Grantor trusts in South Dakota: preserving a planning tool to maintain the state's trust friendly status.

• Author: Barrett, Beau C.T.

Grantor trusts are a valuable estate planning tool for South Dakota legal practitioners. The rules that govern the types of and parameters for grantor trusts consist of a combination of federal statutes, regulations, and common law. Deciding where to create a grantor trust--the trust's situs--is influenced by state statutory treatment of trusts. South Dakota has set itself up as "trust friendly " by passing legislation that has repealed laws injurious to trusts, while also passing statutes that foster a favorable environment for creating them. Consequently, the South Dakota trust industry flourishes as wealthy clients from around the nation choose to situs their trusts in South Dakota. Additionally, grantor trusts are particularly beneficial for South Dakota residents, such as farmers or business owners, whose assets may be illiquid. Upon the death of the owner, the owner's survivors stand to lose the family business to the estate tax without the benefit of grantor trust planning. Nevertheless, many commentators feel that grantor trusts have outlived their usefulness. This scholarly disapproval has been echoed in recent years by Department of Treasury revenue proposals, which recommend imposing specific limitations on different types of grantor trusts. However, these recommendations would be detrimental to the South Dakota trust industry and its clients in that they eliminate or modify valuable estate planning tools. Therefore, South Dakota legal practitioners and estate planners must vigorously advocate to preserve these estate planning tools in order to sustain their use and, in turn, continue to support South Dakota's flourishing trust industry.

1. INTRODUCTION

   The world of grantor trusts gives rise to a wide variety of options for the estate planner, including those grantor trusts labeled GRITs, GRATs, GRUTs, QPRTs, ILITs, and IDGTs.' Despite this vast array of acronyms grantor trusts can generally--and more simply--be defined as trusts wherein the grantor, rather than the trust itself, is taxed on the trust's income. (2) These trusts have evolved with changes in the common law, regulations, and legislation, but the purpose of grantor trusts has always been reducing the tax burden on either the grantor, the beneficiaries, or both. (3)

   While there is a split of opinions on the usefulness and future viability of grantor trusts, (4) they are, nonetheless, important tools for estate planners to help clients because grantor trusts may reduce or eliminate estate taxes upon the client's death by diminishing the amount of a client's taxable property. (5) Additionally, attainment of grantor trust status--given the current compressed marginal tax rates for trusts--has the effect of reducing the income tax paid on the assets placed in trust because the grantor, rather than the trust, will pay the income taxes. (6)

   South Dakota has taken advantage of these benefits by passing legislation that creates a favorable atmosphere for those clients who situs their trusts in the state. (7) However, subsequent to an inversion of the income tax rates in 1986, (8) many commentators argue that grantor trusts have outlived their usefulness and should therefore be eliminated or drastically reformed. (9) The idea for reform has percolated through in recent years as Treasury Department proposals aimed at limiting or destroying the effectiveness of certain grantor trusts. (10) Therefore,

   Irrevocable Life Insurance Trust ("ILIT") takes advantage of specific code provisions to remove from one's estate the value of that person's life insurance policy. Steinkamp, supra, at 78. Finally, an Intentionally Defective Grantor Trust ("IDGT") exploits the differences in estate and income tax through a grantor's sale of property to the trust in exchange for payments on a note. Mark S. Poker, Sales to Intentionally Defective Grantor Trusts: Here is How Defects Can Be Positives, Prac. Tax Law., Fall 2010, at 15, 15-16, 18. See infra Part II for a more nuanced discussion on each of these trusts in turn. South Dakota legal practitioners and estate planners must understand the advantages and disadvantages of grantor trusts and be prepared to advocate for the preservation of these estate planning tools in order to maintain their availability, and to promote South Dakota's flourishing trust industry. (11)

