Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

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adherenceEnergy
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Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by adherenceEnergy »

Brief over of GRAT: https://www.journalofaccountancy.com/is ... rusts.html

I'm looking into GRATs, which is apparently what a lot of ultra wealthy people used, including the Walmart people, and I'm not sure I'm understanding the mechanics of exactly what is happening. I know if they structure it properly, they can effectively the avoid estate taxes of 40%. However, if I'm understanding this properly, don't they just pay substantial (albeit probably slightly less) amounts in income tax from annuity income?

For example, if you look at table 4, which is a zero-ed out GRAT, and assume the numbers are all taxed at top rates, as they would be for the ultra wealthy, you can see that they avoid paying 40% of 5M which represents an estate tax savings of 2M, correct (or in Walton's case, estate tax was 55%)? However, if the ultra wealthy got 10 years of 598K payments, won't they pay 37% on that, which is 5.98M of annuity income * 37% = 2.21m? I can see why it's advantageous for a variety of reasons, but it's not like they end up paying no tax, they just avoid specifically the estate tax, am I correct?
senex
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by senex »

Income tax is only due on the growth portion of the GRAT return. The return of capital is not taxable.

If you put in 5M, and take out 5.98M, you owe income tax on 0.98M.
Iorek
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by Iorek »

Usually they are skirting taxes— often legally but often illegally.
surfstar
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by surfstar »

conGRATulations on being "ultra wealthy" ?
mgensler
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by mgensler »

The GRAT gets a step-up in basis on shares of a company that are put into it. If you own a privately held company, you would place say 10% of the shares into the GRAT after a valuation is done. Once the company is sold then the GRAT shares are exchanged for 10% of the sales proceeds. You can then invest in publicly traded companies with the cash. All taxes on the sales proceeds in the GRAT are paid outside the GRAT account. Each year you take a distribution that is maybe 2 or 3% of the value of the GRAT. The distribution is not taxable but any dividends/capital gains in the GRAT are taxed and paid outside the GRAT account. After 10 years the GRAT account (which has hopefully grown in size) can then be distributed outside of the estate.
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adherenceEnergy
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by adherenceEnergy »

mgensler wrote: Mon Jan 04, 2021 1:15 pm The GRAT gets a step-up in basis on shares of a company that are put into it. If you own a privately held company, you would place say 10% of the shares into the GRAT after a valuation is done. Once the company is sold then the GRAT shares are exchanged for 10% of the sales proceeds. You can then invest in publicly traded companies with the cash. All taxes on the sales proceeds in the GRAT are paid outside the GRAT account. Each year you take a distribution that is maybe 2 or 3% of the value of the GRAT. The distribution is not taxable but any dividends/capital gains in the GRAT are taxed and paid outside the GRAT account. After 10 years the GRAT account (which has hopefully grown in size) can then be distributed outside of the estate.
My googling suggests you don't get step-up basis in a grat. So you're right that the distribution's are not taxable. However, it seems like you get to pass (some) of the appreciation tax free, doesn't this just work out similarly to just gifting the shares immediately? For example, using the original example, you passed on 2M of appreciation estate tax free, but now you still have 5.98M in assets that were distributed that would now apply to the estate tax if you died. Meaning the ultra wealthy would still owe a lot of tax. How is that significantly different tax-wise than if you just gifted the original 5M instead of the grat while you're still alive? Because if you gifted at the start of the grat, all the appreciation would avoid the estate tax as well. I'm just not really seeing the mechanics of how this actually works for a billionaire to avoid paying any tax.
mgensler
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by mgensler »

