A BELLWETHER OF MODERN TRUST CONCEPTS: A HISTORICAL REVIEW OF SOUTH DAKOTA'S POWERFUL TRUST LAWS.

Author:King, Al W., III
 
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I. A HISTORY

  1. RULE AGAINST PERPETUITIES

    This article begins with South Dakota's claim to fame, its 1983 Rule Against Perpetuities ("RAP") statute. This statute codified the 1979 case of Estate of Murphy v. Commissioner (6) in which the IRS acquiesced to the method utilized to abolish the RAP. The Murphy case approach to abolishing the RAP shifted the perpetuities inquiry from remoteness of vesting to suspension of the power to alienate. (7) For example, if the trustee has an explicit or implied power to sell, the trust jumps outside the rule of suspension of alienation, which limits the duration of the trust, thus allowing for an unlimited duration trust. Generally, states that have embraced Murphy have also abrogated or abolished the RAP, which addresses the timing issue. As a result, these states address both the timing and the vesting issues associated with doing away with the RAP as required by Murphy, which is key according to most generation-skipping transfer tax ("GST tax") and RAP experts. (8)

    Murphy was relied upon by both South Dakota and Wisconsin in their respective state enactments of RAP laws prior to the imposition of the modern GST tax in 1986. (9) Idaho also enacted a pre-1986 RAP statute that followed the Murphy case approach to abolishing the RAP. (10) Consequently, these state statutes cannot be construed as an attempt to circumvent the GST tax, thus making them the only three bellwether states.

    Delaware enacted a Murphy case type RAP statute in 1995 in response to South Dakota and the business South Dakota was generating, as delineated in Delaware's legislative history. (11) Alaska then followed suit in 1997 with a RAP statute that partially relied on Murphy; (12) Alaska further amended its statutes in 2000 to advance, but not completely align with Murphy. (13) Missouri, New Hampshire, New Jersey, and North Carolina have also relied on Murphy when designing RAP statutes, but many of these states have other trust, income tax, or asset protection limitations. (14) Many states do not follow the Murphy approach, which may or may not present a significant risk to both self-settled and third party dynasty trusts. (15) The aforementioned states are term-of-years states, hybrid states, and opt-out states. (16)

  2. TRUST INCOME TAXATION

    South Dakota was the only pre-1986 dynasty trust state without an income tax on trusts. Both Idaho and Wisconsin imposed state income taxes on trusts. Wisconsin has since done away with its trust income tax for non-residents. (17) Many other post-1986 dynasty states do not have state income taxes on trusts. (18) A few states have tweaked their dividends and interest taxes to further accommodate their dynasty trust statutes. (19) Several other non-dynasty trust states with high taxes have either enacted laws or are attempting, through the courts, to prevent or make it difficult for clients to establish or change the situs of a trust to a no income tax dynasty trust state. (20)

  3. CONSTRUCTIVE ADDITION

    It is important to note that once the GST tax exemption has been allocated to a trust, any material change to the nature of the beneficial interest might trigger a constructive addition, thereby eroding the GST tax inclusion ratio. As previously mentioned, several of the dynasty jurisdictions have different RAP statutes or perpetuities rules. Caution must be exercised when changing the situs from one dynasty jurisdiction to another (i.e. South Dakota). A change of situs should be able to take place between Murphy states without constructive addition issues. However, changing situs from a non-Murphy state to a Murphy state could pose problems. (21) Consequently, with any change of trust situs coupled with a reformation, modification, or decanting, the existing RAP statute will usually be retained.

  4. CONSTITUTIONALITY OF PERPETUAL TRUSTS

    In a Vanderbilt Law Review article titled Unconstitutional Perpetual Trusts, attorney Steven Horowitz and Harvard Professor Robert H. Sitkoff raised interesting questions about the constitutionality of perpetual trusts in certain states with constitutional prohibitions of "perpetuities;" an issue not present in South Dakota. (22) This raises important questions about possible conflict-of-law issues when a trust settlor's resident state has a strong public policy against perpetual trusts. Eleven states have had constitutional bans on perpetuities. Of those eleven, California and Florida are the only two states to later repeal those bans, thereby leaving nine states that currently have them. (23)

