Friday, October 21, 2011

Tax Theft 6

Succeeding Part 5.

Advanced trust schemes

Using tax trusts to double up the estate tax exemption amount is sufficient to eliminate estate tax liability when the holdings of a dead noble are under double the exemption amount. For example, if the exemption amount is $1 million per person, and Owner A and Wife B own $2 million of assets, they can use the credit shelter trust trick to shield the full $2 million from estate tax. The amount is artificially low now, and will likely jump much higher in the near future, or if kept low, be offset by different parts of the overall tax regime; however, even should the exemption amount be reduced, tricks are available to keep the aristocracy from paying its supposedly fair share of tax on amounts above that already-doubled sum.

Advanced trust schemes are actually quite simple, once you accept the legitimacy of various assumptions on which our society is based. One of these we have already learned to accept: the tax trust. For example, if a wealthy person says, "I have a trust," we all agree to be nice and pretend that there is an imaginary person called Mr. Trust who owns property and does other things. Accepting that various trusts can be independent entities is a vital part of our economy, without which tax theft could not continue: nobles need to be able to make up imaginary people who can do business with them in order to keep the wheels running. So, we all accept that if someone creates a business or a trust, that entity can own property, pay taxes, make income, take actions, make decisions, have interests, etc.

So: for advanced trust schemes to work, we must all accept that a person, Owner A, can create Trust A, and that Trust A is then its own separate entity, distinct from Owner A. Of course, Owner A can do just about anything he wants with property that "belongs to" Trust A. But by law, Trust A can be a separate entity from Owner A.

This is where the fun part comes in. Assume that Owner A has $12 million of assets, he is very old, and he expects he will die in a few years. He has a tax trust, Trust A, all set up so that he doesn't have to pay taxes on $12 million of those assets. This means that, unfortunately, he has $10 million of assets subject to tax (12 - 2 = 10), at a very high estate tax rate (say, 50%). That's a "tax liability" of $5 million; in other words, when he dies, he will owe the country $5 million.

To get out of having to pay this, he comes up with an idea. First, he creates Trust B. Then, he sells Trust B $10 million of his assets. Those assets might include an apartment building, a plot of land in a gated community that someone less worthy could otherwise build a house upon, a commercial building, ownership interests in other businesses, oil/gas rights, etc.)

The fair market value of these assets is $10 million, which is what would be included in Owner A's estate when he dies, and thus be subject to tax. However, Owner A is clever, and when he sells the property to Trust B, he writes the deals in a strange way.

Firstly, Trust B does not have any money to buy the assets--certainly not $10 million. In fact, Trust B was created with only $10.00 to start. So, Trust B gives Owner A a promissory note (an IOU) instead of cash.

Then, instead of Trust B having to pay a market rate of interest (which is the rate of interest anyone else would charge Trust B for borrowing $10 million--a theoretical rate, since no one except Owner A would loan the utterly broke Trust B anything), Trust B pays the lowest possible federal rate. This is generally kept several points of interest lower than the market rate by the Powers That Be.

For example, let's say the market rate is 7%. This means that if you borrow $1 million for one year, you will have to pay back $1,070,000, for total interest paid of $70,000.

So, if you borrowed money from someone at less than the market rate (say, 5%), and then reinvested it, you could turn a profit: for example, if you borrowed $1 million at 5%, you would be expected to pay back $1,070,000, for total interest paid of $50,000, at the end of the year. Thus, if you were clever, you could borrow $1 million at 5%, invest it at 7%, and receive $1 million, $70,000 on your investment. Then, you would pay back your original loan for $1 million, $50,000, and have a $20,000 profit.

For this reason, if the market rate is 7% (or near 7%), no one would loan you money for 5%. Why would they? That would just cost them the 2% difference; i.e., if they loaned you $1 million at 5%, they would be losing $20,000 that year. The only reason someone would do that is if 1) they were gambling that the rate would go down lower than 5% during the year, so that they would be making money on your loan by locking you into that rate, or 2) it wasn't really a loan, but a gift of the amount of difference in interest.

The IRS, though, is very nice to the wealthy. It establishes the federal rate, which is the rate you can make loans at without them being considered gifts (and being subject to gift/estate taxation). The federal rate is kept very low compared to the market rate--in good economic times, it hovers around 3%, and may drop drastically close to zero during bad economic times.

So, clever people can transfer wealth without having to pay gift or estate tax by using sham loans at the federal rate. As this one expressed before, no one actually gives loans to someone at such a low rate, unless it is a gift--the purpose of the lower federal rate is to allow clever people to structure gift transactions as "loans" so that they can transfer wealth between generations of a dynasty without that wealth having to pass through the estate or gift tax process.

But, returning to the main subject of advanced trust schemes: Owner A has just sold his trust, Trust B, $10 million of assets. And, he has made the sale at the federal rate, rather than at the market rate. This means that his imaginary friend, Trust B, is getting a huge deal--$10 million of assets that he can invest at market rate, which he only had to pay federal rate to acquire.

