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WHAT IS THE GENERATION
SKIPPING TAX (GST)?
The current federal Generation Skipping Transfer Tax (GST Tax) came into existence with the Tax Reform Act of 1986 (The original 1976 version was repealed retroactively. Thank goodness it was an unbelievable mess.).
Basically, the federal estate tax is designed to impose a tax on the right to transfer assets at death, and the federal gift tax is designed to make sure the estate tax is not avoided through lifetime giving. Similarly, the federal GST Tax is designed to make sure that taxpayers do not avoid the estate and gift tax through the use of long-term trusts, and to ensure there will be a tax paid at each generation.
The primary target of the GST Tax is the typical generation skipping trust (sometimes called a GST Trust or Dynasty Trust), which provides distributions for the benefit of a child for life with the remainder continuing on for the grandchildren (or more remote descendants).
Under the current estate tax rules, the trust assets would not be taxed at the child's death because the child does not have sufficient powers over the trust to cause the assets to be included in the child's estate. In this context, the reference to generation skipping does not mean that the economic benefits of the trust "skip" the children, but simply that the estate transfer tax is "skipped" at the death of the children. The GST Tax was established to prevent this type of tax "skipping" (at least above certain limits).
In the case of the typical Generation Skipping Trust, the GST Tax would be imposed at the death of the child, when the assets continue for the grandchildren (but only if the assets of the trust are not otherwise subject to estate tax at the child's death). The GST Tax also applies to direct transfers to grandchildren that would otherwise avoid the GST Tax because no trust is involved.
As outlined in the Economic Growth and Tax Relief Reconciliation Act of 2001, a.k.a. “The 2010 Throw Mamma from the Train (if she's still alive) Act”; the Generation Skipping Transfer (GST) Tax is repealed as of the year 2010 but reapplies in its entirety as of 2011. Until 2010, the exemption amount will be the same as the estate tax exemption amount.
A GST can also apply in non-family situations and the GST due and payable if the
beneficiary of a gift or estate is 37.5 years younger than the donor or
Individuals also have a life-time exemption of $1,060,000 in 2001 ($2,120,00 for married couples). Beginning in 2002, the exemption amount drops to $1,000,000 and increases thereafter to match the estate tax exclusion amount in effect for that calendar year.
Gifts given outright that qualify for the $11,000 ($10,000 in 2001) Gift Tax exclusion are shielded from the GST as are education and medical expenses.
THE GENERATION SKIPPING TAX TRUST (GSTT) CAN
HELP PRESERVE LARGE ESTATES
Generation skipping through a trust is a powerful estate-planning strategy that can substantially reduce the taxes owed by your children, while enabling them to maintain considerable control over the assets that are "skipping" them.
Skipping is accomplished by setting up the generation skipping tax trust (GSTT) that allows up to $1,030,000 to be sheltered. The trust owns the assets until your children die, at which point those assets can pass to your grandchildren directly or continue to be held in trust for them. Your children never legally own the assets in the trust and therefore pay no estate tax on them.
Generation skipping is a strategy that applies mainly to couples whose estates are large enough to be pushing the limits of the unified gift and estate tax credit, according to Wil Heupel, principal of Accredited Investors, a financial advisory firm based in Minneapolis. Currently, this credit is $1 million per person and eventually to $3.5 million in 2009, while gradually dropping the top tax rate to 45%. Full estate tax repeal is scheduled to occur in 2010. A sunset provision, however, reinstates the tax in 2011 at the 2001 rate of $675,000 per person and $1,030,000 for a married couple.
Says Heupel: "If a couple's estate is large enough that there's no room for the children to accumulate assets of their own without incurring estate tax when the children die, it's time for Mom and Dad to think about a GSTT." Alternatively, Heupel observes, a GSTT is called for in many cases where the parents' estates are well within the unified credit limits but their children are very successful.
A Generation Skipping Tax Trust reduces estate taxes only for the middle generation-it does not lower that burden at all for the first generation. A family's financial plan – including funding a GSTT – should therefore allow for the first generation's estate tax liability.
Although most people avail themselves of their GSTT exemption at death, Heupel recommends considering funding your GSTT well before you die. The reason? The allowed limits apply to the value of assets at the time they are placed in the trust. GSTTs are therefore excellent choices for assets that might appreciate substantially.
For example, suppose 60-year-old Alice funds her GSTT with a $500,000 stock portfolio that grows in value to $2,500,000 over the next 20 years. When Alice turns 80, she has used up only $490,000 of her $1,030,000 GSTT limit ($500,000 minus $10,000 that can be gifted tax-free in any one year), according to the IRS. Any growth in her portfolio remains completely sheltered for generation-skipping tax purposes.
Another way to take advantage of this provision is by combining a GSTT with an irrevocable life insurance trust (ILIT). A couple might gift $22,000 per year to the trust to cover $11,000 in life insurance premiums for each of two children, thereby staying within the annual $11,000-per-recipient limit for gifts that are exempt from gift, estate, and generation-skipping taxes. When both parents have died, the GSTT might receive death benefit proceeds of $2,000,000 (or more) that would be completely exempt from generation-skipping tax. "It's one way to turn small dollars into big dollars with a GSTT," says Heupel.
If you're concerned about bypassing your children with a significant portion of your estate, Heupel has reassuring advice.
"One of the big selling points for this type of trust is that the children – the middle generation that's being skipped – still maintain quite a bit of control over the assets in the Generation Skipping Tax Trust," he says. At the trustee's discretion, the children can benefit from both income and principal in the trust for the purposes of health, maintenance, welfare, and support. In certain cases, they can even terminate the trust. "It's often the children who persuade their parents to use a GSTT," says Heupel.
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