For clients who wish to benefit their grandchildren, the generation-skipping transfer tax can present a big challenge. The GSTT is a flat tax (at the highest current estate tax rate) imposed on transfers that “skip” at least one generation; the tax is in addition to any estate or gift tax due on the transfer.

So, for clients who wish to make a gift to a grandchild, the gift would be subject not only to potential gift taxes, but also to potential GST taxes. The cumulative effect of these taxes can be to nearly double the cost of making the gift.

Congress first implemented this law in 1986 to prevent wealthy people from circumventing the estate and gift tax system by making gifts directly to grandchildren or future generations, avoiding estate tax which would otherwise occur in one or more “skipped” generations. Congress also implemented an exemption from the GSTT, which may be used during lifetime or at death.

Before the Economic Growth and Tax Relief and Reconciliation Act of 2001, the GSTT exemption was a little over $1.1 million. Under EGTRRA, the GSTT exemption increased to $2 million in 2007, and it will rise to $3.5 million in 2009. However, without current tax law changes, the GSTT will revert back to the 2001 level (indexed for inflation) in 2011 as the EGTRRA sunset provisions kick in. Given this uncertainty, how can you help clients make the most of their GSTT exemption amount? A dynasty trust may be able to help.

A dynasty trust is a popular name for a special type of irrevocable life insurance trust. Unlike a traditional ILIT, the dynasty trust continues for several generations, giving each generation access to the trust assets (such as for health, education, maintenance and support), while keeping the remaining trust assets outside of the beneficiaries’ taxable estates for as long as state law permits.

The clients create a dynasty trust and make lifetime gifts to the trust, allocating their GSTT exemptions to all of the lifetime gifts to the trust on federal gift tax returns. The GSTT exemption may be further leveraged by the purchase of life insurance, particularly for survivorship policies.

For example, assume our clients are a man, age 68, and a woman, age 66, both preferred non-smokers, with a $20 million estate. They make gifts to a dynasty trust of $200,000 a year to purchase life insurance and use their applicable estate tax exclusion amount to avoid paying gift taxes.

Such a straightforward premium gift would purchase a fully-guaranteed survivorship UL policy with a face amount of about $7.5 million. Assuming the money remains in trust and grows at 5% after tax, as much as $50 million could be available for their great-grandchildren (see Option 1 in chart).

There may, however, be a better way to fund the trust. For starters, it can be more efficient to put a lump sum into the trust and use income and principle to purchase life insurance over a timeline. In this case, our clients avoid paying gift taxes by funding the trust with $1 million from each spouse (to fully use their gift-tax exemption amounts) for a total of $2 million. At a 5% rate of return, this could support a full-pay premium of about $118,000 and purchase a life insurance policy of about $9.4 million. As Option 2 on the chart indicates, this alone would increase the potential amount for their great-grandchildren by about $13 million.

The lump-sum funding approach can generate more life insurance and hence more money for the heirs. But how can we use the clients’ entire GSTT exemption amount? One way to do so would be to fund their trust with the full 2007 $2 million GSTT exemption amount each. The drawback to this approach would be that the client would likely have to pay gift taxes for all amounts over the $1 million gift tax exemption.

Since the future of estate taxes is still unclear, it may not make sense for clients to take this approach until there is further clarity. However, it would make sense for the clients to use their wills to allocate the remaining GSTT exemption to the dynasty trust at death. In other words, at the death of the first client, have the client’s estate bequeath an additional $1 million to the trust covered by the remaining GSTT exemption.

The advantage of this approach is that it does not waste the client’s GSTT exemption but also does not force the client to pay gift taxes. Such a strategy also helps the client maintain flexibility in light of future estate tax changes. Assuming the clients took this approach, and the first spouse died in year 2, the ultimate amounts left for the grandchildren could be increased to nearly $82 million. (See Option 3 in chart.)

The dynasty trust can dramatically increase the value of the inheritance that your client’s heirs will receive by reducing estate taxes in future generations. Don’t let your clients miss this opportunity. Make sure they will use, not lose, their GSTT exemption amounts.

Cynthia A. Crino, CLU, is assistant vice president, operations, in the Advanced Markets Unit of John Hancock Life Insurance, Boston, Mass. You can e-mail her at .