   As such, this comment will first explain why South Dakota is regarded as one of the best places to situs a trust, due in large part to its (1) repeal of the Rule Against Perpetuities ("RAP"), (2) lack of income or capital gains tax for individuals or trusts, and (3) favorable trust decanting, directed trust, and asset protection statutes for trustors and trustees of South Dakota trusts. (12) Next, this comment will review the legislative history of the creation of grantor trusts and provide an overview of the current rules that govern grantor trusts. (13) This comment will then clarify the operation of the grantor trust rules and provide a primer on some of the trusts those rules allow, including GRITs, GRATs, GRUTs, QPRTs, ILITs, and IDGTs. (14) Lastly, this comment will analyze scholarly opposition to grantor trusts, including some proposals that could be detrimental for grantor trusts and trusts in South Dakota, while arguing that South Dakota estate planners and their clients should advocate for the status quo to maintain the state's current "trust friendly" status. (15)

2. BACKGROUND

   1. SOUTH DAKOTA: THE TRUST FRIENDLY STATE

      South Dakota consistently makes it onto Best Trust States lists. (16) One reason is that South Dakota was one of the first states to repeal the RAP. (17) Without the RAP, a trustor technically can create a dynasty trust that would allow consecutive life interests to be passed perpetually. (18) This means that "a properly structured trust can continue growing ... indefinitely[.]... free of estate, gift and generation-skipping taxes, which can consume about half a trust's assets." (19) By allowing wealthy families to defer taxes indefinitely, South Dakota has set itself up as an attractive place for those families to situs their trusts. (20)

      A second reason South Dakota is trust friendly is because of its tax laws. South Dakota does not impose any state tax "on the assets that comprise a trust located there[,]" including income, capital gains, dividends, interest, or intangibles. (22) For trusts this is a boon, because paying income taxes, or capital gains on trust assets, erodes the res in trust. (23) It also slows asset growth and diminishes the beneficiaries' shares. (24)

      South Dakota is also a trust friendly place because of its trust decanting, and trust modification statutes. (*5) Decanting is the process whereby a trustee "mak[es] a distribution to a new trust with different terms from the original trust." (26) Decanting essentially allows a trustee to change the terms of an irrevocable trust. (27) There are many reasons a trustee would want to do this, but a few of the more common are: for better federal or state tax advantages, for better administrative provisions, or to add asset protection. (28) But decanting is not the only option to modify an irrevocable trust. (29) South Dakota has taken a permissive stance on modifying irrevocable trusts even before the 2007 enactment of the decanting statutes by allowing judicial and non-judicial reformation or even termination, among other means. (30) An attractive prospect for South Dakota trust clients is that "Tijrrevocable'--more and more in the trust world--does not mean immutable." (31)

      Another reason South Dakota is a trust friendly environment is because of its directed trusts statutory scheme. (32) A directed trust is one where the trust instrument appoints persons to act as trust advisors to direct the trustee with regards to certain areas of trust administration. (33) Directed trust provisions serve two purposes, encouraging better trust administration, and enabling liability mitigation for trustees. (34) Prior to enactment of the directed trust provisions, when the trust or transferred assets to the trust, the trustee was solely responsible for administering those assets. (35) However, given the complexity of modern trusts, a single person may not be the best manager of all of the administrative functions a trust requires. (36) Therefore, in a directed trust, one advisor may serve to administer in the best interest of the investments, while another might be better suited to administer discretionary distributions. This arrangement might allow family members to maintain more control of the trust rather than relying solely on the discretion of a single trustee. (38) Additionally, the South Dakota directed trust provisions provide a higher level of liability protection for directed trustees. (39) With benefits for both the trustor's and trustee's interests, "directed trusts are an obvious win for everyone." (40)

      South Dakota also excels in the area of asset protection, especially for third party beneficiaries and for self-settled trusts. (41) South Dakota codified third party discretionary support that offers protection for beneficiaries from creditors. (42) The 2007 law "states that discretionary interests in a third party trust, limited power[s] of appointment^], and remainder interests are not considered property interests." (43) Additionally, because they are not property interests, "no creditor may attach such interest." (44) South Dakota also has "excellent" self settled trust statutes to further provide asset protection. (45) Through a legislative commitment to "maintain South Dakota as 'a highly desirable jurisdiction in which to locate trusts[,]'" South Dakota has set itself up as a trust friendly place. (46)

   2. History of Grantor Trusts

      Estate planners, for over a half century, have attempted to exploit new legislation to reduce the grantor's estate and income tax liability by creating a separate taxable entity, the trust. (47) Additionally, trusts...