adherenceEnergy wrote: Mon Jan 04, 2021 1:57 pm
mgensler wrote: Mon Jan 04, 2021 1:15 pm The GRAT gets a step-up in basis on shares of a company that are put into it. If you own a privately held company, you would place say 10% of the shares into the GRAT after a valuation is done. Once the company is sold then the GRAT shares are exchanged for 10% of the sales proceeds. You can then invest in publicly traded companies with the cash. All taxes on the sales proceeds in the GRAT are paid outside the GRAT account. Each year you take a distribution that is maybe 2 or 3% of the value of the GRAT. The distribution is not taxable but any dividends/capital gains in the GRAT are taxed and paid outside the GRAT account. After 10 years the GRAT account (which has hopefully grown in size) can then be distributed outside of the estate.
My googling suggests you don't get step-up basis in a grat. So you're right that the distribution's are not taxable. However, it seems like you get to pass (some) of the appreciation tax free, doesn't this just work out similarly to just gifting the shares immediately? For example, using the original example, you passed on 2M of appreciation estate tax free, but now you still have 5.98M in assets that were distributed that would now apply to the estate tax if you died. Meaning the ultra wealthy would still owe a lot of tax. How is that significantly different tax-wise than if you just gifted the original 5M instead of the grat while you're still alive? Because if you gifted at the start of the grat, all the appreciation would avoid the estate tax as well. I'm just not really seeing the mechanics of how this actually works for a billionaire to avoid paying any tax.
My terminology might not be 100% correct and I think their example might not be the best since the amounts are below the current gift tax limitation. The GRAT works if you want to pass more than the lifetime gift limits. If you gift shares now, you lose control of those shares right away. (I'm not sure how that works if the person receiving them is a minor.) Might not be possible in a closely held company anyway.

The key is the low valuation when the shares are put into the GRAT. Say 10% of the privately held company is valued at $5M when it is put into the GRAT. Once it's in the GRAT, the company is then sold for $500M. The shares in the GRAT are now exchanged for $50M. Tax on the sale of the company shares is paid outside the GRAT. You then invest the $50M into index funds for 10 years. At the end of 10 years, the GRAT has grown to now $100M. The funds can then be rolled into a trust for the beneficiaries that you control. You can have that trust payout whenever you choose. Let's say it pays out in another 10 years. During that time the trust has grown to $200M. All of that can be distributed to the beneficiaries outside of your lifetime gift limitation.
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adherenceEnergy
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by adherenceEnergy »

mgensler wrote: Mon Jan 04, 2021 2:41 pm My terminology might not be 100% correct and I think their example might not be the best since the amounts are below the current gift tax limitation. The GRAT works if you want to pass more than the lifetime gift limits. If you gift shares now, you lose control of those shares right away. (I'm not sure how that works if the person receiving them is a minor.) Might not be possible in a closely held company anyway.

The key is the low valuation when the shares are put into the GRAT. Say 10% of the privately held company is valued at $5M when it is put into the GRAT. Once it's in the GRAT, the company is then sold for $500M. The shares in the GRAT are now exchanged for $50M. Tax on the sale of the company shares is paid outside the GRAT. You then invest the $50M into index funds for 10 years. At the end of 10 years, the GRAT has grown to now $100M. The funds can then be rolled into a trust for the beneficiaries that you control. You can have that trust payout whenever you choose. Let's say it pays out in another 10 years. During that time the trust has grown to $200M. All of that can be distributed to the beneficiaries outside of your lifetime gift limitation.
I follow that part of it. However, how is that significantly different than just gifting the $5M of the private company instead of using a grat, and then the kid just experiences all those gains and that 195M growth was also outside the lifetime gift limitation?
Last edited by adherenceEnergy on Mon Jan 04, 2021 3:13 pm, edited 1 time in total.
senex
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by senex »

adherenceEnergy wrote: Mon Jan 04, 2021 2:58 pm I follow that part of it. However, how is that significantly different than just gifting the $5M of the private company instead of using a grat, and then the kid just experiences all those gains?
A gift consumes your lifetime exclusion. A GRAT consumes none of it, because it is not a gift. It is a loan, that will be paid back with interest. You could structure the loan to your child directly; not sure if there are legal reasons it would be disallowed, or simply convention that rich people like to lock up money in trusts, because they're afraid the recipient will squander it or get sued/divorced.

If you set up short term rolling grats, and the market is volatile on the timescale of your grats, you are essentially keeping all losses in your estate, and moving all gains (including rebounds from losses) outside your estate, without consuming any lifetime estate/gift credit.
solar99999
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by solar99999 »

adherenceEnergy wrote: Mon Jan 04, 2021 12:35 pm Brief over of GRAT: https://www.journalofaccountancy.com/is ... rusts.html

I'm looking into GRATs, which is apparently what a lot of ultra wealthy people used, including the Walmart people, and I'm not sure I'm understanding the mechanics of exactly what is happening. I know if they structure it properly, they can effectively the avoid estate taxes of 40%. However, if I'm understanding this properly, don't they just pay substantial (albeit probably slightly less) amounts in income tax from annuity income?

