Co-written by: Doria Aronson
Eventually every estate planning attorney encounters clients who desire to either bypass their children and pass their wealth directly to their grandchildren, great grandchildren, etc., or set up their estate plan to first provide for their children, and second for their grandchildren or subsequent generations upon their children’s deaths. There are numerous reasons for such estate plans, including minimizing the Federal Estate Tax (“FET”) exposure on the estates of the client’s descendents, asset protection for beneficiaries and perpetuating family values. These are the cases when an estate planner needs to understand the generation skipping transfer (“GST”) tax, the GST tax exemption and be able to develop an estate plan that maximizes a client’s ability to pass wealth to “skip” persons, while minimizing the GST tax.
One of the major advantages of general skipping transfers is to avoid unnecessary estate taxes imposed on a client’s descendents. Under The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Tax Relief Act”) the estate tax exclusion amount (“exemption”) is $5,000,000. For example, if an unmarried person passes away with a gross estate of $5,000,000 and leaves the entire amount to a child, there is no estate tax. However, when that child subsequently passes away, then that child’s inherited wealth plus his own assets (e.g. $1,000,000.) are subject to estate tax. Under this example, the child’s estate tax is ($1,000,000. multiplied by 35%) $350,000. This estate tax could have been avoided if the parent had left the child’s inheritance in trust for his or her lifetime with the remaining trust estate passing to grandchildren.
There are three different types of taxable transfers (direct skips, taxable terminations and taxable distributions) that trigger the GST tax. If a GST tax is imposed, the assets are taxed at the then highest FET rate (currently 35%). For lifetime transfers that are exempt from gift tax by virtue of the annual exclusion they are also exempt from the GST tax. IRC § 2642(c)(1).
The first and simplest taxable transfer is a direct skip. This results from a transfer directly to a skip person. A “skip person” is a person who is more than one generation removed from the transferor. IRC § § 2612(c), 2612. If the transferee is unrelated to the transferor, then the transfer is considered a GST if the transferee is more than 37 ½ years younger than the transferor. IRC § 2651(d). When a transferor transfers assets to a grandchild, great grandchild, etc…, this is a GST, because the transferor “skips” his or her child and transfers the assets directly to the next generation. For example, a grandparent gives grandchild $5,000,000. There is an exception to these rules where one generation has passed away and the next generation “steps up” for the purpose of calculating the number of generations (e.g. if a child has predeceased his parents, then his children are viewed as only one generation below his parents). IRC § 2651(e)(1).
The other two types of taxable transfers are taxable terminations and taxable distributions.
A taxable termination is a termination of an interest in property held in trust unless 1) immediately thereafter a non-skip person has an interest in the property; or 2) no distributions may be made at any time thereafter to a skip person. IRC § 2612(a)(1). For example, a parent’s trust pays income to the son for life and at the son’s death the principal is to be distributed to grandchild. At the son’s death a taxable termination has occurred. There is not a taxable termination if income is paid to the son for life, then income and/or principal is paid to the daughter for life, since each beneficiary is only one generation removed from the transferor.
A taxable distribution is a distribution from a trust to a skip person that is not a direct skip or a taxable termination. IRC § 2612(b). For example, a parent’s trust makes discretionary distributions to grandchild prior to the trust’s final termination. When such distribution is made a taxable distribution has occurred.
In a well drafted estate plan, a parent can allocate his GST tax exemption to his trust that will bypass estate tax when a child dies while providing a benefit to grandchildren at the child’s death. The trust can benefit a child for that child’s life, with certain limitations, but avoid inclusion in that child’s gross estate at that child’s death. In this situation, a parent would want to allocate his GST tax exemption to this Trust to avoid GST tax. All subsequent appreciation on this GST is also exempt. It is important to note that the GST tax exemption is automatically allocated to direct skips first, so the client must opt out of this automatic allocation if the client chooses to allocate their GST exemption to a transfer in trust. Opting out of this automatic allocation is done on the client’s gift tax return (Form 709) or estate tax return (Form 706).
The Tax Relief Act of 2010 increased the GST tax exemption to $5,000,000 for 2011 and 2012. (It should be noted that unused GST tax exemption is not portable.) Therefore, wealthier clients should consider GSTs during 2011 and 2012 to take full advantage of the increased GST tax exemption amount. This can be accomplished through direct gifts to skip persons, or through the creation of irrevocable trusts in to which contributions can be made and the GST tax exemption can be allocated. Future taxable terminations and taxable distributions can then avoid GST tax.