Thursday, August 20, 2020

Defending the Dynasty's Fortune

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 2 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 4 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. 



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