How One Little-Known Loophole Fuels Toxic Dynastic Wealth

On the surface, Americans appear to disagree about federal estate and gift taxes.

Dig deeper, though, and you find that the crux of the disagreement is not whether to tax the intergenerational transmission of wealth, but when. We may disagree whether a small business owner and her husband who lived frugally and accumulated a five-million-dollar estate should pay estate tax. But the great majority of us believe it sound policy to tax multi-billion-dollar fortunes with the passage of each generation.

Americans have good reason to view the transmission of dynastic fortunes this way. Their instinct today reflects the concerns of Theodore Roosevelt, when he advocated for enactment of the estate tax over a century ago: “The really big fortune, the swollen fortune, by the mere fact of its size,” Roosevelt explained, “acquires qualities which differentiate it in kind as well as in degree from what is possessed by men of relatively small means.” Indeed, colossal fortunes are inimical to a healthy, functioning democracy. “We can have democracy in this country,” Louis Brandeis famously observed nearly a century ago, “or we can have great wealth concentrated in the hands of a few, but we can’t have both.”

Reflecting Roosevelt’s concerns, the estate tax, as originally enacted, would subject extraordinary wealth to tax each time it passed from one generation to the next.

But wealthy families discovered they could circumvent the estate tax by placing their wealth in trust. The estate tax is a tax on the act of transmitting wealth. When the beneficiary of a trust dies, however, there typically is no transmission of wealth. The rights of the beneficiary to receive trust distributions simply expire. The creator of the trust might pay gift or estate tax upon the initial transfer of wealth into the trust, but never again while the wealth remained there, no matter how much it accumulated.

If reports on the growth of the Mars family fortune over the past 25 years are accurate, they show what happens when dynastic wealth placed in trust accumulates without a once per generation payment of estate tax: exactly what Roosevelt feared. According to Forbes’ reporting, upon the passing of Forrest Mars, Sr. in 1999 and Forrest Mars, Jr. in 2016, the Mars family wealth was not reduced by an estate tax bill. Today, the family controls wealth totaling over $90 billion.

Combatting Undue Wealth Accumulation: The Generation-Skipping Tax

Can something be done to combat this accumulation? Yes. In 1976, Congress enacted the generation-skipping tax, or GST, on the multi-generational passage of wealth to prevent circumvention of the taxes on estates and gifts.

Although there were delays, the 1986 Tax Act amended and implemented the GST. The GST was intended to roughly equalize the tax treatment of the passage of wealth from a person to a grandchild or more remote descendant with the tax treatment of the passage of wealth one generation at a time – i.e., parent to child, followed by child to grandchild, followed by grandchild to great-grandchild, and so on.

The GST works by imposing an additional layer of tax on wealth transfers that skip a generation, for example, from grandparent to grandchild. In the case of a trust providing for multiple generations of an ultra-rich person’s descendants, the additional layer of tax would occur as each generation of descendants passed on and the next generation became the primary beneficiaries of the trust, or upon any distribution to a more remote descendant of the trust creator than the beneficiaries then nearest in generation to the trust creator.

Unmet Goals: GST Design Defects

Due to flaws in the design of the GST, however, the goal of once-per-generation taxation remains unrealized.

There are three major flaws in the GST, all involving the exemption that each person is allowed from GST taxation. The first is that the GST exemption, at $11.7 million per person, is too large. If an ultra-rich grandparent applies her GST exemption to an $11.7 million gift to her young, also ultra-rich grandchild who won’t need to touch the wealth, the gift easily could grow to $500 million during the grandchild’s lifetime.

The second and even more problematic flaw in the GST exemption is that it can be applied to a trust that will last for multiple generations. This trust, known as a “dynasty trust,” is a trust designed to exist for multiple generations of a person’s descendants. The laws of some states allow dynasty trusts to last in perpetuity.

When the GST exemption is used in tandem with other tax avoidance vehicles, the amount wealthy Americans are able to lodge in dynasty trusts is far greater than the current $11.7 million statutory exemption. Massive fortunes, sometimes exceeding one billion dollars, can be placed in dynasty trusts that will remain exempt from wealth transfer taxation for centuries. Consider the accumulation of wealth if, instead of starting out with $11.7 million, a dynasty trust started with $11 billion. Or if the accumulation continued not for the lifetime of a grandchild, but for several centuries.

The third flaw in the GST is that Congress in 1986 granted a perpetual exemption from the GST for trusts that had become irrevocable by September 25, 1985 (the date on which the reformed GST legislation was introduced). Assets transferred to grandfathered trusts before then can continue to grow and be distributed to beneficiaries free of estate, gift, or GST. Consider the size to which the Mars family fortune could grow if, as appears to be the case, it was placed in trust prior to September 25, 1985, and is not subject to transfer tax for the next century.

The past few decades have seen a surge in the wealth stashed in dynasty trusts.  High-net-worth individuals undoubtedly have succeeded in shifting trillions of dollars to dynasty trusts that—under current law—are poised to escape federal wealth transfer taxation forever. The rise of dynasty trusts radically diminishes the revenue-raising potential of the estate and gift tax and is on a course to dramatically worsen the already horrific concentration of wealth in America.

A look at the trajectory of the trust industry in South Dakota, the state known for laws that are friendly to dynasty trusts, tells the story. In 2010, according to the South Dakota Department of Labor and Regulation, 51 state-chartered trust companies held a total of $57.3 billion in assets under management. By 2015, there were 78 state-chartered trust companies in South Dakota, and the total wealth under management had more than tripled, to $175 billion. By 2020, the wealth under management had doubled again, to $367 billion, with 105 state-chartered trust companies.