  5. MARQUETTE CASE (CITIBANK--SOUTH DAKOTA)

    Prior to its 1983 Murphy RAP statute, South Dakota's rise to the top indirectly began with the famous United States Supreme Court case, Marquette National Bank v. First Omaha Services Corporation. (24) Interest rates in 1980 were generally around 20%, while the usury limits generally varied between 10 and 15%. (25) Consequently, usury caps were below actual interest rates, thus posing a profit dilemma for all the credit card and lending banks. The Supreme Court held in Marquette that national banks could locate in a state and apply the state's credit laws to card users nationwide, regardless of the laws in the other states. (26) Previously, a bank in one state lending money to a client in another state had to follow the usury laws of the client's resident state.

    Consequently, following Marquette, the interest rate was applied based upon the locality where the credit decision was made (the lex loci rule), which revolutionized the credit card industry. Citibank began working with then Governor William Janklow and the South Dakota legislature after New York, where Citibank was headquartered, would not change their laws for the bank to benefit from the Marquette decision. (27) When Citibank turned to South Dakota, two emergency bills passed very quickly: one abolishing South Dakota's usury law and the second allowing out-of-state bank holding companies to create South Dakota subsidiaries. (28) This resulted in Citibank moving its credit card operation and approximately 3,000 employees to South Dakota, as well as the eventual establishment of Citicorp Trust South Dakota in 1995, which became a launching pad for the South Dakota trust business. (29) Thereafter, Delaware passed their Dynasty statute in 1995 in response to South Dakota's success marketing its South Dakota Dynasty Trust statute. (30)

    II. MODERN INNOVATIONS

    Though the Rule Against Perpetuities was the watershed moment that put into motion South Dakota's trust industry, the decades that followed saw the creation and adoption of the innovative modern trust laws that would ultimately establish South Dakota as one of the top trust jurisdictions. (31) Each new statute introduced and enacted in South Dakota brought about significant changes to the trust, asset protection, and tax laws of the state, culminating in an unparalleled landscape for families both domestic and international, to implement customized multi-generational planning with a flexibility and control not seen in the United States before.

  6. THE DIRECTED TRUST

    After abolishing the Rule Against Perpetuities, one of the crucial pieces of modern trust law that South Dakota codified was the directed trust. Directed trusts provide a family with maximum flexibility and control regarding a trust's asset allocation, diversification, investment management, and distributions. (32) Nearly all states have "delegated" trust statutes, (33) but only a few select states, such as South Dakota, have "directed" trust statutes. In fact, South Dakota has one of the oldest and highest rated directed trust statutes in the country. (34) A directed trust allows individuals who establish a trust with an administrative trustee in the directed trust state, such as South Dakota, to appoint an investment advisor or committee. The advisor or committee can direct the administrative trustee on how the trust will be invested and to hire an outside investment advisor or manager to manage the trust's investments. Multiple committee members or advisors may be chosen based upon different asset classes or diversification. This allows a family to utilize a Yale or Harvard endowment type asset allocation, which they might not otherwise be able to do with a delegated trust as a result of laws, risks, time, and costs. (35) Alternatively, a family may hold a large position in a public or private security without the need to diversify with a directed trust. (36)

    Any type of trust can be established as a directed trust, including both revocable and irrevocable trusts. The trust instrument vests control over investment discretion with an outside advisor and exonerates the administrative trustee. (37) Consequently, a directed trust combines flexibility and control, as well as the favorable trust, asset protection, and tax laws of the directed trust state, like South Dakota, with the skills of a client's own investment advisors. (38)

    Additionally, a distribution committee may be established to determine when trust distributions should be made and directs the administrative trustee accordingly. Family members can serve on these distribution committees and determine all distributions of income and principal for health, education, maintenance, and support ("HEMS"). Any additional distributions would be tax sensitive and require an independent person (e.g., South Dakota administrative trustee, certified public accountant, attorney, or a combination thereof). (39) South Dakota is one of only a few directed trust states with statutes allowing the administrative trustee to accept "direction" regarding distributions, as well as investments. (40) The administrative trustee can also typically be removed at any time and, alternatively, if desired, the administrative trustee can step into any of the committee functions. Generally, all directed trust fiduciaries are acting pursuant to a gross negligence/willful misconduct standard by...

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