The richest dozen billionaires now have a combined wealth of over $1 trillion. And since March 18, the beginning of the pandemic lock down, the collective wealth of the U.S. billionaire class has increased over $700 billion.
The pandemic, however, has also provided cover for tax avoidance. The wealth planners for the richest 0.1 percent have accelerated the tools they created over the last two decades to place trillions outside the reach of the estate and gift tax.
Institute for Policy Studies Associate Fellow Bob Lord has written a policy brief, “Covid-19, A Perfect Storm for Estate Tax Avoidance,” provides a readable overview to the deployment of two planning devices: the Intentionally Defective Grantor Trust, or IDGT, and the Granter Retained Annuity Trust, or GRAT. Lord explains their workings in his policy brief.
Wealthy families use these planning tools to place billions in wealth into “dynasty trusts” and reduce or eliminate their estate and gift tax obligations. According to Lord, it is too late to capture these funds.
The Intentionally Defective Grantor Trust (IDGT)
Here’s an example of how the strategy would have been employed in 2012:
Late in 2012, John and Mary Rich, then in their mid-40s, make a $10 million gift to an IDGT set
up to benefit their descendants; first, their children, then, after their children’s death, their
grandchildren, and so on. John and Mary also place over $500 million of investment assets in a
family limited partnership. The IDGT than purchases a limited partnership interest from John
and Mary. The partnership interest represents $117 million of investment assets but, because of
the manner in which John and Mary’s advisers have structured the partnership, is valued for
estate and gift tax purposes at only $100 million. That fifteen percent valuation discount is on the
conservative side in the tax avoidance industry. Many planners recommend discounts of 30% or
more.
The IDGT pays John and Mary $10 million in cash (the gift they made to it a short time earlier)
and a $90 million promissory note, which bears a one percent interest rate. The IDGT must pay
interest on the note yearly at this one percent rate. The IDGT will have to repay the principal by
the end of nine years, but it could refinance at that time if necessary. John and Mary’s tax
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planner advised them that in order for this strategy to withstand IRS scrutiny, the IDGT should
have at least 10% equity in its investment.
Assume the assets initially generate $2.4 million of dividend income per year and that income
increases over time as the assets appreciate and unused income is reinvested. That income flows
to the IDGT, but is taxable, under the convoluted rules of intentionally defective grantor trusts, to
John and Mary.
The IDGT uses $1 million per year from this income to pay its yearly interest obligation. John
and Mary then use the $1 million payment to pay the tax on the income from the assets and fund
their living expenses.
To sum up, John and Mary’s children, the beneficiaries of the IDGT, are able to purchase assets
at a substantial discount and realize a rate of return vastly exceeding the rate of interest paid on
the amount borrowed to purchase them, while John and Mary continue to pay the tax liability
attributable to the income on the assets.
Fast forward to June 2020. John and Mary now are in their early 50s. Their net worth now stands
at $1.5 billion. With the runup in the stock market, the discounted value of the IDGT’s
partnership interest has appreciated to $240 million, representing $280.8 million of partnership
assets.
John and Mary now sell an additional partnership interest to the IDGT for $1.26 billion, along
with the IDGT’s $90 million promissory note, for a total sale of $1.35 billion. Because the IDGT
now has $150 billion in equity, it may pay the entire purchase price with a new promissory note
for $1.35 billion. This note bears interest at a 1.01 percent annual rate and has a term of 30 years.
Although the IDGT only is required to pay the interest on the note, it uses the dividend yield
attributable to its share of the partnerships assets to make note payments each year.
Now, make some modest assumptions about the dividend yield paid to the IDGT, the income tax
payable by John and Mary on that dividend yield, the appreciation in the value of the
partnership’s assets, and John and Mary’s living expenses, and assume that the partnership
distributes the IDGT’s share of the assets to it after 30 years, which the IDGT then liquidates.
Here’s where things will stand after 30 years, when John and Mary are in the early 80s:
The IDGT will have paid the promissory note in its entirety.
The IDGT will hold over $4.2 billion of cash.
The note payments John and Mary receive will allow them to fund their living expenses, the
annual income tax on the dividend income, and the tax on all gains from the sale of investment
assets by the IDGT.
That’s $4.2 billion passed in trust to John and Mary’s children with an estate tax cost of zero.
