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.