With the recent increase in the lifetime generation skipping tax exemption to $5 million, effective for 2011 and 2012, you may be thinking that there is no way that this could apply to you (or your spouse). While this may only affect a smaller portion of taxpayers than before for those with potential exposure, let me explain how this works, as simplistically as possible.
Lifetime Generation Skipping Tax Exemption
The generation skipping tax was introduced when the government found that some taxpayers were giving away all their assets to grandchildren at death and thereby bypassing any estate tax upon their children’s deaths. Therefore, the government imposed a limit on how much could be transferred to skip generations. Every individual has an amount that they can pass to grandchildren or more distant descendants (called “skip persons”) free of generation skipping tax. Whatever is not used during lifetime is available for use by the decedent’s estate on their Estate Tax Return. If there is anything going to skip persons, above the lifetime exemption amount then a generation skipping tax is imposed upon such transfer. The GST tax rate has historically been anywhere from 35% to 55%. (No wonder taxpayers want to minimize this tax as much as possible!)
Effectively Allocating Your Available Exemption
You get to choose which transfers receive an allocation of any portion of your available GST exemption. In most cases, if you make a gift to a grandchild or to a trust, solely for the benefit of grandchild, then you will want to allocate a portion of your GST exemption to that transfer. However, if you make a transfer to a trust that is for the benefit of both your children and grandchildren, then, the question is how likely is it that grandchildren or more distant descendants will obtain benefits from that trust? If it is highly likely that grandchildren will benefit, then, you will want to consider allocating some of your GST exemption to that trust.
Now, let’s look at a few other examples:
Example 1: You have been working with an estate attorney and have several trusts in place. One trust may benefit only your children. One trust may benefit only your grandchildren and one trust may benefit a combination of your children and grandchildren. To which one do you allocate GST exemption?
Which trust has a greater probability of passing to grandchildren? You would have to read the provisions of each trust agreement and consider the ages of the children, their health and their childbearing prospects. I would lean more towards allocating to the trust that will most likely end up distributing assets to grandchildren.
Example 2: You have a Life Insurance trust for the benefit of (FBO) Grandchildren and a Retirement trust FBO grandchildren. To which trust do you allocate GST exemption?
Now, this one is a question of which trust has the greatest appreciation potential. Maybe it’s the life insurance trust, because when the policy proceeds are paid out, that could be significantly more than the value you initially transferred into the trust. Or maybe your retirement trust holds stock in companies like Apple Inc. that has gone up from $82/sh to $320/sh in the last year! (Although I would hope that an investment advisor has the portfolio well-diversified!)
Example 3: You have a trust created for the benefit of children and grandchildren. However, in the future, you will probably create a separate trust for the benefit of grandchildren, only.
You would most likely want to hold out and save your available GST exemption for use in allocating it to the second trust. This requires looking into the future and discussing your overall estate plans with your team of advisors.
Effectively allocating your available GST exemption isn’t something that you look at in a vacuum. You may miss an opportunity to more effectively allocate your exemption and pay a tax that you could have avoided. If you are facing potential GST tax in the future, we strongly advise open communication between you, your estate attorney and us.