How to bypass U.S. estate taxes

Tomorrow is tax day, which comes amid a burgeoning debate around our annual payments to Uncle Sam. One particular fight has broken out this week over the estate tax— which affects only those Americans with estates worth more than $5.43 million per person or $10.86 million per married couple. This means the estates of 99.85 percent of all Americans will not be subject to the estate tax.

What’s more, this debate on estate taxes misses one critical point—that a loophole allows many of those who are wealthy enough to face estate taxes to largely bypass the law altogether. This is done through the clever usage of a complicated tax-preferred savings vehicle called a Grantor Retained Annuity Trust, or GRAT, which those at the tippy top of the U.S. wealth and income ladder use to pass on their estate to heirs without it being subject to the full estate tax.

Here’s a basic description of how GRATs work. The first step for the very wealthy is to place a large amount of assets into a GRAT, with instructions that the entire amount should be returned to them over a specified period of time (two annual payments over two years, for example). Because individuals are not taxed when gifting to themselves, no taxes are levied on the original value of the assets placed in GRATs. Any earnings in excess of the assets originally placed in these GRATs accrue to trusts that are bequeathed to specified beneficiaries.

When the GRAT is first set up, the U.S. Internal Revenue Service gives a “gift value” estimate, based on the IRS “Section 7520 Code,” of how much they expect the assets to increase in value. Once the term of the GRAT expires, the wealthy individual who set up the GRAT, the grantor, will have received the original contribution plus this theoretical interest. In December 2014, the 7520 code was 2 percent. So if an individual created a two-year GRAT in that month and put in $1 million, they should receive back the original $1 million contribution and 2 percent interest via annuity payments through December 2016. Any excess appreciation earned beyond the original contribution and IRS assumed rate of return can be transferred to beneficiaries—estate tax free.

Not surprisingly, many savvy grantors will put assets in GRATS that have a good chance of increasing exponentially more than assumed rate of return set by the IRS. Many of the original Facebook founders, for example, put their pre-IPO Facebook stock into GRATs—and then saw their value increase well beyond the predicted IRS rate. Or consider gambling magnate Sheldon Adelson, who set up GRATs during the Great Recession of 2007-2009 using much of his Las Vegas Sands Corp. stock, which had plummeted in value. Because the stocks’ value rebounded as the U.S. economy recovered, he was able to shelter a half a billion dollars for his heirs, none of which will be taxed.

Even if the initial value of the GRAT does not increase to these degrees,  giving heirs $100,000, let’s say (which, relative to some GRATS, is actually small), grantors can continuously reinvest their money in GRATS again and again until they die. And doing so is court approved. A 2000 U.S. tax court ruling found that Audrey Walton’s (part of Walmart Stores, Inc.’s Walton family) GRAT was indeed legal as long as the grantor is alive. If grantors die during the term of their GRATs, all the assets are indeed subject to the inheritance tax (making a short-term, two-year GRAT a popular option among older grantors).

The Obama administration proposes to discourage such practices by requiring a 10-year minimum term on GRATs, but the probability of enacting any kind of restriction in the current political climate is slim. Very wealthy Americans are not obligated to report how much each GRAT passes on to heirs. But one estimate puts the amount that bypassed the estate tax at $100 billion since 2000.

The estate tax was originally enacted in 1916 in order to break up the oligarchic power base created during the Gilded Age of the late 19th century. The soaring wealth gap was not squashed altogether, although it was greatly diminished in part through the economic transformation instigated by World War II. Yet the estate tax has provided a relatively consistent stream of government revenue ever since. What’s troubling, though, is the loophole’s contribution to today’s widening wealth gap, which is at its highest point since the 1920s.

There is a valid debate to be had over the degree to which the estate tax can help alleviate rising wealth and income inequality in the United States, but it remains somewhat irrelevant if the premise on which that debate is based—the existence and enforcement of an estate tax for the wealthiest families—is far too easy to circumvent through the use of GRATs or other similar loopholes.


Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch