‘We Are Not Taxing the Very Wealthy Enough’: Runaway Inequality About to Get Worse
The United States' astronomical levels of economic inequality are poised to become further entrenched in the coming years.
In America today, thanks to glaring loopholes in the tax code, even modestly competent tax attorneys can help their wealthy clients sidestep the federal estate tax almost entirely.
By Bob Lord
Estate and gift taxes, a Bloomberg News analysis earlier this year noted, raised only about $14 billion in revenue last year.
That meager sum, observers estimate, amounts to not much more than 1 percent of the $1.2 trillion passed down in America each year.
How low have tax collections from the estates of wealthy Americans fallen? This low: In all likelihood, the fees the wealthy pay to their tax planners each year now dwarf our $14 billion in annual estate tax revenue.
Could estate tax collections from America’s wealthy drop even lower? Absolutely. In fact, the 1 percent effective estate tax rate is now heading toward zero. Whatever window of time we have to avoid that result is closing quickly. Every day, wealthy Americans are placing billions beyond the reach of the estate tax — forever.
Why is this happening? Tax avoidance planners are seizing on distortions in our current federal estate tax law, and the insane distortions in this law have rendered the estate tax virtually defenseless against a competent planner.
Collectively, those distortions allow wealthy couples to sell assets to their children at deeply discounted prices, with the purchase price paid back over time at below market interest rates — and the tax on the income from the assets paid by the parents, not the children. Unless the parents die early, this approach lets these wealthy families defeat the estate tax.[pullquote]Insane distortions in the tax code have rendered the estate tax virtually defenseless against a competent tax attorney. [/pullquote]
This estate tax-avoidance approach comes cloaked in legal jargon, terms like “family limited partnership” and “intentionally defective grantor trust.”
What are these impenetrable legalisms hiding? Let’s look at how a typical “intentionally defective grantor trust” scenario actually plays out.
John and Mary Rich, for starters, sell $100 million of investment assets to a trust set up for the benefit of their son, Junior, for $70 million, a 30 percent discount. They take payment in the form of a promissory note. This note bears a 3.5 percent interest rate.
Junior must pay interest on the note yearly at this 3.5 percent rate. But Junior doesn’t have to pay any principal for decades down the road. Assume the assets initially generate $5 million of income per year and that income increases over time as the assets appreciate and unused income is reinvested. That income flows to Junior, but is taxable, under the convoluted rules of intentionally defective grantor trusts, to John and Mary.
Junior uses $2.45 million from this income to pay his yearly interest obligation. John and Mary then use the $2.45 million interest payment to pay the tax on the income from the assets. Should John and Mary ever need any additional cash for living expenses, Junior makes an early principal payment on the note.
After 20 years, John dies, leaving all his wealth to Mary, including his share of Junior’s promissory note. As the surviving spouse, Mary faces no estate tax. Five years later, Mary dies, leaving only a minimal taxable estate.[pullquote]The 1 percent effective estate tax rate is now heading toward zero.[/pullquote]
Junior’s principal payments have by now fully paid off the note. His assets and the income they’ve generated, net of the payments to John and Mary, have now grown to a tidy $250 million nest egg, all safe, secure, and beyond the reach of the estate tax.
But the Rich family’s tax avoidance has only just begun. You see, Junior didn’t actually purchase those assets himself. The “trust” set up for his benefit made this purchase. Junior can tap the assets in the trust whenever he wants something, but for tax purposes these do not belong to Junior.
Junior’s living expenses will barely dent the growth of his fortune. When he dies, the expanded fortune will remain in trust, free of estate tax, for his children. A generation later, when Junior’s children die, billions will pass, free of estate tax, to John and Mary’s great-grandchildren. And so on.
The federal tax code does sport a generation skipping tax designed to prevent this result, but the generation skipping tax does not apply here.
This sort of planning requires no exotic accounting magic, just sophisticated technical expertise on the planner’s part. Executed competently, this strategy will withstand IRS challenge. Today, in law firm conference rooms all across the country, competent tax attorneys are making just these sorts of arrangements.
Inside those conference rooms, in effect, America’s ultra-wealthy are furiously transforming their wealth into giant trusts, permanently exempt from estate tax.
We don’t know exactly how far along they have come in the process. But we do know that if they complete the process before we plug the holes in our estate tax law, we may as well not bother.
Bob Lord, an Institute for Policy Studies associate fellow, practices tax law in Phoenix.