Income Tax Planning Opportunity for Clients in Non-Community Property States – as a powerful alternative to joint property.
South Dakota law allows clients from across the country to establish a South Dakota Special Spousal Trust i.e. Community Property Trust (“SST”). South Dakota is one of only three states to allow individuals to opt into community property laws via trust.
The SST is a powerful planning vehicle allowing spouses to elect assets held by the SST to be treated as community property under IRC Section 1014(b)(6); thereby allowing for a 100% step-up in basis at the death of the first spouse. As such, the new statute provides a unique planning vehicle for clients to maximize potential tax benefits at the death of the first spouse, a particularly useful benefit for highly appreciated assets.
A few statutory requirements are needed for the trust to qualify as a SST; for example, statutory disclosure and consent language at the beginning of the trust, both spouses signing the trust document, and a qualified South Dakota trustee (i.e. South Dakota Trust Company). Furthermore, the SST cannot affect child support obligations, certain creditor’s rights or the duty of good faith between the spouses.
Joint Property Versus Community Property
As mentioned, one of the key benefits of the SST is the potential to receive a 100% step-up in cost basis of assets held in the SST at the death of the first spouse. This is in contrast to non-community property states (i.e. joint property) where at the death of the first spouse, the surviving spouse does not receive a full step-up in cost basis. Instead, with joint property, the surviving spouse only receives a partial increase in cost basis. Consequently, only one-half of the joint property included in their gross estate would receive a cost basis adjustment. There is no basis adjustment of the other half.
For example, assume a husband and wife owned securities in a joint property state. Their basis in the securities is $5,000,000. At the time of the husband’s death, the fair market value of the securities was $10,000,000. Even if no estate tax return is required to be filed, the wife’s basis in the securities would be $7,500,000 (one-half at the original basis of $5,000,000, divided by 2 and one-half at the fair market value of $10,000,000 divided by 2). If the surviving spouse then sold the securities at fair market value ($10,000,000), they would expose a $2,500,000 gain to capital gains tax. If, however, the husband and wife placed the securities in a South Dakota SST, then, at the death of the first spouse, the asset would receive a step-up in basis to the current fair market value for the entire asset ($10,000,000). Then the surviving spouse could sell the appreciated asset for the fair market value ($10,000,000) with no tax consequences (i.e. avoiding the capital gains tax that would have been incurred without a full step-up in basis).
Marketable securities with a low-cost basis are generally an ideal asset for an SST. Though other asset types may be placed into the SST, including real estate, which needs to be carefully reviewed with the client’s lawyer. Generally, for out-of-state real estate, it is recommended that the property is owned by an LLC, so that the real estate may be deemed personal property. This is important to assure that South Dakota law governs rather than the law of the state where the real estate is located.
Furthermore, the SST can also be combined with South Dakota’s other top-rated trust, tax, privacy and asset protection laws. These top-rated South Dakota statutes also provide flexibility and control regarding trust distributions and investments. For more information on unique South Dakota law and features please click here.
The South Dakota Special Spousal Trust provides clients a powerful planning strategy, particularly for spouses with low-cost basis investment assets.
Please note that the IRS has not commented or ruled on the SST or Community Property Trust since the first statute was enacted in 1998. However, many advisors believe that the IRS will continue to recognize that state law defines what property is and the characteristic of marital property. In either case, the clients will be no worse off than if they did not establish the SST, except for the minimal costs to establish the SST (which is also the case with the SDING).