Among the nation’s billionaires, one of the most sought-after pieces of real estate right now is a quiet storefront in Sioux Falls, S.D.
A branch of Chicago’s Pritzker family rents space here, down the hall from the Minnesota clan that controls the Radisson hotel chain. Other rooms are held by Miami and Hong Kong money.
Most days, the small offices of this former five-and-dime are shut. But even empty, they provide their owners with an important asset: a South Dakota address for their trust funds.
In the past four years, the amount of money administered by South Dakota trust companies such as these has tripled to $121 billion – almost all of it from out of state. The families needn’t move to South Dakota, deposit their money at a local bank, or even touch down in the private jet. Little more than renting an address in Sioux Falls is required to take advantage of South Dakota’s tax-friendly trust laws.
States such as South Dakota are “creating laws that are conducive to a massive exploitation of a federal tax loophole,” said Edward McCaffery, a law professor at the University of Southern California. “We have a tax haven in our midst.”
South Dakota’s sudden popularity illustrates how the wealthiest Americans are embracing ever more creative ways to reduce taxes legally. Executives at South Dakota Trust Co., one of the state’s biggest, estimate that one-quarter of their business comes from special vehicles known as dynasty trusts that are designed to avoid the federal estate tax. Creation of such trusts has surged in recent years as changes in federal law have enabled more money to be placed in them.
While the super-rich use various tools to escape the levy, the advantage of dynasty trusts is that they shield a family’s wealth forever. That defies the spirit of the estate tax, enacted almost 100 years ago to discourage the perpetuation of dynastic wealth.
Out-of-state customers also see a chance to shelter their investments from income taxes in their home states.
Others are drawn by South Dakota’s iron-clad secrecy and protections of trust assets from creditors and ex-wives, with features emulating those available in Bermuda and other island havens.
Lawmakers in South Dakota, home to two of the nation’s 10 poorest counties, say they’re bolstering the trust industry to generate work for local law firms and bankers while forging ties with prosperous families that could eventually build a factory or a warehouse here. The legislators are turning the Mount Rushmore State into the Bermuda of the prairie.
As much as anyone, Pierce H. McDowell III can take credit for this transformation. He works upstairs from the hall of empty offices, as president of South Dakota Trust.
At 56, McDowell has been promoting the state he affectionately calls “North America’s Siberia” for most of his career. In 1993, he published an article in a national estate-planning journal recommending that wealthy people nationwide establish dynasty trusts in South Dakota.
Because the estate tax is imposed on large fortunes at death, McDowell wrote, wealth large enough to last for generations must contend with multiple tax bills. A father pays the tax when he leaves his money to his children, who pay again when they pass it down. Each generation faces a toll. The current rate is 40 percent.
McDowell’s solution was for the father to establish a never-ending trust that pays each generation of heirs only what they spend, while the rest of the money grows. In 1993, when McDowell was writing, that wasn’t possible in 47 of the 50 states because of an ancient rule limiting the duration of trusts to the lifetime of a living heir, plus 21 years.
South Dakota repealed that rule in 1983, and unlike Idaho and Wisconsin – the other two states without the provision – it had no income tax. So, McDowell wrote, a trust set up there could shield a big fortune from taxes for centuries, escaping tax bills as it hands out cash to great-great-great-grandchildren and beyond.
McDowell’s sales pitch got far more attractive when Congress gave the idea an inadvertent boost.
“I call it the trust tsunami of 2012,” McDowell said.
Rush to meet deadline
Most Americans don’t have to worry about the estate tax; fewer than 1 in 700 pay it. Congress applies the tax, and related taxes on other transfers to heirs, only when a fortune exceeds certain thresholds. For complicated reasons, the amount that most people can place in dynasty trusts is usually limited to one of these exemptions, set at about $1 million throughout the 1990s. It’s the size of the glass into which a wealthy family can pour the wine.
Since 2000 this exemption rose, reaching $5 million per person by 2011. The temporary law was scheduled to expire after 2012, at which point it would revert to $1.4 million. Congress didn’t act to make the higher amount permanent until Jan. 1, 2013.
With the fate of the exemption uncertain, McDowell said, his clients rushed to meet the deadline during the last months of 2012, creating billions of dollars’ worth of new trusts. By the end of the year, he had added about 500 trusts to his rolls, more than twice the number in a typical year.
McDowell’s firm now administers trusts worth $14 billion, according to its website, almost all of them originating in other states.
President Barack Obama has called for closing the dynasty trust loophole in annual budget proposals, even though the change wouldn’t boost tax receipts under his administration. The impact of dynasty trusts on federal revenue is far in the future – though potentially enormous, said Lawrence Waggoner, a retired professor at University of Michigan Law School.
“The federal government won’t lose out for maybe 90 years, and maybe that’s why Congress is not terribly interested in the subject,” Waggoner said. “The longer they procrastinate, you have larger and larger amounts in perpetually tax-exempt trusts.”
State revenue modest
One clue to how much wealthy families might save comes in McDowell’s 1993 article. Just $1 million invested in a dynasty trust, and earning 12 percent a year, would swell to $1.9 billion in 85 years, he wrote – compared with $488 million if the same trust was located in New York, subject to both state income taxes and the federal estate tax when it expired.
Beneficiaries must still pay personal income tax on distributions from these trusts, McDowell said. If a family runs out of heirs before a trust is exhausted, the leftovers are typically directed to a charity.
Loosening local laws to attract out-of-state business is a proven tactic for South Dakota. In 1981, it lured Citicorp’s credit card business, and hundreds of jobs, from New York by becoming the first state to repeal limits on interest rates. Other lenders followed. The credit card industry, along with a boom in farm profits, help explain why Sioux Falls’ unemployment rate of 2.9 percent is less than half the national average.
But the trust industry’s contributions to state coffers have been modest. Without an income tax, South Dakota doesn’t get revenue directly from the trusts.
Nor has the industry become a major employer. The state estimates that about 100 South Dakotans work for locally chartered trust companies. By comparison, a typical Walmart Supercenter employs about 350.
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