GENERATION SKIPPING TRUSTS
Karen Sinchak Higby
The federal generation-skipping transfer (“GST”) tax is primarily designed to prevent the tax-free transfer of wealth from a grandparent to his grandchild or great-grandchild. Prior to the advent of the GST tax, families could avoid the death tax that is imposed upon each generation by skipping a generation or two on at least a portion of the wealth. In other words, grandparents would leave some assets to the children and some to the grandchildren and, perhaps, some to the great-grandchildren. Death taxes were imposed on the grandparents’ estate before it was divided up among the heirs. Later, when the children passed away, the inherited assets remaining in their estates were taxed again before they reached the grandchildren. The assets which the grandparents left directly to the grandchildren, however, were not taxed again at the children’s deaths, because they were never owned by the children. Thus, a family could bypass death taxes at least once or twice as the family wealth moved down the bloodline.
The GST tax, originally enacted in 1976 and subsequently superceded by the current law enacted in 1986, represents Congress’ effort to stop these generation-skipping tax-free transfers. Instead, the current tax laws impose a tax at each generation regardless of whether the assets have actually been used or enjoyed by each generation. If Grandma and Grandpa leave assets to a grandchild, the government first taxes the assets as a part of the Grandparents’ estate and then re-taxes those same assets as a part of the child’s estate – as if the child had received the inheritance, then died, and passed it on to the grandchild. The two taxes together could equal more than 50% of the assets, so that less than half goes to the grandchild.
The 1986 GST tax law currently allows each person an exemption from the GST tax equal to whatever death tax exemption is then in place ($5,340,000 in 2014). This means that the first $5.34 million of wealth can move from one generation to another, for a very long period of time, without the imposition of a death tax at each generation. For a married couple, the amount is doubled ($10.68 million). While this exemption represents a slight “drop in the bucket” for large estates, it is adequate to completely shelter many estates from inter-generational transfer taxes.
The GST tax exemptions do not result in any tax savings for the estate of the first generation – the grandparents’ estate. Under current law, grandparents can together pass $10.68 million tax-free to their heirs – $5.34 million from each of them. Any assets in excess of the exempt amount will be taxed; the tax rate is a flat 40%.
Many individuals, including professional advisors, think of skipping a generation when they think of generation-skipping. To them, this is a way to bypass one’s children in order to save taxes. That limited view of the GST tax laws misses its most important feature – the ability to leave wealth to the first generation (a child) who can in turn pass it on to future generations (grandchildren and/or great grandchildren, and so-on) without taxation. Here’s a brief example of how valuable a GST exemption can be to an heir:
1. Husband and wife (the parents) have a $2,900,000 community estate. Husband dies and passes the estate to wife (tax free).
2. Wife dies later; the estate is valued at $4,600,000 at the time of her death. The entire estate passes to son tax-free.
3. By the time son dies, his inheritance has grown and is now worth $5,300,000; son’s own assets are worth $400,000, totaling $5,700,000.
4. At son’s death, his assets ($400,000) will pass to his children tax-free, through the use of his regular estate tax credit. His inheritance from his parents ($5,300,000) is also tax-free because it remains “sheltered” within the GST trust created by them. In Arizona this trust can remain sheltered for an extended period of time (500 years). Even when the inheritance is relatively small (say, $100,000 to $200,000), the ability to protect these assets is still valuable.
A second but important benefit of the generation-skipping trust is the creditor-protection it affords to the heirs. Consider these points:
• If a child goes through a divorce, his spouse will likely have no claim to any of the inherited property;
• If a child suffers financial difficulty, even goes through a personal bankruptcy, he will likely not lose the inherited property.
An important question in designing a GST trust is: Just how much “control” can son have over his inheritance and still keep the inheritance from becoming part of his own taxable estate? Most parents want their children to enjoy the use of the inherited property; they aren’t interested in saving taxes for the grandchildren if it means cutting out son’s control and use of the inherited funds. The balancing of “control” to the heir with the correct trust provisions to secure long-term benefits to the heir is an important element of trust design.
The following is a description of a sample generation skipping trust:
• It allows the heir to be trustee of his own trust (assuming he has reached the age of “financial maturity,” whatever that age may be).
• It gives him the right to spend the income and spend principal for his health care, maintenance, support and education, as he determines appropriate.
• It gives him the right to disburse funds to others in any amount during his lifetime (the “inter vivos power of appointment”); this power can be broadly defined (i.e., it may be exercised in favor of anyone other than the heir and his creditors) or it can be more narrowly defined (i.e., it may be exercised in favor of family members only).
• He may select his heirs at death (the “testamentary power of appointment”); the same considerations exist here as with the inter vivos power.
These powers and discretions given to the heir have been selected based upon a careful balance between giving control to the heir (so he or she can enjoy the inheritance to its fullest extent) and maintaining the long-term benefits of the trust. The goal is to vest the management and spending decisions affecting the heir’s property at the time (or times) selected by the original estate owner and, at the same time, give the heir the best possible protection of his inheritance for the remainder of his lifetime. The generation-skipping rules permit the heir to transfer the same benefits to his heirs, in most cases.
The use of the GST tax exemption and its rewards to the family are enormous and can justify the degree of complexity, even in rather modest estates.