The IDGT’s $4.2
billion value undoubtedly will grow during the Rich children’s remaining lifetimes. When they
die, their children will become the beneficiaries of the IDGT, with no estate tax paid. And a
generation later, John and Mary’s great-grandchildren will become the beneficiaries of the
IDGT, which by then could have a value of over $100 billion
The Grantor Retained Annuity Trust (GRAT)
The IDGT typically involves the use of some amount of a wealthy person’s exemption from
estate and gift tax.
The second strategy, the Grantor Retained Annuity Trust, works even for
those who have entirely consumed their exemption from estate and gift tax. And the current
environment turbocharges the obscene estate tax avoidance achieved through the GRAT as much
as, perhaps more than, it does the IDGT.
The technical aspects of GRATs may be difficult to grasp. The estate tax avoidance planning
strategy associated with GRATs, however, is fairly simple. GRATs are used by the ultra-rich to
sell investment assets, repeatedly, to trusts for the benefit of their descendants, with a slight
twist: If the assets appreciate substantially in value, the trust pays the purchase price. Otherwise,
the sale is undone, and the assets revert back to the ultra-rich seller. Now, think how rich you
might become if you could see how a stock performed before paying for it. And think of how
bad your investment results would be if every time you sold a stock its value increased, and
every time you held a stock it lost value.
That’s the essence of estate and gift tax avoidance with GRATs. The senior generation gradually
loses wealth over time, while the junior generations steadily gain wealth. The net-net is a transfer
of enormous wealth from one generation to the next that is not considered a taxable gift.
Avoiding estate tax through the use of GRATs is like spearfishing in a bucket even in ordinary
times. If a billionaire establishes enough GRATs, sooner or later she’ll have transferred billions
in wealth to her children free of gift and estate tax.
Still, some times are better than others for avoiding massive amounts of estate and gift tax with
GRATs.
Two factors drive the efficiency of GRAT estate tax avoidance: interest rates and investment
market volatility. When Mary Rich “sells” assets to a GRAT, she does so by exchanging the
assets for a two-year annuity -- two annual payments, that is -- payable on the first and second
anniversaries of the GRAT formation. Those annuity payments must include an IRS-determined
amount of interest, which is based on then-prevailing interest rates.
So, the lower interest rates
are, the less Mary must be paid for her assets. The interest Mary must charge is the hurdle, in
terms of performance, that the GRAT must clear to move wealth to her descendants. If the
GRAT fails to clear that hurdle, all its assets will return to Mary.
Mary typically would not create just one or two GRATs. Instead, she might create a GRAT every
month, or every week, or even multiple GRATs every week. If the financial markets are volatile,
Mary is more likely to time some of her sales shortly before the assets she sells to the GRAT
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jump sharply in value. At that point, the GRAT may sell the appreciated assets, and lock in a
gain. Yes, there will be other sales where volatility causes an immediate drop after Mary sells to
a GRAT. But Mary is not concerned about those sales. She can undo them.
Which makes the current pandemic the perfect storm for estate tax avoidance through GRATs.
Interest rates are at all-time lows, and the financial markets are as volatile as they’ve been in
decades.
The required interest rate on sales to GRAT’s has been below one percent per year since May. It
now stands at 0.4% per year.
At the same time, the stock market has been on a roller coaster ride. In the second quarter of
2020, the major stock indices rose over 17%. The Nasdaq increased over 30% in those three
months. The price of Amazon stock has nearly doubled since March.
The bottom line: The best time ever for avoiding estate and gift tax through GRAT planning is
now. And America’s billionaires and wannabe billionaires are seizing on the opportunity. Every
time the stock market swings in one direction and then in the other, billions of dollars of wealth
move beyond the reach of the estate and gift tax system. Under current federal and state law, it
will remain beyond reach for the next century or so.
The Mars family may have its wealth protected through the creation of dynasty trusts. Although
the family has not divulged any details of its estate planning, the reported wealth of Mars family
members, according to Bloomberg and Forbes, suggests this is the case, for two reasons. First,
with the passing of Forrest Mars, Sr., in 1999 and Forrest Mars, Jr., in 2016, the family’s total
reported wealth did not decrease, as it logically would if estate tax were paid. Second, the
reported wealth of family members in the same generation tends to be exactly equal, suggesting
that their wealth is held in a trust separated into equal shares.
The state of South Dakota has built a dynasty trust industry with an estimated $350 billion
sheltered from estate and other forms of taxation, up from $57 billion a decade ago.
