South Dakota trusts are commonly used by carried interest holders to reduce state taxes, manage estate exposure, and protect long-term compounding without changing federal tax treatment.
For technology executives, venture capital partners, private equity principals, and fund managers, carried interest is often the most valuable asset on the balance sheet and the least understood from a planning perspective.
Carried interest is not a bonus. It is not a salary. It is a long-duration, illiquid, contingent ownership interest whose value may not fully materialize for a decade or more. And when it does, it often arrives in large, uneven waves that can trigger:
This is why many sophisticated investors eventually encounter a strategy that sounds opaque at first, but is widely used among ultra-high-net-worth families:
The South Dakota Trust.
When properly designed, a South Dakota trust can be a powerful structure for holding carried interest. Not because it changes the federal tax rules on carry, but because it aligns jurisdiction, tax mechanics, estate planning, and long-term compounding around a uniquely complex asset.
This article explains, in plain but precise language, how South Dakota trusts work, why they are used for carried interest, what the tax implications actually are, and when this strategy makes sense and when it does not.
Carried interest has characteristics that make traditional planning inadequate:
Planning for carried interest is not about optimizing a single tax year. It is about owning the upside in the right legal and tax environment before the upside becomes obvious.
This is where trust jurisdiction matters.
A South Dakota trust is not a special tax loophole or a bespoke product. It is an irrevocable trust that is governed by South Dakota law and administered by a South Dakota trustee.
South Dakota has spent decades intentionally building one of the most trust-friendly legal frameworks in the United States. As a result, it offers a rare combination of features that are especially well-suited to carried interest planning:
For carried interest holders who live in high-tax states such as California, New York, or New Jersey, this jurisdictional choice alone can have seven-figure implications over time.
South Dakota allows directed trusts, which separate control into defined roles:
When drafted correctly, this structure allows the grantor to retain strategic influence without triggering estate tax inclusion or undermining trust integrity.
This distinction is critical. The goal is not control. The goal is governance.
One of the most misunderstood aspects of trust planning is the idea that an irrevocable trust must be a non-grantor trust. That is not true.
An irrevocable trust can be:
The difference has nothing to do with revocability and everything to do with who pays the income tax.
This is often intentional. Paying the tax personally allows the trust to compound without erosion and functions as an additional estate freeze.
South Dakota non-grantor trusts can eliminate state income tax entirely, which is why many trusts are designed to start as grantor trusts and later convert to non-grantor trusts.
An Intentionally Defective Grantor Trust (IDGT) is not a different kind of trust. It is a grantor irrevocable trust that is deliberately designed to be “defective” for income tax purposes but effective for estate planning.
This structure allows a carried-interest holder to sell assets to the trust rather than gifting them.
Why that matters:
In an IDGT transaction:
Often, a small "seed gift" is used to capitalize the trust, but the bulk of the transfer occurs through sale rather than gift.
It depends entirely on how the transfer is structured.
For clients with large expected carry and limited exemption, the IDGT structure is often preferred.
Carried interest is not valued at its headline economics. It is valued as a contingent, illiquid, subordinated interest.
A proper valuation considers:
As a result, valuation discounts of 50–70% or more are common in early-stage funds. These discounts are not aggressive when supported by qualified, independent appraisals.
A South Dakota trust does not change the federal tax treatment of carried interest.
IRC Section 1061 requires a three-year holding period for carried interest gains to qualify for long-term capital gain treatment.
Importantly:
Trust planning affects who owns the economics, not how the IRS characterizes the income.
When structured properly:
This is where long-term compounding becomes meaningful. A carried interest that grows from $5 million to $40 million over time can avoid tens of millions in transfer taxes when held inside a dynasty trust.
South Dakota offers some of the strongest asset protection statutes in the country, including protections for self-settled trusts when properly structured.
This matters for carried interest holders who face:
While no structure protects against fraudulent conveyance or tax liens, South Dakota trusts provide meaningful insulation against future unknown creditors.
This strategy is typically appropriate when:
Below that level, complexity may outweigh benefit.
A South Dakota trust is not about avoiding taxes at all costs. It is about placing a unique, long-duration asset into the right legal and tax environment before its value fully emerges.
For carried interest holders, that distinction can define the difference between transient wealth and lasting capital.Below that level, complexity may outweigh benefit.
A South Dakota trust is used for advanced wealth planning, particularly to minimize state income tax, protect assets, and allow long-term compounding without estate or GST tax erosion.
Yes. Carried interest can be held in an irrevocable trust, including grantor trusts, non-grantor trusts, and IDGTs, provided fund documents allow transfer.
No. Federal income tax rules, including Section 1061, still apply. The trust primarily affects state tax, estate tax, and asset protection.
It depends. A gift uses the lifetime exemption. A properly structured sale to an IDGT does not, except for any seed gift.
Carried interest is valued based on its contingent, illiquid nature, often resulting in significant valuation discounts supported by independent appraisals.
In a grantor trust, the grantor pays the income tax. In a non-grantor trust, the trust pays its own tax. Both can be irrevocable.
Yes. Section 1061 applies regardless of whether the owner is an individual or a trust.
Yes. The three-year holding period is determined by the length of time the fund held the underlying investment.
Yes, if the trust is drafted with appropriate provisions. This is common in long-term planning.
South Dakota trusts can be powerful, but only when structured correctly and aligned with your fund documents, tax profile, and long-term goals.
If carried interest represents a meaningful portion of your future wealth, proactive planning matters.