Closing the Loopholes America’s Super Rich Love: Can the Dog Catch Its Tail?

We’ve all at some point witnessed a dog trying to catch its tail. As the dog’s head moves towards the tail, the tail moves further away, forever remaining just out of reach.

The ongoing – and so far unsuccessful – congressional effort to close the loopholes in America’s estate, gift, and generation-skipping tax system brings that futile canine ritual to mind.

What makes loophole-closing so agonizingly difficult? Let’s start with the process of evaluating – “scoring” – the proposed tax law changes that come before Congress.

The Congressional Budget Office currently determines the revenue that every proposed tax law change will likely produce – or cost – in each of the first two decades following enactment. The CBO score for that initial ten-year window makes all the difference in the world. A weak score may doom a tax-change proposal, especially if those who’ll be paying the tax wield considerable political power.

A proposal that involves major structural reform will end up with a strong score, on the other hand, when the CBO calculates that the reform will generate significant additional revenue within the first ten-year window. But proposals to close loopholes on the wealth transfers the super rich make have a hard time on that front, mainly because these proposals can only draw revenue – in the ten years after their enactment – from a relatively tiny share of America’s richest.

Essentially, the only affluents who would pay more in transfer taxes in that first decade would be those affluents who haven’t completed their transfer tax avoidance planning before the reforms’ enactment and who also aren’t going to live beyond that first decade and don’t have a surviving spouse who’s going to live another decade either. A small group indeed.

Most members of our ultra-rich set do have more than a decade left to live or at least have a spouse who does. Of the ones who don’t – generally those over 75 – most have already implemented transfer tax avoidance plans. So a newly enacted measure designed to close transfer tax loopholes is going to find precious few grand fortunes to impact in that first ten-year window after the measure becomes the law of the land. Weak scores for such measures will almost be automatic.

We saw all this play out last September when the House Ways and Means Committee considered two transfer tax loophole-closing measures in its version of the Build Back Better legislation. One of these technical provisions would have limited the practice of forming “family-controlled entities” to claim “valuation discounts.” CBO analysts concluded that this provision would translate into a mere $18 billion of new revenue over the next ten years. A second provision to close the gaping loopholes around “grantor-retained annuity trusts” and “intentionally defective grantor trusts” scored even worse, raising just $9 billion in new revenue over the next decade.

You can guess what happened next. With the two proposed tax reforms generating such a slight share of total projected federal revenue, just 1.5 percent, and America’s richest 0.1 percent in heavy-duty opposition mode, the reforms stood no real chance. The House leadership, without providing any express reason, dropped these two transfer tax loophole closers from the Build Back Better legislation the full House went on to pass in November.

Those two loophole closers would, of course, have generated substantial revenue in the years after the first ten-year window. In fact, their revenue impact would have strengthened with each passing decade, as a smaller and smaller share of the ultra-rich would have completed their tax avoidance planning before the loopholes had closed. But revenue that will arrive more than ten years into the future, remember, carries practically no weight with lawmakers.

Think of that revenue beyond the first ten-year budget window as the dog’s tail.

To visualize this dog’s tail effect at work, suppose another attempt at closing transfer tax loopholes comes a decade from now. By then, our ultra-rich will have implemented another decade’s worth of transfer tax avoidance plans. Just as now, the revenue to be realized within any new reform’s ten-year budget window would be minimal. And the bulk of the potential revenue to be realized from closing transfer tax loopholes will have moved beyond the ten-year window, just like the dog’s tail that keeps moving as the dog gives chase.

Could we ever catch this tax-loophole dog’s tail? Maybe, but only if we think outside the box.

We need to get still a bit more technical here. Let’s consider, as one example, the wealth-held-in-trust loophole to our existing federal generation-skipping tax.

Under current law, if wealth passes from parent to child and then, a generation later, from child to grandchild, estate or gift tax can apply at the time of both transfers. But if the wealth passes directly from grandparent to grandchild, only one event triggers gift or estate tax. The generation-skipping tax now on the books attempts to remedy this distortion by imposing an additional layer of tax on transfers that skip one or more generations.

This generation-skipping tax, the GST, applies to both direct and indirect generation-skipping transfers. Direct generation-skipping transfers include gifts from grandparent to grandchild or transfers to “trusts” that benefit only remote descendants of the transferor. Trusts let deep pockets give another party, the trust’s trustee, “the right to hold title to property or assets for the benefit of a third party, the beneficiary.”

Indirect transfers occur in the context of multi-generational trusts. These transfers occur either when wealth is distributed to remote descendants of the trust’s grantor while the generation nearest the grantor is still living or when the “beneficial interest” of the generation nearest the grantor terminates because the last of that generation dies off.

The federal generation-skipping tax works well enough in the case of direct transfers. If the total direct generation-skipping transfers of a transferor exceed the GST exemption, that transferor’s excess direct transfers become subject to the generation-skipping tax. The fatal flaw of the tax, as now on the books, lies in the application of the generation-skipping tax exemption, currently $12 million per person, to indirect transfers.

A wealthy individual making an indirect transfer may apply the generation-skipping tax exemption to any amount transferred into trust. The exemption continues to apply, no matter how large the trust grows or how long it remains in existence or how many generations of trust beneficiaries are avoiding transfer tax on the passage of wealth from generation to generation. That means indirect transfers to the grantor’s remote descendants can ultimately dwarf the amount of the generation-skipping tax exemption and easily reach totals well into the billions.

The solution? Our tax law should limit the generation-skipping tax  – and the generation-skipping tax exemption – to direct transfers.

We should replace the GST for indirect transfers through trusts with an annual excise tax on trust-held wealth. The excise tax would apply to trust-held wealth from the same grantor above a threshold of $10 million. We could make exceptions here for trusts set up to protect children and other individuals who could be disadvantaged by direct receipt of gifts and bequests.

The excise tax rates would be progressive: 1 percent on all trust-held wealth between $10 million and $50 million, 2 percent on between $50 million and $100 million, 3 percent on between $100 million and $1 billion, and 4 percent on trust-held wealth in excess of $1 billion. The excise tax would be deductible in determining the taxable income of the trust.

This reform would accomplish important objectives. It would replace that part of the generation-skipping tax that allows our wealthiest to exempt virtually unlimited amounts from tax with a tax that allows an exemption for modest amounts held in trust, but otherwise extracts an annual levy that, over the course of a generation, would reach the result the generation-skipping tax was designed to achieve.

Reaching that result would significantly increase revenue inside the first ten-year budget window. Every $1 trillion of wealth subject to the tax at the 1-percent level would result in $10 billion of excise tax annually, or $100 billion over 10 years. Even if our richest used the entire amount of excise tax paid to reduce their trusts’ taxable income, the net revenue increase would be in the $60 billion range.

Over the longer term, the excise tax revenue from this reform likely would diminish as more of the ultra-rich abandoned the “dynasty trust” structure in favor of transfers not subject to the tax. But that change in approach would cause a substantial increase in the number and size of estates subject to estate tax. And if we accompanied the replacement of the GST tax as it applies to trust-held wealth with measures to close estate and gift tax loopholes, we would finally have realized the long-term transfer tax revenue now going uncollected.

We would have caught the dog’s tail.

Bob Lord, an Institute for Policy Studies associate fellow, currently serves as a Patriotic Millionaires tax policy senior advisor.