with that state was simply its designation as the governing law. Accordingly, although it is clear that there must be something more that the expression of the trustor's intention in making a binding choice of law, the necessary number and quality of the trust's contacts with the chosen state is a question of fact. Accordingly, the more contacts the trust's constituent parts – its trustees, beneficiaries and assets – having with South Dakota, the stronger the case will be that the trust is in fact a South Dakota trust.
At a minimum, in addition to the selection of law and situs provisions in the trust instrument, the client establishing the trust and his or her lawyer should take the following steps to ensure that South Dakota law in fact applies to the trust.
- At least one trustee should be a resident of South Dakota. This requirement could be satisfied by the appointment of a South Dakota "administrative trustee" to act in conjunction with non-South Dakota resident individuals or trust companies. An administrative trustee's duties would typically be limited to holding physical evidence of the trust assets, filing federal income tax returns, preparing accountings, holding legal title to trust assets and conducting trustee meetings. The others trustees, who would not be residents of South Dakota, would possess powers over discretionary distributions and trust investments.
- Evidence of the trust assets, such as stock certificates, should be physically present in South Dakota.
- As much administrative activity of the trust as possible should take place in South Dakota, including the preparation of trust accountings, trustee meetings and the preparation and filing federal income tax returns for the trust.
- The trust instrument should contain a forum selection provision requiring that any disputes arising under the instrument be submitted to a South Dakota court.
- If arbitration is a desirable means of resolving disputes, the trust instrument should specify that the South Dakota arbitration statute applies and that the arbitration take place in South Dakota.
Changing Situs To South Dakota
If a client already has an irrevocable trust in place, it may be possible to change the law governing its validity and its administrative situs to South Dakota. If the governing instrument limits the present term of the trust to the period of the rule against perpetuities of the jurisdiction in which it was created, moving the trust's situs of administration to South Dakota will not overcome that limitation. In that case, the only advantage of moving the trust is the possibility of escaping the state income tax of the state under which it was formed, which depends largely on how that state defines a "resident trust" for income tax purposes. If, however, the trust instrument does not expressly limit the term of the trust by the rule against perpetuities, switching the situs to South Dakota may allow for an unlimited term under South Dakota law, provided that an effective change of the law governing the validity of the trust occurs.
One method of changing the situs of a trust from one state to another is by an agreement among the trustor (if living), the present trustees and all beneficiaries to transfer the situs. Alternatively, one or more of the present trustees could resign and the beneficiaries could then appoint a South Dakota resident as successor trustee, if the trust instrument permits. The trustees would then physically transfer the evidence of the trust assets to South Dakota, where they should remain. The trustees or the beneficiaries could also petition a court of the original state to order the change of situs. The method the parties use will depend on the terms of the trust instrument and local law.
Although South Dakota has no fiduciary income tax, changing the situs of administration of a trust to South Dakota will not necessarily result in the elimination of state fiduciary income tax. If, following the move to South Dakota, the trust remains a resident of another state for income tax purposes, the trust will continue to be subject to that state's fiduciary income tax. For instance, under the laws of some states, a trust is a resident trust, and therefore subject to tax on all its undistributed income and gains, if the trustor was domiciled in the state when the trust became irrevocable. E,g., Minn. Stat. § 290.01, subd. 7b; N.J. Rev. Stat. § 54A: 1-2(m)(3). Moving such a trust to South Dakota will not eliminate the first state's tax on the trust.
In contrast, some states base trust residency for tax purposes on the administration of the trust in the state or the trustee's residency in the state. E.g., Or. Rev. State § 128.135; Hawaii Rev. Stat. § 235-1. If a trust is moved from one of these states to South Dakota, and no trustees reside in the former state, the trust will probably no longer be subject to state fiduciary income tax, except if the beneficiaries reside in the state that bases a trust's residency for income tax purposes on the beneficiaries' residency in that state. E.g., Ariz. Rev. Stat. § 43-313; Cal. Rev. & Tax. Code § 17742(a).
