States Sidestepping Congress on Taxing Family Wealth

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By Allyson Versprille

July 22 — It wasn't supposed to work this way. A decades-old tax was created by the federal government with the intent of keeping the wealthy from using trusts to pass their fortunes on to future generations without facing estate taxes.

Instead, state law changes in recent years allowing trusts to live in perpetuity are now undermining the federal law's intent—and it is occurring against a backdrop of an election year and public anger about inequality.

The generation-skipping transfer tax is imposed on gifts and bequests to transferees who are two or more generations younger than the transferor, such as grandchildren. The 40 percent GST tax applies once an exemption amount is surpassed; for 2016, the amount is $5.45 million.

When structured correctly, a $2 million gift to a trust where a $2 million GST exemption is applied simultaneously could grow to more than $250 million by the time it gets to the parent's great-great grandchildren, according to Robert Adler, an attorney at Adler & Adler PLLC.

Adler said that accumulated value in the trust would only be about $50 million had the GST exemption not been allocated and the tax been imposed.

The strategy allows taxpayers to avoid taxes on appreciating assets within generation-skipping trusts by applying the GST exemption upfront when the trust is established, Adler said during a June 22 webinar.

The GST tax is equal to the highest federal estate tax rate in effect multiplied by an inclusion ratio, Adler said. “If, when we create a trust, we allocate GST exemption dollar-for-dollar to gifts made to a trust, we end up with a trust that has an inclusion ratio of zero,” and thus a GST tax of zero, he said.

A House Ways and Means Committee Democratic aide told Bloomberg BNA July 6 that such a strategy is “not something Congress ever anticipated being possible.”

Rule Against Perpetuities

Congress enacted the GST tax in the Tax Reform Act of 1986 to prevent the avoidance of estate and gift taxes through the use of a trust that gives successive life interests to multiple generations of beneficiaries.

However, when the tax was established, most states had included within their laws the common law rule against perpetuities (RAP) or some version of it, the committee aide said.

The RAP generally requires that every trust terminate no later than 21 years after the death of a person alive at its creation. “There was no practical way for people to gift beyond their great-great grandchildren to get around the estate tax rules because you couldn’t have a trust that lasted that long,” the aide said. “It wouldn’t be legal.”

This same idea has been reflected in the Obama administration's fiscal year 2017 revenue proposals, known as the “Greenbook.”

A number of states—including Alaska, Arizona, Delaware, Idaho, Illinois, Maryland, Nevada, Ohio, South Dakota and Wisconsin—now either have repealed or limited the application of their RAP statutes, with the effect that trusts created subject to the law of those jurisdictions may continue in perpetuity, a FY 2017 Obama administration budget proposal on the GST tax exemption said.

“As a result, the transfer tax shield provided by the GST exemption effectively has been expanded from trusts funded with $1 million (the exemption at the time of enactment of the GST tax) and a maximum duration limited by the RAP, to trusts funded with $5.45 million and continuing (and growing) in perpetuity,” the proposal said.

90-Year Rule

To combat this change, the 2017 proposal suggested the GST exclusion allocated to the trust terminate on the 90th anniversary of the trust's creation. Specifically, this would be achieved by increasing the inclusion ratio of the trust to one, thereby rendering no part of the trust exempt from GST tax, the proposal said.

Because contributions to a trust from different grantors are deemed to be held in separate trusts under tax code Section 2654(b), each separate trust would be subject to the same 90-year rule, measured from the date of the first contribution by the grantor of that separate trust, the administration's proposal said. It also included a few exceptions to the 90-day rule.

A bill (H.R. 1544) introduced in the House in March 2015 and sponsored by Ways and Means Committee member Rep. Jim McDermott (D-Wash.) includes language similar to the 2017 administration proposal for limiting the GST tax exemption in perpetual dynasty trusts.

Another bill (H.R. 2907) sponsored by Rep. Jan Schakowsky (D-Ill.) and introduced in June 2015 went a step further to suggest eliminating the GST tax exemption for certain trusts, such as ones where the date of termination exceeds 50 years after the trust's creation. In June 2015, Sen. Bernard Sanders (I-Vt.) introduced similar legislation (S. 1677) in the Senate.

Conversely, most Republican legislation on estate and generation-skipping transfer taxes has sought to repeal the GST tax. A bill (H.R. 1105) sponsored by Ways and Means Committee Chairman Rep. Kevin Brady (R-Texas) called for repealing both the estate and GST taxes. The legislation was introduced and passed in the House. It was received in the Senate in April 2015 but hasn't been voted on.

The Joint Committee on Taxation estimated (JCX-74-15) that the bill would cost $269 billion from FY 2015 through FY 2025. The measure doesn’t include provisions to offset the forgone revenue.

Sen. John Thune (R-S.D.), a member of the Finance Committee, sponsored legislation (S. 860) introduced in the Senate in March 2015 that also sought to repeal the estate and GST taxes.

Use of Exemption ‘Not Surprising.'

A Republican tax aide said he isn't surprised by the use of the GST tax exemption in the type of scenario described.

“That was Congress's intent in terms of building in a layer of transfers that aren’t taxed in terms of beneficiaries,” he told Bloomberg BNA July 14.

If lawmakers wanted to make the GST tax more widely applicable, an easy way to do that would be to lower the exemption amount, he said.

The Democratic committee aide said the current exemption amount of $5.45 million is too high, which makes avoiding the GST tax easier.

“You have very, very, very wealthy individuals with highly appreciable assets able to put assets into a trust that are $1 million today—like stock—and not even come close to using the $5.45 million exemption they have,” he said. “Beneficiaries can benefit from the income that the trust generates, the corpus of the trust never gets drawn down and you have this sort of giant, appreciating trust that almost can never run out.”

The Republican tax aide said the GST tax is meant to act as a backstop to keep people from making an end run around estate and gift taxes, and it's up to policy makers to decide how high they want that backstop to be.

At the same time, he said, regardless of how policy makers change the tax or exemption, the estate planning world will react. “No matter what you do as a policy matter, decedents’ estate planners will respond and will change their strategies,” he said.

“It’s not like if you turn one dial, you automatically will get a certain amount of revenue or certain result; there’s a lot of planning that goes on,” he said.

Upcoming Election Matters

Both aides said the upcoming elections will have an impact on estate and related taxes, such as the GST tax.

The Ways and Means Committee aide said Democrats would need to win back the Senate and maintain the presidency for any limitations on the GST tax exemption to be passed.

“I don’t think any of this would get passed in a Republican House and Senate even with a Democratic administration,” he said, adding that he believes such a provision would be a “nonstarter” on the Republican side. GOP lawmakers would see a strengthening of the GST tax as an additional tax, which they have historically opposed, he said.

The Republican aide said that, while repealing the estate tax has been a popular issue among conservative leaders, “you don’t have a lot of people really focusing on the GSTT,” specifically.

That being said, Republicans would probably initially resist a a measure that strengthens it, he said. “It just depends on how the elections go and how the playing field looks” afterward.

It also depends on how the issue plays out in the campaign, the aide said.

People will really begin to focus on it if it becomes an area where there’s a lot of support or opposition, he said. “We don’t know that yet because it hasn’t attracted much attention.”

To contact the reporter on this story: Allyson Versprille in Washington at

To contact the editor responsible for this story: Cheryl Saenz at

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