“Only morons pay the estate tax.” That is a bit of hyperbole, of course, from Gary Cohn, the director of the National Economic Council during the first Trump administration. But those paying attention know that the federal transfer taxes don’t work very well. Instead, highly effective estate tax dodges pervade, and these techniques are particularly effective as applied to the largest estates. Brian Galle, David Gamage, and Bob Lord, in their paper, Taxing Dynasties, citing their own empirical study of data culled from the IRS, conclude that these taxes fail to reach at least $4.5 trillion of huge, family-controlled fortunes. And for this, they’ve proposed a meticulous, politically savvy, and technically brilliant prescription.
They point out that most of this $4.5 billion in transferred wealth is held in “dynasty trusts,” which are devices designed to escape wealth transfer tax for generations, if not permanently. Taxing Dynasties proposes an annual “withholding tax” on these trusts. It takes aim at trusts held by those “with more money than they can reasonably spend in a lifetime, the .01% richest citizens,” and would function as a minimum tax on those trusts. The authors’ proposal is not just an academic pipe dream. They are working with at least one Senator to devise legislation incorporating their ideas, which they expect to be introduced in Congress sometime in 2025.
Of course, progressive tax reform is politically difficult, and the authors acknowledge that well-funded transfer tax opponents often shape impending tax legislation in their favor. Here they plausibly claim some political advantages to their withholding tax. An annual payment of transfer tax in small increments, in most cases as a kind of “pre-payment,” will reduce political opposition, because, as they observe, “prepayments strengthen government budgets and enforcement incentives, especially over the ten-year accounting window that Congress generally employs.” And familiar political tropes about the estate tax as a “death tax” that forces liquidation of estates could be weakened, they suggest, by implementing a tax that is not exacted in one big chunk at death, but instead hits large fortunes in “bite-sized pieces over time, ideally in advance.”
But first they explain what’s wrong with the current scheme. How do dynasty trusts escape the estate tax under current law? To begin with, dynasty trusts are multi-generational tools. And the “generation-skipping transfer tax” (GST), originally implemented to close a loophole left open by the gift and estate taxes on multi-generational trusts, includes a poorly-designed exemption, a $14 million free pass, that each taxpayer can allocate among transferred assets as they choose. This GST exemption, when coupled with the elimination of the Rule Against Perpetuities (RAP) for most trusts (see my JOT dated July 12, 2021), essentially allows the allocated GST exemption of a taxpayer to balloon over time, and creates a planning opportunity that, when implemented, prevents the GST from ever reaching this massive pool of assets. This allows a wealthy couple to fund an irrevocable trust with almost $28 million, tax-free, by allocating the couple’s combined 2025 GST exemption to the trust. The trust, no longer subject to the RAP, is then permanently free from federal transfer taxes, even if the value of the trust corpus swells over time to many multiples of its value at inception.
The authors maintain that this GST exemption is “at the root” of what they describe as “critical modern abuses.” They deftly summarize complex estate planning techniques (“avoidance strategies”) that further game the exemption and leverage the amount that can be stuffed into GST-exempt trusts. Despite the complexity of these techniques, the authors’ clear explanations are comprehensible by non-experts, and are sure to be enlightening for the general reader. They contend that lawyers, through the invention of these schemes, which are astonishingly effective at making the transfer tax base disappear, “have broken the wealth-tax-transfer system.” This combination of the flawed GST exemption, the repeal of the RAP, and what the authors call the “near complete evisceration” of the transfer tax scheme through creative planning, permits “the creation of massive trusts holding wealth well into the billions of dollars.”
Taxing Dynasties is comprehensive and thorough, and cannot be easily summarized in a short review such as this one. Scholars and practitioners interested in this important issue should read the full article, which describes the longstanding policy debate about imposing wealth transfer taxes, the ways in which dynasty trusts pose unique problems, and the various considerations for tax reform. The authors then provide an overview of their proposed taxation scheme accompanied by helpful examples. At the risk of oversimplifying the proposal, I’ll briefly summarize just a portion of its approach.
