GRATS: Loophole or Blackhole?


Respectfully submitted by Lawrence E. Rafferty (rafflaw)-Guest Blogger

We have all heard the political arguments for and against an Estate Tax, or as some have called it, a Death Tax.  Over the years while I attended several Continuing Legal Education seminars and Trust School presentations, I have often learned about the estate and gift tax avoidance strategy called a Grantor Retained Annuity Trust, or GRAT.  Since these estate reduction strategies are best used with very large estates, I have rarely had the opportunity to recommend it to any of my clients or trust customers. Recently, I read an article that provided some documentation just how prominent and popular the GRATS are with the super wealthy.

Just what is a GRAT and why should any of us be concerned with its use?  In my opinion, it is important to understand that when the über wealthy complain about any tweaking of the estate tax, most of them pay little or no estate or gift taxes due to the use of techniques like the GRAT.  Just how does a GRAT work?

Simply put, the donor transfers money or stock into a trust and if the assets increase in value, any increase in the stocks beyond the principal and the minimum interest rate that must be paid back to the donor, goes directly to the beneficiaries tax-free.  When you are talking assets worth millions and in some cases, billions, huge sums of money can escape the estate and gift tax process entirely. 

To make sure you fully understand how a GRAT works in the real world, please take a look at the linked Bloomberg article which includes a couple of graphs that are easy to understand.

Just how could this process be legal?  The IRS didn’t think it was legal when a Walton family member used it and sued the IRS when they disallowed the trust.  The Walton family member was successful in court and the GRAT was officially validated.

“Three years after the new law took effect, Covey created a pair of $100 million zeroed-out GRATs for Audrey Walton, the former wife of the brother of Wal-Mart Stores Inc. founder Sam Walton. The IRS, which had banned such GRATs through regulation, demanded taxes and took her to court.

In 2000, the U.S. Tax Court found in Walton’s favor, determining the 1990 law didn’t prohibit a “zeroed-out” GRAT. Covey had won a rare prize: an official seal of approval for a tax shelter.” Bloomberg

Needless to say, when the news got out that there was a court sanctioned process to allow the wealthy to avoid millions in estate and gift taxes, the use of the GRAT spread quickly.  In fact, the attorney who first devised the GRAT, Richard Covey, claims that the use of the GRAT technique has cost the United States government billions.  “These tax shelters may have cost the federal government more than $100 billion since 2000, says Richard Covey, the lawyer who pioneered the maneuver. That’s equivalent to about one-third of all estate and gift taxes the U.S. has collected since then.” Bloomberg

This same estate planning pioneer thinks that the use of the GRAT is harming the tax system.  “The popularity of the shelter, known as the Walton grantor retained annuity trust, or GRAT, shows how easy it is for the wealthy to bypass estate and gift taxes. Even Covey says the practice, which involves rapidly churning assets into and out of trusts, makes 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 says with a shrug.” Bloomberg

It is arguable that the use of the GRAT is an example of great lawyering that actually works too well.  At least when it comes to the country losing out on $100 Billion in estate and gift taxes in a very short period of time.  You might be thinking that if the GRAT is being used to avoid paying into the taxing system, why hasn’t Congress or President Obama done anything to stop it or curtail it?

The answer to that question is found in the current state of our politics.  Both Republicans and Democrats alike rely on wealthy donors to get reelected and those politicians aren’t likely to bite the hand that feeds them.  Some may consider the use of the GRAT a “loophole”, but with the bite its use has taken out of the tax coffers, I consider it a black hole of tax avoidance.

Since the GRAT is legal, Congress will have to act before the Billions in taxes that are being lost to the black hole can be stopped.  When money is the king when it comes to politics these days, I do not see any Congress member or Presidential administration that both need immense sums of money to be elected and stay elected, taking any substantive steps to curb this procedure.

Do you think the GRAT should be repealed or curbed?  When millions and billions are being cut from programs that benefit the vast majority of this country, it is my opinion that the idea of over $100 billion escaping the tax coffers, just since 2000 is an abomination.  Especially when these tax avoidance strategies can’t be used by 98 or 99 percent of the population.  Let me know if you agree and why you agree or disagree.

Additional Sources:  BB&T;

27 thoughts on “GRATS: Loophole or Blackhole?”

  1. It seems there are two schools of thought here, each having opposite goals

    The first aspect is that assets are the property of the individual and not the government’s and that people have a right to keep their assets within their own family and to dispose of their property as they choose.

    The other is that the wealth generated in mulitgenerational inheritance tends to grow in such a way that dynasties are created where unfair political and social advantages tend to be contained within a priviledged few and to level the equality in society the estate should be reduced upon death.

    Both have costs and benefits and are a matter of perspective if they are right or not.

    The political reality of what is happening in the United States might dictate whether or not either side, or a combination is better. The present real world is that the extremely wealthy in the US are becoming increasingly dominant in the political process and accordinly the lives of most citizens. Another is that the federal politicians have a proven tendency to spend on a factor of excess over current tax revenues. Some believe denying the federal government tax revenue is one way to curb empire building and excessive pork barrel spending. Another is that inheritences can benefit children of parents whereupon they can flourish, but the tradeoff of this is the stereotype of a trust child with little ambition but to live the high life with little contribution to society.

    On balance what should be recognized here is currently the estate tax is levied on inheritences in excess of five million and is adjusted upwards annually so it is not like the current implementation of the Alternative Minimum Tax that is fixed and with inflation is increasingly decending to the level where once intended to affect only the über rich it now does for middle income levels. Spouses are generally allowed unlimited inheritences. Most average middle class families do not have estates above five million dollars, yet the lower upper class will be affected by this more than the über-class because those worth a tenth of a billion dollars can easily get by on ten or less percent of that and still maintain a luxurious lifestyle.