This isn't small potatoes: if market rate is 7% and the rate of the loan Trust B took out to buy the assets (federal rate) is 3%, Trust B can invest the $10 million, make $700,000 in the first year (7% of $10 million), pay $300,000 interest on the "loan" to Owner A (3% of $10 million), and have a $400,000 tax free gift in the trust.

This gift of the extra money the trust made will ultimately go to the trust's beneficiaries, i.e., the same people who would have inherited that money directly from Owner A if he had died without making up Trust B first. That money would otherwise have been in Owner A's estate, and subject to estate tax. This fake "sale," where Owner A pretends he is selling his assets to an imaginary person named Trust B, is one of the tricks used to get Owner A out of paying taxes based on what he is actually worth.

A nice savings. If Owner A had invested the $10 million himself (rather than having his imaginary friend Trust B invest it), he would have had the $400,000 of income in his estate when he died at the end of the year. That $400,000 would have been taxed at the high estate tax rate (say, 50%), so by making up that imaginary person (Trust B), he just avoided $200,000 of tax. If he lives for another year, and the trust makes another $400,000, there's another $200,000 of savings. If he creates the trust 5 years before he dies--well, the "savings" just goes up.

The savings on Trust B's earnings, though, is just one way to get out of taxes using the "selling assets to your imaginary friend" trick. An even better part of the trick, which Owner A has already used, is that the debt Trust B gave him in order to purchase his $10 million of assets is nowhere near $10 million, even though that's what the IOU says it is.

How does that work? Well, think about it from Owner A's perspective. He sold assets to Trust B so that they would not be "his" anymore, and therefore subject to that nasty estate tax. However, doesn't it seem like if he sells $10 million of assets in exchange for a $10 million debt (Trust B's promise to repay him for the assets), his estate did not actually get any smaller? For example, reasonably speaking, if Owner A sells Trust B $10 million of assets in exchange for a $10 million debt with interest, and then Owner A dies, that debt--that IOU--is worth $10 million, right?

Wrong--and therein lies the best part of the "selling assets to your imaginary friend" plot. For a number of reasons, the IRS allows Owner A to pretend that his IOU of $10 million is worth less than $10 million.

One reason might be that the interest rate is so low. But wait--I thought, if Trust B promised to pay the federal rate, then the transaction was completely acceptable and legitimate. Well, it was--except that, once it has been deemed legitimate, Owner A can say that the IOU is worth less than $10 million, because it is not paying a market rate of interest. Owner A's argument is, "This debt is not even paying me market rate! So, I am losing money on it, because if I had invested my $10 million of assets elsewhere, they could be making a higher profit than federal rate!"

Luckily for Owner A, he is allowed to have his cake and eat it, too. So, because the IOU is at lower than market rate, he can value it at, say, $9.5 million instead of $10 million.

Thus, $500,000 more of assets are exempted from estate tax because they are owned by an imaginary friend who gave him an IOU worth less than the assets. This is considered intelligent American tax planning.

But we're not done yet. There's another problem with the IOU that Owner A has. Can you guess? That's right: it's an unsecured loan. Unlike your typical home mortgage, which is secured by an interest in the house in question until the buyer pays the bank off, the IOU that Trust B gave Owner A is not secured by an interest in any of the assets that Owner A sold Trust B. So, clearly, Owner A's IOU is not even worth $9.5 million. As Owner A would say, "No one else would buy this risky IOU for $9.5 million--not without security!" So, he is allowed to value it at, say, $8.5 million instead.

Another $1 million saved from estate tax. But wait--you guessed it. There is still another problem with the IOU that Trust B gave Owner A. It has limitations on transfer. As part of the IOU agreement, Owner A agreed to limitations on how he could trade the IOU for someone else's IOU. For example, the IOU contract might say, "This debt is non-transferable on the third, seventh, and nineteenth days of any month" (or some other similar nonsense).

Because of this "transferability problem," Owner A could argue that, on the free market, he couldn't get $8.5 million for his IOU, because potential buyers would be put off by the limitation on what days of the month the IOU could be transferred at. So, Owner A gets to value the IOU even less. Let's say down to $8.3 million.

And so on. In the end, Owner A will actually end up paying some tax, but he will avoid hundreds of thousands of dollars (or millions and millions, depending on how many assets are "sold" to how many "trusts") of his fair share. He might sell the IOU to someone else in exchange for a different IOU to another wealthy person's trust, or he might sell it for other business interests, and in doing so, cause it to be "worth" even less.

Now, in a sane world, someone might point out that the whole reason there are so many "problems" with the IOU is because Owner A doesn't really have an IOU from his imaginary friend; rather, he is just playing pretend with his assets so that he can act like they are worth less, and skip out on his tax. But in America, that viewpoint holds no water.

Trust B, as just described above, is the Intentionally Defective Grantor Trust, or IDGT ("I dig it"), which is one of the most commonly-used tools for reducing estate tax for nobles with estates larger than the doubled exemption amount.

Followed up in Part 7.

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