The wealthiest Americans have avoided paying about $100 billion in taxes through a loophole that essentially makes estate taxes voluntary, according to the attorney who devised the legal maneuver.
Under current law, the wealthy must pay taxes on estates valued at more than $5.25 million for an individual or $10.5 million for couples, with the top rate capped at 40 percent.
But many billionaires get around these taxes by shuffling their company’s stock in and out of trusts, which allows them to give away millions of dollars to their heirs while avoiding taxes on gifts valued at more than $14,000.
For example, the casino magnate Sheldon Adelson has given at least $7.9 billion to his heirs and avoided about $2.8 billion in gift taxes since 2010, according to filings with the U.S. Securities and Exchange Commission.
Hundreds of executives have used the same strategy, and Richard Covey, the attorney who pioneered the technique, said it has cost the federal government about one third of all estate and gift taxes collected since 2000.
According to the Tax Policy Center, only about 3,780 households — about 0.14 percent of all estates — will owe any estate taxes this year, averaging about $3.8 million on estates worth $22.7 million, which is an effective rate of 16.6 percent.
Congress created the loophole to stop another scheme developed in 1984 by Covey, an attorney at Carter Ledyard & Milburn LLP in New York, called a grantor retained income trust, or GRIT.
Covey had figured out how to make large gifts appear small by having fathers, for example, create trusts for their children with instructions that the trust must pay back income to the father – and the value of that potential income would be subtracted by the father’s gift tax obligation.
The trusts usually invested in growth stocks that paid low dividends so most of the returns still ended up going to the heirs, but Congress passed legislation in 1990 to stop what was determined to be an abusive practice.
The new legislation replaced the GRIT with the GRAT – or grantor retained annuity trust – which was intended to allow parents to keep stakes in gifts to their children while outlawing the abuse Covey had devised.
But the attorney said the new law created an even larger loophole.
Covey saw that his clients could avoid gift taxes if they put money into a trust with instructions to return the entire amount to themselves within two years, because they wouldn’t have to pay taxes on gifts to themselves.
If the trust’s investments earn enough, the extra money goes to the heirs tax-free. If they don’t make much, the only costs are lawyer’s fees of about $5,000 to $10,000, Covey said.
Three years after the new law went into effect, Covey created a pair of $100 million GRATs for Audrey Walton, the former wife of Wal-Mart founder Sam Walton’s brother.
The IRS, which had banned such trusts through regulation, demanded taxes from Walton and took her to U.S. Tax Court, which found in Walton’s favor.
Since then, other lawyers have refined the technique to generate even more savings for their clients.
Former Aetna CEO John W. Rowe, for example, puts corporate stock options into a GRAT, while Goldman Sachs banker Stacy Eastland recommends a husband funding GRATs with the proceeds from an options bet with his wife.
President Barack Obama has included proposals to shrink the GRAT loophole in each of his budget plans, but he hasn’t pressed Congress to do anything about it, and congressional committees working to overhaul the tax system haven’t addressed estate or gift taxes.
Covey said wealthy donors to each party want to keep the loophole large enough to funnel their wealth through to their heirs.
But Covey, now 84, admits the technique he pioneered has made a mockery of the tax code.
“You can certainly say we can’t let this keep going if we’re going to have a sound system,” he said with a shrug.
[Image: A protester demonstrates on Oct. 18, 2011 against New York Gov. Andrew Cuomo's resistance to raising taxes on wealthy Americans by Flickr user bogieharmond]
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