South Dakota Address Helps Richest Shelter Wealth Forever from Taxes
(Bloomberg) Among the nation’s billionaires, one of the most sought-after pieces of real estate right now is a quiet storefront in Sioux Falls, South Dakota.
A branch of Chicago’s Pritzker family rents space here, down the hall from the Minnesota clan that controls the Radisson hotel chain, and other rooms held by Miami and Hong Kong money.
Don’t look for any heiresses in this former five-and-dime. Most days, the small offices that represent these families are shut. 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 like these has tripled to $121 billion, almost all of it from out of state. The families needn’t actually move to South Dakota, or 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 like South Dakota are “creating laws that are conducive to a massive exploitation of a federal tax loophole,” said Edward McCaffery, a professor at the University of Southern California’s Gould School of Law. “We have a tax haven in our midst.”
South Dakota’s sudden popularity illustrates how, at a time of rising U.S. economic inequality, the wealthiest Americans are embracing ever more creative ways to reduce taxes legally. Executives at South Dakota Trust Co., one of the biggest in the state, estimate that one-quarter of their business comes from special vehicles known as “dynasty trusts,” which are designed to avoid the federal estate tax. Creation of such trusts has surged in recent years as changes in federal law enabled more money to be placed in them.
While the super-rich use various tools to escape the levy—some have exotic names like the “Jackie O” trust and the “Walton GRAT”—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.
The dynasty trust isn’t South Dakota’s only lure. Another attraction, for customers in places like New York and Massachusetts, is the chance to shelter their investments from income taxes in their home states. In November, a government commission in New York recommended tightening trust laws to avoid income-tax leakage to states like South Dakota, estimating the change would raise an extra $150 million a year.
Still others are drawn to South Dakota’s iron-clad secrecy, and protections of trust assets from creditors and ex-wives. Many of these features emulate those available in Bermuda and other island havens. Some wealthy families are also attracted by South Dakota rules that enhance their control over investment decisions and make it easier for them to set up their own trust companies rather than rely on a bank trustee.
In South Dakota, a farm state that’s home to two of the 10 poorest counties in the U.S., lawmakers say they’re bolstering the trust industry to generate work for local law firms and bankers, and forge ties with prosperous families that may one day decide to 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, on the second floor of the old Kresge five-and-dime, where he’s president of South Dakota Trust Co.
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 across the country establish dynasty trusts in South Dakota.
Because the estate tax is imposed on large fortunes at death, McDowell wrote, wealth that’s big enough to last for generations will have to 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. The concept has been a part of Anglo-American jurisprudence since a case decided by England’s Lord Nottingham in 1681.
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 here could shield a big fortune from taxes for centuries, escaping tax bills as it hands out cash to great-great-great-grandchildren and beyond.
Over dinner at a Sioux Falls restaurant this month, McDowell elaborates on the idea. He has curly gray hair and a quick laugh, and he’s wearing an open collar under a quilted winter vest. He’s known around town for making the one-mile trek to his office on a fat-tire bicycle, even in December.
“I like to equate it to the wine in this glass,” McDowell says, covering his Cabernet with his right hand. “Here you’ve filled it to the rim and push it downstream to the next generation. You can sip from it, you can have the equivalent of outright ownership, but you don’t own it under the law. Your children—they too will have the opportunity to sip from it.” He cups his hands as if to cradle the precious liquid.
“In most states, the glass has to pour out completely in a generation or two. We did away with that in 1983.” He chops the air with his hand.
McDowell’s sales pitch got far more attractive in the past few years, when Congress gave the idea an inadvertent boost.
“I call it the trust tsunami of 2012,” McDowell said.
The reason most Americans don’t have to worry about the estate tax—fewer than one in 700 pay it—is because 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, which was set at about $1 million throughout the 1990s. It’s the size of the glass into which a wealthy family can pour the wine.
Throughout the 2000’s, this exemption rose, and by 2011, it reached a record $5 million per individual. 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 few months of 2012, creating billions of dollars’ worth of new trusts. He had to turn away new customers, and hire retirees to handle the crush of paperwork. There were late nights and shortened Christmas vacations. By the end of the year, he said he’d added about 500 trusts to his rolls, more than twice the number in a typical year.
For the richest families, even a $5 million dynasty trust represents only a fraction of their fortunes, so lawyers have invented complicated strategies to squeeze bigger sums into the vehicles—as much as $39 million, according to a presentation by McDowell’s firm published last year. Such aggressive maneuvers, once common, have become rare in recent years, McDowell said.
McDowell’s firm now administers trusts worth $14 billion, according to its website, almost all of them originating in other states. An additional $75 billion is overseen by the offices downstairs, each of which is technically a separate trust company catering to just one family. The companies pay rent to McDowell for the office space, and fees for handling paperwork and administrative duties like filing tax returns; McDowell declined to comment on the price of these services. All of these are necessary steps if the families want to prove that the trusts are truly South Dakotan.
The tenants include companies like Carlson Family Trust Co., serving the Minnesota family behind Radisson and the TGI Friday’s restaurant chain, and JHN Trust Co., linked in state incorporation papers to the family of the late New York hedge fund pioneer Jack Nash. Other companies have ties to Thomas Peterffy, the Connecticut online-brokerage billionaire; the descendants of a namesake of the Dillon Read & Co. investment bank; and the heirs of a Peruvian sugar plantation, state filings show.
