The Pandora Papers — the trove of more than 11.9 million confidential documents shared with The Washington Post and partner news organizations — shine a light on South Dakota’s role as an offshore financial center. For the most part, the revelations relate to the Mount Rushmore State’s status as a magnet for foreign wealth, including money derived from international drug smuggling and exploitative labor practices. But it’s not just foreigners who are moving assets to the “little tax haven on the prairie”: High-net-worth Americans also are shifting billions to South Dakota and a handful of other domestic havens, shortchanging federal and home-state tax collectors in the process.
The rise of domestic tax havens marks a troubling new chapter in the history of American federalism. Supreme Court Justice Louis Brandeis hailed states as “laboratories of democracy,” but increasingly U.S. states are becoming laboratories of sophisticated tax avoidance. So far, Congress and the states whose tax bases are being cannibalized by the domestic havens have done little to fight back. Hopefully, the Pandora Papers will catalyze a reaction that’s long overdue.
Congress, for example, could close the loopholes in federal tax law that domestic havens exploit. And the states that lose out from cross-border tax wars could bolster their own legal defenses. Of course, lawmakers in the domestic tax havens also could halt their efforts to emulate overseas havens such as Luxembourg and Switzerland.
There is nothing new — or terribly remarkable — about states competing to lure residents and businesses by offering low tax rates. New Yorkers have long moved to Florida, and Californians relocated to Nevada, to avoid state income taxes. Domestic havens such as South Dakota, however, allow high-net-worth clients to minimize taxes without leaving the comfort of their Manhattan condos and Napa Valley chalets.
South Dakota’s history as a domestic tax haven dates to 1983, when the state legislature voted to lift all durational limits on trusts. Previously, South Dakota — like all but two other states — followed the “rule against perpetuities,” inherited from English common law, which generally prevented trusts from lasting much longer than three generations. And the two states that didn’t follow the rule — Idaho and Wisconsin — weren’t terribly attractive trust fund destinations because they imposed state tax on trust income. With the 1983 law, South Dakota became the first state to allow trusts to exist free of state income tax forever.
The opportunity to establish a perpetual “dynasty trust” with no state income tax induced many of the richest American families to locate their trusts in South Dakota. The Pritzkers of Hyatt hotel fame and the heirs to the Wrigley chewing-gum fortune both opened private trust companies in the state’s largest city, Sioux Falls. By the end of fiscal 2020, financial institutions in South Dakota managed more than $367 billion in trust assets. The state’s success attracted copycats: Delaware followed suit by allowing perpetual trusts in 1995, Alaska in 1997 and a flood of others afterward. Perpetual trusts — rare before the 1980s — have now become a standard tool in the high-end estate planning kit.
The biggest loser in all this is the U.S. Treasury. Carefully designed, a South Dakota dynasty trust can operate as a perpetual estate-tax-avoidance machine. If wealthy families passed their fortunes from grandparents to children to grandchildren and so on, a 40 percent federal estate tax would apply at each generational interval. Shifting those fortunes to perpetual trusts allows them to escape estate tax indefinitely. (A separate federal tax — the generation-skipping transfer tax — is intended to prevent estate tax avoidance via perpetual trusts, but flaws in the design of that levy mean that as a practical matter it often doesn’t achieve its end.)
Soon, other states, often encouraged by high-end estate planners, started to pass statutes that facilitated additional creative tax-avoidance strategies. Alaska — the “Last Frontier” — emerged as a new frontier of domestic haven activity in the late 1990s. Most notably, in 1998, Alaska enacted a statute designed to exploit a loophole in the federal tax rules regarding the treatment of gains at death.
In general, when an individual owner of an asset (for example, stock or real estate) dies, her heirs’ basis in the property (the benchmark against which gains are calculated for tax purposes) is increased — or “stepped up” — to the fair market value at the time of the individual’s death, thus wiping away any tax liability on pre-death gains. But when a married couple owns an asset jointly and one of the spouses dies, the surviving spouse receives only a 50 percent step-up and still will owe tax on half the gain if she sells the asset. High-net-worth couples wanted a way to ensure a 100 percent step-up upon the first spouse’s death. Alaska was happy to help.
Alaska’s strategy takes advantage of an anachronism in the federal stepped-up basis rules for couples in states with “community property” laws, which mandate that assets acquired during marriage be split 50-50 upon divorce. In those states, the surviving spouse receives a 100 percent step-up in basis upon the first spouse’s death. Only nine U.S. states had community property regimes before the late 1990s — and Alaska wasn’t one of them. But Alaska now allows couples to transfer assets to an “Alaska community property trust” before the first spouse dies and ostensibly gain the benefits of living in a community property state. The IRS hasn’t confirmed that the Alaska maneuver is legal under federal law. But that hasn’t stopped Florida, Kentucky, South Dakota and Tennessee from passing similar statutes.
Possibly the most pernicious of these state-sanctioned tax-avoidance strategies is one engineered by Nevada. Known as the Nevada incomplete-gift nongrantor trust (NING), this vehicle allows an out-of-state resident to set up a trust in Nevada that will be treated as a “nongrantor trust” for income tax purposes — meaning that it reports and pays tax separately from its owner. Normally, a gift to a nongrantor trust would trigger a 40 percent federal gift tax, but NINGs are structured to avoid that result under federal law. The upshot is that residents of high-tax states such as California — which has a top state income tax rate of 13.3 percent — can transfer stocks and other investment assets to NINGs and avoid state income tax on dividends and gains, all without any negative federal gift tax consequences. (Delaware, South Dakota and Wyoming now offer similar trusts, known as DINGs, SDINGs and WINGs.)
From a broad public policy perspective, all this is certifiably crazy. States such as South Dakota are helping out-of-state residents reduce federal and home-state tax liabilities so that in-state financial institutions can get a cut. Brilliant lawyers are devoting their time and brain power to devising new strategies and finding state legislatures that are willing to go along. Collectively we would be better off if states would call a truce — but if, say, South Dakota is doing it, then Alaska and Nevada want to ensure that their trust companies get in on the game, too.
Not all of the blame lies with the states that have carved out niches for themselves as domestic havens. The dynasty trust and community property trust strategies exploit loopholes in federal law that Congress — if it cared — could close. For example, lawmakers could impose a limit on the length of time that assets in a dynasty trust may remain outside the federal wealth-transfer tax system (say, two generations). Likewise, Congress could eliminate stepped-up basis at death, which would render Alaska community property trusts and their doppelgängers in other states obsolete. (President Biden has proposed to tax gains over $1 million per person at death, but his proposal has faced pushback from some congressional Democrats.)
States also have some power to protect themselves against domestic havens. NINGs, DINGs, SDINGs and WINGs take advantage of tax laws in high-tax states that exempt out-of-state nongrantor trusts from state income tax. New York amended its law in 2014 to prevent Empire Staters from taking advantage of NINGs and other incomplete-gift nongrantor trusts. By failing to do the same, California and other high-tax states (and the District of Columbia) have made themselves sitting ducks. The millions of dollars that they lose when wealthy residents shift assets to NINGs is money they could use to fund schools, roads and other public services.
Federalism, at its best, lets states craft innovative laws that respond to local needs. Surely there are better ways for states to use their sovereign power than to cater to the tax-avoidance interests of wealthy out-of-staters while padding the pockets of a few in-state lawyers and bankers. As Brandeis put it, “It is one of the happy incidents of the federal system that a single courageous State may … try novel social and economic experiments without risk to the rest of the country.” States can live up to that ideal without also trying novel ways to beggar their neighbors.