The authors’ goal is not to increase the transfer tax rate (which stands at 40%), but rather to make it less vulnerable to political attack, and to reduce opportunities for gamesmanship by subjecting a broader base of wealth to transfer taxation at existing levels. The withholding tax would mandate annual installment “withholding” payments equal to 2% of the current value of trust assets (appraised annually). Crucially, the accumulation of payments made would be credited back to the trust beneficiaries in proportion to their relative distributions from the trust.
Several examples illustrate how the proposed tax would thwart common avoidance strategies. In one example, the taxpayers (Ma and Pa), who have not yet used their GST exemptions, create a perpetual trust, and fund it with shares of a startup venture valued at $26 million. They assign a portion of their GST exemption to the trust (they have between them a total of $28 million available), ensuring that the trust is wholly GST-exempt. Beneficiaries of the trust include Son and Daughter-in-Law (lifetime beneficiaries), and Grandson and Granddaughter (remainder beneficiaries). The transfer to the trust would be potentially subject to gift tax, but no gift tax is due at the time of the transfer to the trust because the lifetime gift tax credit (unused by Ma and Pa until the funding) equals the same as the GST exemption of $14 million per donor.
Under the proposed tax, the trust will pay an annual amount equal to 2% of the value of the trust in each year. The trust corpus will need to be valued annually but, because the tax is only a withholding tax at this point, the ultimate tax liability will not be determined until later (a touted advantage of this is that disputes over valuation are minimized for trusts with property that might be hard to value).
In the example, the trust property experiences substantial growth in value (the startup proves to be a success). For simplicity’s sake, the trust is assumed to be valued at $5 billion per year over the twenty years that pass between the time of the funding of the trust and the death of the survivor of Son and Daughter-in-Law. Two percent of $5 billion equals $100 million per year, or $2 billion in total withholding tax paid by the trust over the twenty-year period. The authors assume that the trust distributes $1 billion to Son and Daughter-in-Law during their lifetimes but they spend all this (!) and nothing is left at the death of the survivor of them. Distributions to Son and Daughter-in-Law during their lifetimes will not trigger transfer tax as, for gift tax purposes, any gift to them was deemed made at the trust’s inception. At the death of Daughter-in-Law, who survives Son, the trust has a tax “credit” of $2 billion (the total tax withheld). Daughter-in-Law is entitled to 1/5 of the credit, because she and Son received 1/5 of the trust assets ($1 billion of $5 billion total). So her estate receives a gross refund of $400 million (1/5 of the $2 billion paid) but that $400 million is included in her estate for estate tax purposes. So her estate pays a tax at the estate tax rate of 40% on the $400 million ($160 million) leaving it with a net refund of $240 million.
What about the GST tax? Normally, the death of Daughter-in-Law would be an event called a “taxable termination,” triggering GST tax on the entirety of the trust assets. So this trust would owe a tax on the remaining value of the trust, which is $9 billion, at the 40% rate. The trust would also receive a gross refund of the remaining credit amount of $1.6 billion (4/5 of the $2 billion withheld) which would also be subject to a 40% tax. However, this trust is GST-exempt, as Ma and Pa allocated their GST exemptions to their transfers. So the taxable termination does not trigger the GST tax.
But the authors propose that GST-exempt trusts, such as this one, should pay the withholding tax but get no credit against an event that would otherwise trigger the GST. Likewise, an amount subsequently distributed to Grandson and Granddaughter, since it would trigger no transfer tax, qualifies them for no credit. This means that the trust will have paid $1.76 billion in tax ($2 billion withheld, less $240 billion refunded to Daughter-in-Law’s estate). In the current scheme of taxation, in contrast, no tax would have been paid at all.
One major advantage to this proposal over some other proposals out there is that it would begin collecting tax as soon as it goes into effect. The article compares features of the withholding approach with other proposals, and also addresses concerns about constitutionality. The authors are confident that their proposal is constitutionally sound and politically feasible.
When the infamous bank robber Willie Sutton was asked why he robbed banks, he is said to have replied, “because that’s where the money is.” Although this story is likely apocryphal, it inspired “Sutton’s law” of medicine and other areas of diagnostics and treatment, imploring problem solvers to focus inquiries on the most obvious maladies and remedies. The authors here make a good case that the transfer tax is broken due to common avoidance schemes and a faulty GST exemption. As the stratagem most widely employed by tax planners, dynasty trusts are the right place to focus transfer tax reform.