Trusts overseen in the Kresge five-and-dime building hold all kinds of assets, from stakes in private companies to a castle in Italy. While their holdings aren’t public, securities filings sometimes offer a glimpse. In July, the two top executives at Monster Beverage Corp., the Corona, California-based energy drink maker, shifted $478 million of their stock to undisclosed “entities” controlled by a trust company based in the building.
In 2010, the Pritzker family, whose members include U.S. Commerce Secretary Penny Pritzker, revealed in a securities filing that one branch had moved $360 million of Hyatt Hotels Corp. stock to trusts overseen by a native South Dakotan named Thomas J. Muenster. Muenster, whose sister married a Pritzker, maintains an office in the Kresge building.
The SEC disclosures don’t show whether any of these moves resulted in federal or state tax savings; the amounts exceed what one individual could put in a dynasty trust. Most state and federal tax filings are private, and McDowell declined to comment on specific clients. He said most families that set up private trust companies are attracted by South Dakota’s flexible trust management rules rather than tax avoidance.
The Monster executives declined to comment through a spokeswoman, as did the Carlson family. Jay Robert Pritzker, his sister Penny Pritzker, and his brother-in-law Muenster didn’t respond to messages seeking comment, nor did Peterffy or Joshua Nash of JHN.
“Our family tradition has been to keep things private,” said Mark Collins, a manager of Dillon Trust Co. “We prefer to keep it that way.”
In 2007, the Wrigley family, heirs to the candy fortune, transferred oversight of family trusts holding $1.9 billion of company stock to a private trust company in the Kresge building, according to an SEC filing.
The family picked South Dakota because of the state’s favorable laws governing the formation of private trust companies, the Chicago family said last week in a statement attributed to William Wrigley Jr. The family said the move didn’t involve any state or federal tax savings.
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.”
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, he said.
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. Pockets of poverty persist in American Indian reservations in the state’s midsection.
So far, 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. Companies like McDowell’s pay franchise taxes on their earnings, a levy that raised about $1.2 million last year, according to the state Department of Revenue, out of a state budget of about $4 billion.
Nor has the industry become a major employer. The state estimates that about 100 South Dakotans work for locally chartered trust companies. Then there are an unknown number of jobs in local trust units of national banks such as Wells Fargo & Co., and more work for local law firms and accountants. The trusts aren’t required to hire local money managers or invest in local businesses. By comparison, a typical Wal-Mart Supercenter, of which there are two in Sioux Falls, employs about 350 people.
“If you’ve got several hundred well-paying jobs, it’s worth it to us,” said Governor Dennis Daugaard, a Republican who used to travel to Minneapolis pitching tax-saving trusts when he worked at a bank in Sioux Falls. “It also gives us the opportunity to develop relationships with people who have the ability to encourage business here of other sorts. Now, I can’t point to a single case where that’s occurred yet, but I think it’s possible.”
When he’s away on state business in New York or Chicago, Daugaard said, he sometimes takes time to meet with wealthy clients of the South Dakota trust industry. He said he thanks them for doing business in his state.
McDowell’s 1993 article publicizing South Dakota’s advantages helped him land a job at Citicorp, setting up trusts for the bank’s clients. As the lender started promoting South Dakota’s advantages nationally, Delaware passed a similar law allowing perpetual trusts.
Alaska was next, after a fishing trip there inspired a New York estate planning lawyer named Jonathan Blattmachr to draft the legislation. A half dozen states, including Nevada and New Hampshire, now jostle for the business of the super-rich.
To try to maintain its edge, South Dakota assembled a permanent task force comprising industry players such as McDowell to monitor developments in other states and propose new legislation each year. In March, Governor Daugaard signed the group’s latest submission into law, making it harder for former spouses and their offspring to tap certain trust assets.
The bill was sponsored by the House’s Committee on State Affairs, whose chairman, David Lust, is also House majority leader and head of the trust task force. When the part-time legislature isn’t in session, Lust works at a Rapid City law firm where one of his partners is a leading trust lawyer.
Lust receives no “direct benefit” from the legislation, he said.
Bernie Hunhoff, a Democrat and the House minority leader, said some in his caucus roll their eyes when the task force’s annual proposals come up for a vote. They’re aware that the trust industry drains revenue from the U.S. Treasury, which supplies almost half the state’s budget each year, he said.
“There’s a bit of an irony there, if not hypocrisy,” said Hunhoff, editor and publisher of South Dakota Magazine. “Anything we can do to poke the federal government in the eye, or to help anybody, even wealthy strangers from 1,000 miles away, avoid taxes, that seems to be a popular thing out here.”
Still, Hunhoff said the proposals have bipartisan—and virtually unanimous—support.
“If we don’t provide for these kinds of trusts here, this will happen in some other state, so we might as well try to get the activity here,” he said. “If we can find opportunity for a few dozen young lawyers, I guess I’ll set my philosophical concerns aside.”
—With assistance from Richard Rubin in Washington and Michael Novatkoski in Princeton. Editors: Daniel Golden, Lisa Wolfson