    Yet we should also look at the legislative intent of the original law. Perhaps it should be revisited. Though I have to firmly agree this is going to be a tough sell especially when bribes, I mean, campaign contributions are dictated by those with the most gold.

  2. Years ago, I read a science fiction story about a fellow who was invited by aliens to visit their spacecraft and their planet. The story had a number of interesting twists, but the man was told by his hosts they did not pay taxes on anything they earned. They got to keep it all. However, upon death, all their assets went to the government. The aliens explained they believed everyone should make their own way in life. Inherited wealth gave the fortunate few an unfair advantage over those not fortunate enough to be born into wealth.

  3. Nick you sound like a true commie. Why should the state get a persons wealth when they die. All the rich will do is move all their wealth off shore like the Kennedys do to avoid inheritance taxes

  4. Bron,

    As you might expect, I don’t actually support wealth taxes. There’s no upside or fairness to providing our monstrous government another avenue for sustenance, as Spinelli implies.

    That said, it’s curious to me that within the United States the focus is generally on income taxes and not on taxation of assets. Excise or other property taxes are the only common exception to that, and those are minor and regressive in comparison to taxing something like stock or bond holdings for the wealthiest among us. Even in Rafflaw’s reply above “… only very high income estates benefit from this tax planning device…” a false assumption that income implies wealth (and presumably merits taxation) underlies his reply.

    DavidM is correct. Government has no higher right to take your assets when you are dead than when you are alive. It is the ultimate form of redistributionist tax, penalizing only your heirs and having no benefit to you.

  5. I think we should be able to leave our children gifts without them having to be taxed on it. The laws should allow middle income people to do all these things that the wealthy do to avoid taxes. Avoiding taxes is a good thing.

  6. Estate taxes should not be, especially on money on which taxes have already been. But the idea that big money gets bigger breaks than small or medium money is especially abhorent.

  7. Elaine,
    Thanks for the definition link. As mentioned in the article and in the comments, this technique has no utility for small or middle income estates. Only very high income estates benefit from this tax planning device.

  8. I believe that when you die your entire estate should go to your heirs and people you give to, not one cent in tribute to the government of these united states. If we need money to pay of Karzai so he can buy a new cape to wear in Afghanistan instead of an afghan then tax the income or tax the sales of wool. If you are worried about government spending of your tax dimes then tell Obama to pull out now like his father should have.

  9. More economic injustice, please! Corporations to avoid paying billions in taxes by offshoring profits, wealthy avoid paying taxes with capital gains and other congressional supplied goodies, so I guess they deserve to avoid paying the estate tax as well. Those poor souls….But back to reality.

    Funny, some readers apparently think that the middle class is affected by estate taxes: : Everybody dies, but only the richest 0.14 percent of estates pay any estate tax — fewer than 2 out of every 1,000 people who die — owe any estate tax whatsoever because of the high exemption amount, which has more than quadrupled since 2001.

    Estate taxes are due only on the portion of an estate’s value that exceeds the exemption level; at the current exemption level of $5.25 million,a $6 million estate would owe estate taxes on $750,000 at most. Second,heirs can often shield a large portion of an estate’s remaining value from taxation through various deductions.

    Only 20 small business and farm estates nationwide will owe any estate tax in 2013.

    The estate tax is the most progressive component of a tax code that overall is only modestly progressive, particularly when regressive state and local taxes are taken into account.

  10. I think all money and assets should be distributed to Federal, State and local governments upon the death of all US citizens.

  11. puzzling:

    1.5% of tax revenue? Why bother? Did you see the exclusions? The super wealthy win again with those.

    When the socialists say “screw the rich”, they neglect to tell people that rich is defined as having more than $500.00 in the bank or in assets.

  12. Estate Tax

    The Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death (Refer to Form 706 (PDF)). The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your “Gross Estate.” The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets.

    Once you have accounted for the Gross Estate, certain deductions (and in special circumstances, reductions to value) are allowed in arriving at your “Taxable Estate.” These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses and qualified charities. The value of some operating business interests or farms may be reduced for estates that qualify.

    After the net amount is computed, the value of lifetime taxable gifts (beginning with gifts made in 1977) is added to this number and the tax is computed. The tax is then reduced by the available unified credit.

    Most relatively simple estates (cash, publicly traded securities, small amounts of other easily valued assets, and no special deductions or elections, or jointly held property) do not require the filing of an estate tax return. A filing is required for estates with combined gross assets and prior taxable gifts exceeding $1,500,000 in 2004 – 2005; $2,000,000 in 2006 – 2008; $3,500,000 for decedents dying in 2009; and $5,000,000 or more for decedent’s dying in 2010 and 2011 (note: there are special rules for decedents dying in 2010); $5,120,000 in 2012 and $5,250,000 in 2013.

  13. I doubt that this will work for the middle class with much smaller estates. I am not in favor of estate taxes generally. I paid my taxes on those assets and I should be able to pass them on to whomever I want to tax free both federal and state. Unfortunately, the middle class get hosed on this again because tax avoidance tools are complex and expensive and most likely out of their reach. Again, I pay the taxes the rich never pay and they are the examples used to keep this tax going. Unfair, I’ll say. Paying for the sins of others without enjoying the sin.

  14. Maybe I’d rather have heirs getting those billions than having it go to more Defense (Offense) spending, the darkest of all money holes.

  15. rafflaw:

    Thanks for the heads up, does this work with smaller estates as well? The middle class should jump on this and quickly.

    Thanks much, my kids thank you as well if this will work for small estates.

    The better thing to do is eliminate estate taxes.

    100 billion over 20 years is 5 billion a year which is chump change to the profligate spenders in DC. As far as I am concerned that is 100 billion used by the private sector to some productive end.

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