Estate Taxes: Why Congress Needs to Plug the Loophole That Builds Up Dynastic Wealth
I want to alert you to a tax loophole for the "lucky sperm club" (otherwise known as the heirs of the rich) that gets almost no publicity. Congress could plug the loophole when it reconfigures estate taxes for 2011 and beyond (when exactly that will happen is anybody's guess). Without public outcry, however, there's no pressure to do so -- and let's face it, the loophole benefits all the millionaires in the Senate and House. If nothing changes, we'll be well on the road to building enormous pools of untaxed dynastic wealth.
Under current law, wealthy people can put property into "perpetual trusts." These trusts last forever, with estate taxes never coming due and the investments compounding through the generations. Already, roughly $100 billion has been stashed away for the benefit of current heirs and descendants yet unborn. The families could leave that money untouched for centuries, paying dividends to heirs but otherwise letting the principal grow.
Congress and the states, together, drove the move to perpetual trusts. Here's the story, in a nutshell:
In the typical estate, parents leave their money to their children. Estate taxes are due on amounts over, say, $7 million for a married couple --at least that was the level in effect last year (the estate tax vanished in 2010 but is expected to resume next year. The amount exempted from tax hasn't been decided yet, however.) When the children die, the money passes to the next generation -- again, with an estate tax on amounts over $7 million.
When the family is rich and the children don't need the money, the parent might leave the property to a grandchild in trust, so it won't be taxed twice. Congress tried to close that loophole in 1986. Property left to the second generation (or beyond) is subject to a Generation Skipping Tax (GST), at the highest estate-tax rate.
But there's an exemption from the Generation Skipping Tax, equal to the amount that's exempt from estate taxes. As a result, a wealthy family can use a trust to pass, say, $7 million to distant descendants, untaxed.
That might not sound like a lot of money, compared with the amount of wealth rich families have. But $7 million can be leveraged into much higher amounts. For example, the trustee could use it to buy a large life insurance policy, real estate for the beneficiaries' use, shares in a start-up business, or minority interests in an existing family business, priced at a discount.
How long trusts can last depends on state law. In 1986, most of them imposed limits -- typically, 100 years or fewer. But with the passage of the Generation Skipping Tax, the more aggressive states saw a money-making opportunity. They passed laws allowing trusts to last 500 years, or to last forever, in order to attract lucrative estate-planning business to its law firms and banks. They also protected the trusts from creditors, and exempted the income they earned from state taxes if they were set up with out-of-state funds. There are currently 25 such trust-friendly states, plus Washington D.C.
A 2005 study shows that "the wealthy are creating GST-exempt perpetual or near-perpetual trusts in large numbers in these trust-friendly states," says Lawrence Waggoner, law professor at the University of Michigan. "The loss of tax revenue will become more acute as time passes."
Congress could stop this drain by putting a two-generation limit on the exemption from the Generation Skipping Tax. A wealthy grandparent could avoid the tax on money left to grandchildren in trust but not to great-grandchildren. That would bring the law roughly back to where it stood in 1986, when the GST was passed.
Such a law would actually do the families a favor, although they might not see it now. Perpetual trusts will become contentious, over time. There could be 450 beneficiaries after 150 years and 7,000 beneficiaries after 250 years. If Samuel Hinckley, a Pilgrim who died in Massachusetts in 1662, had created a perpetual trust, his more-than-100,000 beneficiaries living today would include President Barak Obama and his children, as well as former President George H.W. Bush and his children, Waggoner says.
A trustee would be tasked with keeping track of all these heirs, looking out for their differing interests, investigating applicants who might be pretenders, and risking lawsuits by unhappy beneficiaries. These distant descendants will have no common interests. They'll be related to each other only through a ghost from the far-away past. The trust's provisions -- a dead hand from the grave -- might be wholly inappropriate for the future's changed conditions.
Perhaps perpetual trusts will fail. After 150 years or more, poor investments, squabbling families and increased legal and trustee fees might deplete the funds. But trustees who invest wisely and withhold big distributions to heirs could amass enormous fortunes that pass through the generations untaxed.
Dynastic money has always been antithetical to America's values. The tax laws were intended to break up huge concentrations of riches, over time. Congress should reject trusts that build up the wealth of kings. Two protected generations is enough.
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