Lawyers and their clients should be sensitive to these state fiduciary income tax residency issues when moving a trust to South Dakota. The law in this area is evolving and has significant constitutional overtones. For example, if the trust is being moved from a state that taxes a trust based on the trustor's domicile, but the trust's constituent parts otherwise have no connections to that state, the lack of nexus to the state may make taxation of the trust unconstitutional under the due process clause of the 14th amendment. See Swift v. Dept. of Revenue, 727 S.W.2d 880 (Mo. 1987). But see District of Columbia v. Chase Manhattan Bank, 689 A.2d 539 (D.C. Ct. App. 1997). For a discussion of these issues, including an analysis of recent case law, see M. Read Moore and Amy Silliman, State Income Taxation of Trusts: New Case Creates Uncertainty, Estate Planning, June 1997, at 200-209.
In light of this issue, a lawyer might consider giving notice of a court petition to change situs to the taxing authorities of the original state. The decision about whether to do this would depend on as analysis of the state tax statutes, the trust provisions, the activity in administering the trust and the domicile of the trustor, the beneficiaries and the trustees. If the analysis of those factors convinces the lawyer that a strong case can be made for avoiding the state income tax in the state of origin, an effort should be made to obtain a court order to that effect over the objection (if any) of the state revenue department. If a court order is not necessary to move the situs, the trustee should simply file a final return in the state of origin.
A further issue that lawyers and their clients should consider is whether changing the applicable perpetuities period of a trust by moving it to South Dakota will jeopardize the trust's exemption from the GSTT. If the perpetuities period that applies to a trust grandfathered from the GSTT is changed, thereby extending the trust term, the change is likely to cause a grandfathered trust to lose its GSTT-exempt status. See, e.g., PLRs 9448024, 9244019 (trust exempt from GSTT will lose exempt status following a change is quality, value or timing of beneficial interests in the trust). If, however, the trust is exempt from the GSTT by reason of an allocation of GSTT exemption, changing the perpetuities period does not appear to change the exempt status of the trust under current law.
South Dakota Inheritance Tax Considerations
No nonresident of South Dakota would be interested in establishing a trust in South Dakota if doing so might subject the trust assets to South Dakota inheritance tax. Although a detailed analysis of the South Dakota inheritance tax is beyond the scope of this article, nonresidents of South Dakota should be sensitive to the following possible bases for imposition of the South Dakota inheritance tax on a perpetual trust established under South Dakota law:
- Transfer by a nonresident of property physically located in South Dakota. SDCL 10-4-2.
- Transfer of intangible property with a connection to South Dakota intended to take effect in possession or enjoyment at or after the death of the transferor. SDCL 10-4-2.
- Transfer of intangible property with a connection to South Dakota made within one year of death, creating a rebuttal presumption that the transfer was made in contemplation of death and is therefore taxable (if it is over $100,000). SDCL 10-4-1(1).
SDCL 10-4-4 and 10-40-5 erase the concerns of the latter two provisions by providing that transfers of intangibles by nonresidents are not subject to the South Dakota inheritance tax if the transferor is a resident of a state or territory of the United States that at the time of the transfer did not impose a transfer tax in respect of intangibles owned by residents of South Dakota. Almost all states have reciprocal exemption statutes or simply exempt a nonresident's intangible property from state death taxes. Accordingly, South Dakota is unlikely to tax transfers by a nonresident of intangible property with a connection to South Dakota, transfers of such property by a nonresident intended to take effect at death and transfers of such property made within one year of death.
Even if the reciprocity statutes of not apply to nonresidents of South Dakota, the only real exposure to the South Dakota inheritance tax is for transfers to a perpetual trust made within one year of the trustor's death. Nevertheless, even the presumptive contemplation of death intent ascribed by that statute is rebuttable on a proper factual showing. If the presumption is rebutted, then the tax should not apply because the transfer to the trust was completed at the time it was made.
A perpetual trust created inter vivos by a South Dakota resident may be subject to the South Dakota inheritance tax even if created more than one year before death. The argument in favor of taxation is that the transfer was intended to take effect in possession at or after death. See Estate of Crowell, 128 Cal. Rptr. 613 (Cal. 1976). As shown by the authorities collected at Annotation, Succession Tax – Postponed Enjoyment, 6 ALR 2d 223, §§ 11, 12 (1949), this rule seems to be in accordance with the weight of authority. Nevertheless, there is respectable and better reasoned authority to the contrary that all beneficial and legal interests in the trust property pass from the trustor at the time of the creation of the trust, even though the time of distribution is deferred until after the trustor's death. See Re: Heine's Estate, 100 N.E.2d 545 (Ohio 1950). Obviously, transfers to a perpetual trust created in a testamentary instrument of the death of the trustor (a South Dakota resident) would be taxed as a transfer at death.
