Even estate planning professionals sometimes struggle with the generation skipping tax. The GST is an extra tax imposed–in addition to possible gift or estate tax–when there’s a transfer to grandchildren or to a family generation more remote than children. The current GST rate is 45%.
In 2009, the GST exemption is $3.5 million–up from $2 million in 2008. The bigger exemption makes some estate planning opportunities more attractive.
The GST applies to lifetime gifts or death-time transfers to any person who is two or more generations below that of the transferor. In the case of a death-time transfer, the GST can combine with the estate tax to reduce an amount intended for grandchildren by nearly 70%.
There are three types of transfers that are subject to the GST:
? Direct skips
? Taxable distributions
? Taxable terminations
Direct skips are transfers–by gift or at death–to one or more skip persons. A direct skip may be a transfer to a trust under certain circumstances. A taxable distribution occurs when a trust makes a distribution to a skip person, and the distribution is not subject to estate or gift tax. A taxable termination occurs when all beneficial interest in a trust, by passage of time or some other event defined by the trust, passes solely into the hands of one or more skip persons.
The GST exemption may be allocated to gifts held in trust. If the exemption is used to cover the entire value of the trust, the trust is said to have a zero inclusion ratio for GST purposes. Wealthy prospects might especially consider implementing strategies in 2009 to take advantage of the relatively large GST exemption.
Gifts to an ILIT
The simplest and most powerfully effective way to leverage the use of the GST exemption is to use life insurance.
During a married couple’s lifetime, the grantors might establish an ILIT that is for the benefit of grandchildren. To fund the ILIT, the spouses each use their annual gift tax exclusions–or gifts using the grantors’ lifetime exemption–to fund survivorship life insurance premiums to be paid by the trustee. A properly implemented ILIT keeps the life insurance out of the donors’ taxable estates.
If the donors each allocate part of their generation-skipping exemptions to each gift made to the ILIT, the death proceeds would escape the GST as well. At the grandparents’ death, the survivorship death benefit will be available for the grandchildren and following generations income, estate and generation-skipping tax free.
Because the GST exemption is relatively large at $3.5 million for each of the trust grantors, and because survivorship insurance premiums tend to be relatively small, there is a small cost for making the GST election with regard to premium contributions.
Zero inclusion ratio trusts–now or later
Because of the usual difference in age between the grantor and skip persons, lifetime or post-death transfers in favor of skip persons are often in trust. If such trusts have an inclusion ratio of zero, any future distributions or terminations from the trust would be GST-free.
To ensure a generation-skipping trust has a zero inclusion ratio, the grantor must make appropriate plans in advance. For example, assume the grantor is making revocable trust plans designed to distribute assets at death. The trust should include wording that at the grantor’s death, the trustee has the power to create a separate trust–for the primary benefit of grandchildren or other skip persons–that makes maximum use of the GST exemption to create zero inclusion ratio trusts.
That kind of GST planning should be integrated into normal A-B style estate tax management planning. Say we have a couple whose revocable trust divides an estate at the first death into a family portion for $3.5 million of estate tax-exempt assets, with a QTIP portion for the benefit of the surviving spouse with the rest of the estate. Say for the purpose of discussion that the rest of the estate is worth $5 million.
Depending on the circumstances after the first spouse’s death, the trustee may want to allocate the GST exemption to part of the QTIP, part of the family portion, or parts of each. Say that the trustee is inclined to allocate the GST exemption to the family portion, which is worth $5 million.
Given a choice, the trustee would prefer not to allocate the GST exemption of $3.5 million to the entire family trust, which would be worth $5 million. That allocation would create a trust with an inclusion ratio of greater than zero–because the trust value at the time of allocation is bigger than the exemption.
The trust document should be drafted to give the trustee the power to sub-divide the family portion into separate trusts. If the trust so provides, the trustee could create a family portion worth $3.5 million, and another worth $1.5 million. The trustee would allocate the GST exemption to the family portion worth $3.5 million–using up the exemption, and creating a GST exempt trust. Future distributions or terminations from that trust, including appreciation, would be GST-free.
This technique of creating zero GST inclusion ratio trusts is also available for lifetime gifts. For example, a wealthy wife may decide to make a gift in a QTIP trust to her husband, to make sure that estate taxes are minimized no matter who dies first. The wife may also decide to allocate her GST exemption to the gift, so that the remainder interest intended for grandchildren at husband’s death escapes the GST.
Since the $3.5 million GST exemption available in 2009 may be smaller in the future, it makes sense to make plans to maximize its use now.
Linas Sudzius, J.D., CLU, ChFC, is president of Advanced Underwriting Consultants, Franklin, Tenn. He can be reached at [email protected]