As Congress weighs reinstating the estate tax, one area that probably won't get too much consideration is the often-overlooked generation-skipping transfer tax (the GST tax). The GST tax was first passed in 1976 in response to a clever bit of tax evasion by wealthy families. Those families realized that, over the course of several generations, they could cut their total estate tax bills in half by leaving their wealth to their grandchildren rather than their children. This led to a sort of testamentary "leapfrogging": rather than leave her estate to her children, the wealthy taxpayer left her estate to her grandkids. Her children would leave their wealth to their grandchildren, and so on. Rather than assets being taxed at each generation, they were taxed at every other generation, which slashed the family's estate tax in half. Congress's answer to that was the generation skipping transfer tax.
The original 1976 statute proved to be an administrative nightmare, but in 1986 an improved version was passed. Notwithstanding a few minor tweaks over the years, the basic structure is still with us today.1 Importantly, the tax is equal to the top estate tax rate: this is crucial because, by doubling the tax due on transfers to a "skip person" (the jargon term for "a grandchild") it frustrates the ability of wealthy families to cut that tax in half. So, say I'm rich (I can dream, right?) and my daughter, having received inheritance from my father, doesn't need money. Let's say I die and leave my fortune to my granddaughter. My estate will be taxed at the 45% estate tax rate (assuming 2009 tax law for the moment), and the transfer to my granddaughter will be slapped with an additional 45% tax. If I leave $10,000,000 to my granddaughter, about $9,000,000 (45% estate tax + 45% GST tax) goes straight to the government.2
This is a pretty harsh result, so there are several ways in which it's mitigated. For example, there's an exclusion from gift tax and GST tax for transfers that are less than the "annual exclusion amount," which is indexed to inflation and currently stands at $13,000. For tax policy, however, the more important exception to the GST tax is the "GST exemption." We have what's called a unified gift and estate tax regime. One of the upshots is that, under 2001 law, everyone could exempt $1,000,000 from estate tax. Because the system is unified, however, I could use that credit before I die. IOW, over my life I can give away $1,000,000 without paying any tax. If I didn't give any gifts (over the aforementioned annual exclusion amount), then when I die my estate can use the exemption and $1,000,000 can pass from my estate without any tax. This is called the "unified credit."
The GST exemption amount is tied to that credit: under 2001 law - which, barring any further congressional action, will also be 2011 law - I can give away $1,000,000 to grandkids without having to pay any GST tax.3 That may not seem like a whole lot for someone that's worth north of $100 million, but there are several ways that exemption can be leveraged. For starters, a million bucks can grow to be a substantial sum over the course of two lifetimes (which is when the GST tax would kick in). $1,000,000 bucks can also buy a shitload of life insurance; as long as the premium doesn't exceed the $1,000,000, then the life insurance proceeds pass free and clear of GST tax. Alternately, a wealthy person can loan a trust money w/ a low-interest loan4 and not use any exemption at all. Because a loan isn't a gift, they can use zero exemption and still pass hoardes of money to the second generation and beyond.
For a while, the utility of these devices was limited by the bane of every law student's existence: the rule against perpetuities, a state law that governs the duration of trusts. In his infinite wisdom, my property law professor thought it was a boring anachronism and didn't make us learn it, so my understanding is pretty sketchy. The gist of it, though, is to ensure that trusts can't exist forever. At some point in the future (usually 21 years + a lifespan, so call it 100 years), the trust would have to terminate and be passed to whomever had a beneficial interest in the trust.
From the start of the GST tax and through the 1990s, then, there was an uneasy truce: a super-wealthy person was less likely to put a lot of time, energy and money (those lawyers and tax professionals don't come cheap) into setting up a dynasty trust when it was just going to terminate a mere century hence and be left to a bunch of ungrateful grandkids that wouldn't even remember said hyper-rich heir's name.
That all changed in 1997. Between 1997 and 2000, 8 states repealed their rule against perpetuity laws. Why? There was a lot of money to be made by enticing the wealthy to set up eternal dynasty trusts in their states. In order to stay in the legal clear, the assets of those trusts would be custodied at banks and trust companies in that state. This changed the ground considerably: now the super-rich person could set up a trust - and a legacy - that would live forever. If that $1,000,000 exemption could be leveraged (or avoided altogether by loaning funds to the trust), then the assets of the trust would go on forever and never be smacked with estate or gift tax. The upshot is that dynasty trusts are now a booming business, resulting in greater concentration of wealth and a considerable loss in tax revenues.5
So the federal tax laws have relied on state tax law to put limits on the ability of families to avoid tax, and the states, in response, have kicked the stool from under the federal tax code. What to do?
An idea that's being circulated now is to reinscribe the logic of the rule against perpetuities into the tax code itself. Here's the proposal of Lawrence Waggoner, tax professor at University of Michigan Law:
Two questions that Congress seems poised to resolve later this year are what the rate and maximum exemption will be when the tax returns and whether the tax will be reinstated for this year. As part of its 2010 tax bill, Congress should also close the loophole in the GST Exemption by providing that a trust loses its exemption once the trust continues beyond the death of the youngest beneficiary who is no more than two generations younger than the trust settlor. A two-generation limit would be consistent with the policy of the GST Tax, which focuses on taxing private wealth as it shifts from generation to generation or bypasses a generation without incurring federal estate or gift taxes. Coincidentally, a two-generation limit would also be consistent with the perpetuity rule recently adopted by the American Law Institute, which requires a trust to terminate no later than the death of the youngest beneficiary who is no more than two generations younger than the trust settler.
Some minor nitpicking w/ his proposal aside,6 this is an excellent approach to an underreported but critical issue in a time of increasing concentration of wealth. As boring and dry as tax policy is, and as awful as it can be delve into the details, it's pressing stuff and hopefully Congress is up to the task of correcting the law to prevent dynastic transfers. We'll see.
1 Well, sort of. Like the estate tax, the GST tax sunset in 2010 and is scheduled to reappear on January 1, 2011.
2 It's actually a little more complicated than that, because the estate tax is a so-called "inclusive" tax, while the GST tax, like the gift tax, is a so-called "exclusive" tax. Here's the difference: to make the math easier, assume a top marginal estate tax rate of 50%. If I want to leave $100 to my kid, with the estate tax I have to pass $200, $100 of which is paid in tax and the remaining $100 of which goes to the kid. With the gift tax, we take the amount passed and then levy the tax on it: $100 to the kid, and only $50 to the government. So the inclusive / exclusive difference can make quite a difference.
3 The amount is actually indexed to inflation, so it'll be $1 million + change, around $1,030,000 or so.
4 The IRS sets a floor for interest rates; these rates are very, very low.
5 One number I've seen kicked around is that, between 1997 and 2005, about $100 billion in assets has poured into states that have repealed their rule against perpetuities statutes.