What Is South Dakota Law?
It is easy for lawyers and clients interested in a South Dakota perpetual trust to focus on the state's lack of a rule against perpetuities and an income tax. Several other statutes, however, may affect a South Dakota perpetual trust. The following lists significant South Dakota statutory provisions that affect the administration of a South Dakota perpetual trust.
- SDCL 43-5-1 prohibits suspension of the power of alienation for longer than the lives of persons in being plus 30 years. As long as a trustee has the power to sell assets, a perpetual trust will not violate this rule. SDCL 43-5-4. The existence of the power of sale does not, of course, mean that the trustee must distribute the proceeds of the sale. Rather, the trustee has the freedom to reinvest the proceeds in trust.
- Real estate is not a desirable investment for a South Dakota perpetual trust. If a perpetual trust owns real estate, SDCL 43-6-4 provides that the trustee may not accumulate the income from the real estate for longer than the period of minority of a minor beneficiary. Accumulations in violation of this rule, however, are void only as to the time beyond the minority of the beneficiary.
- South Dakota has adopted the Revised Uniform Principal and Income Act. SDCL 55-13. In a significant departure, South Dakota's version provides that the increment in value of obligations for the payment of money, such as zero coupon bonds, constitutes income only when distributed by the obligor in cash.
- South Dakota has adopted the Prudent Investor Rule. SDCL 55-5-7 through 55-5-16. Lawyers and their clients should note that SDCL 55-5-16 permits a trustee to prudently delegate responsibilities to investment experts.
- Under South Dakota's version of the revised Uniform Limited Partnership Act (SDCL 48-7-603), a limited partner has no right to withdraw from a limited partnership except as otherwise specified in the partnership agreement. Although this statute does not apply to partnerships in existence on June 30, 1996, the lack of a statutory right of withdrawal from a limited partnership is relevant to establishing the value of South Dakota limited partnership interests that a perpetual trust might acquire.
- South Dakota has adopted the Uniform Trust Act. SDCL 55-4. The Act prohibits self-dealing between (among others) a trustee and a relative, employer, partner or other business associate in the absence of express authorization in the trust instrument. SDCL 55-4-13 allows a trustor to relieve a trustee from all duties, restrictions and liabilities otherwise applicable, except these self-dealing provisions. Therefore, lawyers and clients should specifically anticipate transactions between a trustee and related parties, particularly those that are intended to initially fund the trust, and specifically permit them in the trust instrument.
- As part of the Uniform Trust Act, SDCL 55-4-37 provides that a trustee may be a general partner in a limited partnership and the trustee's liability as such is limited to the assets of the trust.
- South Dakota codifies the concept of a trust protector in its "directed trust" statute. SDCL 55-1B. Among other things, the trust instrument may give the trust protector the power to amend a trust agreement to achieve favorable tax status or to address changes in the tax statutes, rulings or regulations. The trust instrument may also give a trust protector the power to increase or decrease the interests of beneficiaries and to modify the terms of any power of appointment granted by the trust. The statute also allows a trust instrument to give investment duties to trust advisors and permits the trust instrument to absolve such advisors from liability.
- SDCL 51A-6A permits formation of private trust companies in South Dakota. Thus, interested clients may form their own company to act as the resident trustee of a perpetual trust in South Dakota. There is a $200,000 capital requirement and a $25,000 application fee, but the administrative officers administering this statute have been quite liberal in the application and fulfillment of the requirements.
Perpetual trusts serve a vital function in the reduction and elimination of transfer taxes for clients with large estates and an interest in making some part of those estates available to their descendants unfettered control of the client's assets. South Dakota is one of several states that facilitates the use of perpetual trusts and provides the possibility of avoiding state fiduciary income tax. Whether South Dakota is the best state in which to create a perpetual trust depends on a number of factors, which lawyers and clients must carefully consider before making a decision.
The South Dakota Inheritance tax has been repealed for deaths after June 30, 2001
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.