For a super-wealthy family, the dynasty trust makes the accumulation of great wealth almost inevitable under America’s current tax structure. The wealthy can employ talented investment managers to grow their wealth at a healthy rate. Their extravagant lifestyles consume wealth at only a fraction of that rate.

Massive accumulations of wealth, as Brandeis observed, threaten our democracy. The lack of any limit on wealth accumulation inside GST-exempt dynasty trusts—combined with recent Supreme Court decisions dismantling campaign finance regulations—raises the risk that individuals and families in control of these trusts will be able to purchase a degree of political influence that is inconsistent with a well-functioning democracy.

A Proposal to Amend the GST

Here’s a proposal Professor Daniel Hemel and I developed to amend the GST that would stem the rise of dynasty trusts while still allowing more than 99 percent of American families to pass wealth across multiple generations transfer-tax-free:

First, the GST exemption should be reduced from its current level of $11.7 million per person to $3.5 million per person. That revised exemption level is considerably more generous, after accounting for inflation, than the exemption proposed by President Reagan and adopted in 1986. At the time, the Reagan administration urged Congress not to deviate significantly from that exemption level. A $3.5 million per person GST exemption would be sufficient to fully exempt the generation-skipping transfers of the vast majority of Americans.

Second, the manner in which the GST exemption applies to trusts should be modified. Under the proposal, a trust could continue to qualify for exemption from the GST, but the trust’s GST exemption would apply only to distributions to beneficiaries who are within two generations of the transferor (essentially, the transferor’s grandchildren) and to more remote beneficiaries, such as great-grandchildren, who were alive at the time of the trust’s inception. A trust’s GST exemption would not apply to distributions to beneficiaries who are three or more generations from the transferor unless those beneficiaries were alive when the trust was created. A trust’s GST exemption would expire, and the GST would apply, upon the passing of the last beneficiary of the trust to whom an exempt distribution could be made.

Third, for any trust created prior to adoption of the proposal, the proposal would apply as if assets had been transferred to the trust on the date the proposal becomes effective. This would mean that all descendants of the creator of a pre-existing dynasty trust who are alive before adoption of the proposal would not face the GST, but all descendants born after that date would. That seems to strike the appropriate balance.

This proposal, explained more fully in this article by Professor Hemel and me, would ensure that extraordinary fortunes do not escape from federal wealth transfer taxation for significantly longer than a single human lifetime. In contrast to other possible reforms, the proposal would protect the bottom 99 percent of the wealth distribution from inadvertent of the GST. For example, some have proposed eliminating the GST exemption entirely. That could cause routine gifts from grandparents to grandchildren to be taxable. Although that approach would effectively curtail use by the ultra-wealthy of trusts to escape wealth transfer taxation, such an approach would not be sound policy. The GST should exist as a check on extraordinary dynastic wealth, not as a trap for the unwary.

The following examples illustrate how the proposal would apply:

Example 1. Vera Rich has two children, four grandchildren, and a great-grandchild, Richey Rich. Under her Will, Vera transfers $3.5 million to an irrevocable trust for the benefit of her descendants and allocates $3.5 million of her available GST exemption to the transfer. Under current law, the trust would never be subject to the GST and distributions from the trust always would be exempt from wealth transfer taxation, regardless of how large the trust grew in size. Under the proposal, the trust would be able to make GST-exempt distributions to any grandchild of Vera or to Richey Rich, but not to any other great-grandchild or more remote descendant of Vera’s. Thus, a distribution to Vera’s grandchild would not be subject to GST, but a distribution to a great-grandchild of Vera’s other than Richey would be subject to the GST. The GST would apply to the trust assets upon the death of the last to die of Vera’s children, grandchildren and Richey.

Example 2. On January 1, 1975, Candy Mars established and funded an irrevocable trust for the benefit of her descendants. Under current law, distributions from the trust never would be subject to the GST because the trust pre-dated September 25, 1985. If the proposal were adopted effective January 1, 2022, the trust would be treated as if it were a GST-exempt trust created by Candy on January 1, 2022. A distribution to Candy’s grandchild would not be subject to the GST. A distribution to any descendant of Candy who was alive on January 1, 2022 also would not be subject to the GST. However, a distribution to Candy’s great-grandchild or more distant descendant would be subject to the GST if the great-grandchild or more distant descendant was not alive on January 1, 2022. The GST would apply to trust assets upon the death of the last to die of the beneficiaries who either are within two generations of Candy or were alive on January 1, 2022.

Conclusion

Unless the generation-skipping tax is strengthened, the proliferation and growth of dynasty trusts is a near certainty.  Generation-skipping tax reform requires difficult design choices and tradeoffs. However, the status quo—in which trillions of dollars in dynasty trusts can grow free of federal wealth transfer tax forever—is untenable. Under the proposal here, GST-exempt trusts could continue to make distributions free of GST to beneficiaries who are within two generations of the transferor or who were alive at the time of the initial transfer, but distributions to more distant beneficiaries who were not alive at the time of the initial transfer would be subject to the GST. Existing GST-exempt trusts would be brought back within the federal wealth transfer tax system under a reasonable transition rule that places these trusts on equal footing with GST-exempt trusts created today. No living beneficiary would be negatively affected, and the overwhelming majority of estate plans would experience no impact.

The reform proposed here would provide an important check on the growth of dynasty trusts and would help to ensure that extraordinary fortunes do not escape federal wealth transfer tax into eternity.