For example, if you look at table 4, which is a zero-ed out GRAT, and assume the numbers are all taxed at top rates, as they would be for the ultra wealthy, you can see that they avoid paying 40% of 5M which represents an estate tax savings of 2M, correct (or in Walton's case, estate tax was 55%)? However, if the ultra wealthy got 10 years of 598K payments, won't they pay 37% on that, which is 5.98M of annuity income * 37% = 2.21m? I can see why it's advantageous for a variety of reasons, but it's not like they end up paying no tax, they just avoid specifically the estate tax, am I correct?
Anyone wishing to avoid the 40% estate tax due upon death on assets in excess of the estate and gift tax exemption should consider using GRATs.

The annuity payments are not taxable income to the grantor.

The GRAT's income, such as capital gains, interest, dividends, etc, are taxable income to the grantor as GRATs are disregarded as separate entities for the purposes of income taxes (federal and in most states).

Using Table 4 as an example, if the grantor transfers, let's say 5,000,000 shares of a non-dividend paying stock valued at $1 per share into the GRAT and the GRAT never sells any shares, the grantor does not incur any additional taxable income from the GRAT over the 10 year period.

Each year, the GRAT transfers shares worth $598,179 back to the grantor as a nontaxable transaction and at the end of year 10, the GRAT would distribute shares worth $2,129,068 to the beneficiary or beneficiaries.

Essentially, a zero-ed out GRAT is an estate planning technique to transfer capital appreciation tax free to a beneficiary with virtually no downside risk.

Should the underlying asset drop in value instead, the grantor would get all the shares back less than 10 years and the GRAT would dissolve. This is no different than had the grantor never created a GRAT in the first place.

Using GRATs comes with additional administrative burdens, such as gift tax filings, drafting up trust agreements, opening separate bank accounts, and annual valuations.
Last edited by solar99999 on Mon Jan 04, 2021 10:49 pm, edited 2 times in total.
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mgensler
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by mgensler »

adherenceEnergy wrote: Mon Jan 04, 2021 2:58 pm
mgensler wrote: Mon Jan 04, 2021 2:41 pm My terminology might not be 100% correct and I think their example might not be the best since the amounts are below the current gift tax limitation. The GRAT works if you want to pass more than the lifetime gift limits. If you gift shares now, you lose control of those shares right away. (I'm not sure how that works if the person receiving them is a minor.) Might not be possible in a closely held company anyway.

The key is the low valuation when the shares are put into the GRAT. Say 10% of the privately held company is valued at $5M when it is put into the GRAT. Once it's in the GRAT, the company is then sold for $500M. The shares in the GRAT are now exchanged for $50M. Tax on the sale of the company shares is paid outside the GRAT. You then invest the $50M into index funds for 10 years. At the end of 10 years, the GRAT has grown to now $100M. The funds can then be rolled into a trust for the beneficiaries that you control. You can have that trust payout whenever you choose. Let's say it pays out in another 10 years. During that time the trust has grown to $200M. All of that can be distributed to the beneficiaries outside of your lifetime gift limitation.
I follow that part of it. However, how is that significantly different than just gifting the $5M of the private company instead of using a grat, and then the kid just experiences all those gains and that 195M growth was also outside the lifetime gift limitation?
Assuming this is a privately held company, the person you gift the shares to would then own part of the company. If there are other owners, they might object to this. In a GRAT you still maintain control of the shares so in theory less objection from other owners.
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Re: Estate Tax question - do ultra wealthy really skirt death tax or just pay different taxes up front?

Post by bsteiner »

A GRAT shifts the income and growth in excess of the Section 7520 rate (presently 0.6%) out of your estate, free of estate and gift tax.

If you create enough GRATs, some of them will earn more than the Section 7520 rate.

So if you're willing to accept the cost and complexity, GRATs can be a good way to shift value out of your estate.
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