Commentary October 16, 2021 at 07:44 AM Share & Print
What You Need to Know
- The Pandora Papers highlight how South Dakota has become one of the most popular tax havens in the world.
- Lawmakers looking to raise taxes on the wealthy are licking their chops at trust laws.
- One of the most popular trusts in South Dakota and other trust-friendly states has never been tested in court.
The most recent release of confidential documents from the super wealthy — dubbed the Pandora Papers — highlights how South Dakota has become one of the most popular tax havens in the world. Naturally, those looking to minimize taxes, especially in high-tax states, want in on the game, too.
South Dakota offers everything a wealthy person setting up a trust could want. There is no state income tax or capital gains tax, so investment gains on assets placed in the trust are tax-free if it’s structured correctly. Robust protections provide anonymity and shield assets from creditors. And special provisions allow trusts established there to last forever, which means those assets would never be subject to the federal estate tax (currently 40% for estates worth more than $11.7 million).
But there are some reasons why creating a trust in South Dakota — or any of the other states that have equally favorable trust laws such as Nevada, Delaware and Alaska — could backfire. That is true especially now, as lawmakers at both the federal level and in some states weigh policies to make the rich pay a higher share in taxes.
First, one of the popular types of trusts used in South Dakota and Nevada has never actually been tested in a court of law. That means it’s unclear, if it were to face a challenge from, say, a high-tax state looking to get its share, how a judge would rule.
Part of why the trust, known as an incomplete gift non-grantor trust, or ING, could be more open to scrutiny than other types of trusts is that someone using one is effectively talking out of both sides of her mouth.
Let’s say a wealthy person in California, a high-tax state, wanted to set up an ING in South Dakota. She would say it’s a non-grantor trust, which means it’s a wholly separate entity and, as such, pays its own income tax.
But, in the same breath as she says she’s hands off, she also says she still has some control over the assets she’s putting in there — and for that reason, her gift to the trust is incomplete so she isn’t tapping the annual $15,000 limit for gifts or the $11.7 million lifetime exemption before the federal gift tax starts to kick in.
The workaround most of these trusts use to reconcile the two positions is by creating a special committee that has to approve any payouts made to the creator of the trust.
Lawyers who have created these trusts have typically gone to the Internal Revenue Service to get a written statement that de facto approves them. But a private letter ruling, as it’s known, isn’t the same as an official IRS ruling. What’s more, earlier this year, the IRS said it would stop issuing these private letter rulings for most INGs.
Some states have taken matters into their own hands already. Several years ago, New York state passed a law that negated most of an ING’s advantages for its residents. As buzz around INGs grow, others may follow suit.
At the federal level, it’s possible that the perpetuity benefit for trusts created in South Dakota (and other states like Nevada and Wyoming that allow for incredibly long terms) could be challenged. House Democrats have already proposed big changes for grantor trusts (where the individual pays income tax instead of the trust) that would make them much less attractive.
Senate Democrats could take aim at dynasty trusts, and they would be wise to do so as they search for revenue, considering the hundreds of billions of dollars that are at stake. The big money wouldn’t necessarily materialize in the first 10 years — that’s the period of time used by Congress’s scorekeepers when figuring out how much money tax changes will raise or lose. But that’s no excuse for lawmakers to sit tight. And it’s worth noting that there isn’t a constitutional requirement to let pre-existing trusts off the hook.
Those with billions or even hundreds of millions may be willing to roll the dice with INGs or dynasty trusts in South Dakota or elsewhere, because they think the tax savings and ability to preserve their wealth for future generations outweigh potential impending changes. For those with fewer zeroes, going to such great lengths may just not be worth the hassle anymore.