A Million to a Billion, in Three Generations…Tax Free
The Generation Skipping Transfer Tax (GST tax) is an extra tax on gifts or bequests from grandparents to grandchildren (or lower generations) that would otherwise skip successive gift or estate taxation. The GST tax rate is a flat 40% regardless of the amount of the transfer or the donor/testator’s gift or estate tax bracket. The combination of gift/estate tax and GST tax can be confiscatory.
Assume that a wealthy grandmother who is in a 40% gift tax bracket and has used up her GST exemption makes an outright gift of $1,000,000 to her grandchild. The total taxes are $960,000 as follows:
- Gift tax: $400,000
- GST tax: +400,000
- Gift tax on GST tax: +160,000
- Total taxes: 960,000
That’s right, there’s a gift tax on the GST tax as it is considered an additional gift to the grandchild. Thus, the taxes are 96% of the gift. It takes $1,960,000 to make a gift of $1,000,000.
The taxes are even worse if the grandmother waits until she dies to bequest the $1,000,000 to the grandchild; the taxes total $1,333,333 so it takes $2,333,333 to net the full $1,000,000 to the grandchild. Follow the steps:
- Start with $2,333,333
- Estate tax at 40% – $933,999
- That leaves $1,400,000
- GST tax: – $400,000
- Net to grandchildren $1,000,000 The combined tax rate is 57%
Direct Skips, Distributions, and Terminations
The above were examples of direct skips: gifts or bequests directly to grandchildren. In direct skips, the transferor (grandparent) pays the GST tax. A direct skip can also be in trust.
- E.G. A grandparent gifts $1,000,000 to a trust to provide income to a grandchild for a period of years with the distribution of the principal delayed until the grandchild reaches a certain age, or dies. This is a direct skip and the grandparent pays the GST tax upfront.
Similarly, a trust set up during life or at death to provide income to grandchildren, then income to great grandchildren, etc., is a direct skip and the taxes are paid upfront. But, if “non-skip” persons, such as children, are intervening beneficiaries, the GST tax is not paid until there is a taxable distribution or termination.
- E.G. A grandfather sets up a trust that provides income to his children for life, with the principal to his grandchildren at the death of the children. The GST tax is paid when his children die and the principal is distributed to the grandchildren. This is a taxable termination and the grandchildren pay the GST tax.
Distributions of principal or income to the grandchildren while the children are living are GST taxable distributions. The trustee pays the GST tax and, like a direct skip, the GST tax itself is treated as an additional distribution to the grandchildren. Distributions to children are not subject to the GST.
Assignment of Generations and Predeceased Child Exception
The GST tax does not apply to gifts or bequests to “non-skip” persons. It only applies to transfers to “skip” persons, or those who are two or more generations below the transferor: grandchildren or later generations. Individuals who are not related by blood or adoption to the transferor are assigned generations based on their date of birth compared to the transferor. Persons born within 12 ½ years of the transferor are the same generation as the transferor; those born between 12 ½ and 37 ½ years are one generation removed, and therefore not a “skip” persons. Persons born more than 37 ½ years after the transferor are “skips”.
If a parent predeceases his/her children, the children move up a generation.
- E.G. A gift by a grandparent to a grandchild is not subject to the GST if the child’s parent, the son or daughter of the transferor grandparent, has predeceased. Similarly, if a grandparent makes gifts to a trust that provides income to a child and principal to grandchildren, trust income or principal that is distributed to the grandchildren is subject to the GST. But, gifts by the grandparent to the trust after the parent-child dies meet the predeceased parent exception the GST
GST Exemption, Allocation and Exclusions
Each transferor (grandparent) has a $11,700,000 GST exemption. Thus grandparents have $23,400,000 in total. Like the regular gift/estate tax exemption ($11,700,000), the GST exemption is automatically applied to direct skips during life or at death so there is no need to elect to use the exemption on the gift/estate tax return. But, election or allocation of the GST exemption is more important with gifts in a trust where the GST tax will be applied upon distribution or termination, rather than upfront as with a direct skip. The amount of the GST tax on taxable terminations or distributions is based on a formula to determine the “inclusion ratio” or percent of the distribution to which the 40% tax rate applies. The numerator for the “inclusion ratio” is the exemption amount allocated to the transfer and the denominator is the total amount of the transfer.
- E.G. If a grandparent gifts $20,00,000 to a GST trust, the ratio is 58.5% ($11,700,000/$20,000,000). The inclusion ratio is the reciprocal or 41.5% (1-.585). Later, when a taxable distribution or termination is made, the GST tax will be 16.6% (41.5% x 40%) on the amount distributed.
Early allocation of the GST exemption is very important with life insurance funded trusts. The transferor should make the allocation with each gift on the gift tax form 709. Late allocations can be made by the transferor, even by the executor after the transferor’s death, but the value of the property at the time of the allocation will be used rather than the value when transferred. With life insurance, this means the proceeds will be used as the late allocation value at the transferor insured’s death rather than the premiums which could have been used earlier.
There is also a $15,000 annual exclusion ($30,000 by spouses) for GST gifts. Unlike the gift tax annual exclusion, the GST exclusion does not apply to typical “Crummey” trust provisions. It only applies to outright gifts or gifts to “vested” trusts where the trust funds will be included in the beneficiary’s estate. Thus, the annual exclusion is not used in Dynasty or generation skipping trusts.
Dynasty Trusts and Perpetuities
A Dynasty trust is just another term describing a generation skipping trust. However, it implies something that will last for generations to come. Historically, a trust can only last for as long as “lives in being and 21 years thereafter” (the rule against perpetuities). Thus, you could set up a trust to last for as long as any of your grandchildren or great-grandchildren live, as long as they are alive when you set up the trust. Many states have eliminated the “rule against perpetuities” and a trust can theoretically last forever (AK, DE, ID, SD, WI).
While the Dynasty trust trustee has the usual discretionary powers to distribute income and principal to the beneficiaries, it would be counterproductive to distribute principal as that would be included in the beneficiaries’ estate. Therefore, to enhance the purpose of long-term generation skipping, the trustee often has the discretion to purchase homes or businesses for the use of the beneficiaries thereby retaining asset ownership in the trust.
Life Insurance Leverage and Options
Practically any assets can be put into a Dynasty trust, but it makes sense to get the biggest bang for your buck with assets that will go up in value and will not generate taxable income or capital gains tax. Therefore, the tax advantages and leverage of life insurance may be the magic mover of Dynasty trusts.
- E.G. On a product with a death benefit guarantee, a single premium of $2,000,000 used to purchase a policy on a female age 65 preferred non-smoker designed to minimize initial face amount could purchase of policy of slightly more than $2,650,000.* By age 85 the policy would have a death benefit of approximately $6,275,000 at a 7% gross (6.18% net) assumed rate of return. That’s a lot of tax free cash paid to the trust at death that could be invested by the trustee for the benefit of children, grandchildren or generations to come. Sure, they could invest the $2,000,000 in some other way rather than buying life insurance, but will that other investment accumulate, net after taxes, to the same amount as the insurance proceeds? Furthermore, the benefit of income tax-free death benefit could become greater if President Biden’s tax proposals eliminating step-up in basis become law.
The insurance does not have to be on the grandparent-donors. The insurance could be on the children to enhance the benefit for grandchildren and later generations.
Wouldn’t that be a nice legacy to leave grandchildren?