Do you have any clients who might get tripped up by the generation-skipping tax? If you do, or aren’t sure, please read on.
The generation-skipping tax is an estate tax on steroids.
It is essentially a double tax. Generation-skipping tax is imposed on gifts or other non-exempt transfers (the rules are complex, and we’re just outlining them here) to someone other than a child who is more than 37.5 years younger than the giver.
The tax rate on Generation Skipping Tax is currently 40%. This tax is in addition to the estate tax.
The tax can be challenging to understand, and even more challenging when it cannot be avoided.
(Click here to request an Advisor Guide.)
The effective tax rate on a taxable generation-skipping gift can be an astonishing 80%.
For example, suppose that a widow, Mrs. Generous, has no remaining estate or generation skipping exemption. She dies, leaving $1 million to her sole surviving heir, her granddaughter.
Her granddaughter is considered a “skip” person, and because Mrs. Generous has no remaining exemption, the entire $1 million is subject to both the estate tax, and the generation-skipping tax.
Each of those taxes is 40%, on the entire $1 million. The estate tax, therefore, will be $400,000. The generation-skipping tax is also $400,000. After paying those taxes, the estate retains only $200,000, which is what the granddaughter receives.
That’s an effective tax rate of 80%!
Exemptions
Until the scheduled sunset of the 2017 tax law, each person currently has a lifetime estate and gift tax exemption of $13.6 million (which will be approximately $14 million in 2025).
The sunset, if it takes effect as scheduled on January 1, 2026, will reduce that exemption to about $7 million.
The same exemption amounts apply to the generation skipping tax.
Simple Example
The simplest way to apply an exemption is to make a gift to a person, and apply the appropriate exemption.
For example, suppose that Mrs. Jennifer Generous (known to her friends as Jen I) gives a gift worth $1 million dollars to her daughter, Jennifer, known as Jen II. It doesn’t matter whether the gift is cash, or assets valued at $1 million. Jen I makes the gift, and when she files a gift tax return (form 709), she applies $1 million of estate/gift tax exemption.
The gift is tax free.[1] Jen I owes no tax on the gift. Jen II owes no tax on receiving the gift.
Now suppose that Jen II several years later gives $1 million to her own child, whom she has creatively named Jennifer. Everyone calls this person Jen III. That gift too, can be a tax-free gift, provided that Jen II has enough remaining lifetime exemption.
Jen II gives $1 million to Jen III. Jen II files a gift tax return, and uses $1 million of her lifetime exemption.
A Better Way to Use Exemption
If the total value of the assets given from one generation to the next is significantly less than the lifetime exemption, the way that the Generous family did it in the above example will not create any tax, and there’s probably no strong reason not to do it that way.
No one in the example has used a Generation Skipping Tax Exemption, but because there was no “skip” the set of transfers didn’t result in generation-skipping tax.
However, there’s probably a better way, and that becomes especially important as the value of the assets gets bigger.
The Better Way
The better way is to apply both gift/estate tax exemption, and a corresponding amount of Generation Skipping Tax (GST) exemption.
To apply that GST exemption will generally involve a trust.
Trusts that are designed to have GST exemption applied to the assets given to the trust are usually referred to as Generation Skipping Trusts. You will sometimes hear the term “GST” applied to those trusts. It might be a bit confusing, because “GST” can refer to both the Generation Skipping Tax and the trusts designed to avoid that tax, called a Generation Skipping Trust. If someone uses the term “GST” and you’re not sure what they mean, it’s probably a good idea to ask.
Generation Skipping Trusts
A Generation-Skipping Trust allows assets to be transferred to descendants of the grantor, including those at least two generations below the grantor, such as grandchildren, and later descendants, while avoiding the estate tax and the generation-skipping tax.
The trust must be drafted correctly, and when the trust is funded, the appropriate amounts of the estate tax and GST exemptions must be applied.
When done correctly, the entire assets in the Generation-Skipping Trust are then exempt from estate or generation skipping tax for far into the future.
Avoiding a $143,000,000 Opportunity Loss
For the wealth creator who wishes to build long term wealth for his or her family, the proper use of a Generation Skipping Trust can make a giant difference in the long run.
Let’s consider an example. Suppose that each generation has children 30 years apart. For simplicity, let’s assume the following:
- The lifetime exemption (for estate tax and GST) stays at today’s $13.6 million.
- Gen 1 passes $13.6 million to Gen 2 today. There’s no tax.
- Gen 2 invests the $13.6 million at an annual 5%, compounded, after income taxes.[2]
- After 30 years, Gen 2 transfers the assets to Gen 3, and pays estate tax at 40% on the amount over the exempt amount.
- Gen 3 grows the net after-tax amount it receives, and after 30 years passes that to Gen 4.
Given these assumptions, Gen 4 will receive $111 million in year 60. That’s a lot of money, but it represents a compound, after-tax growth rate of only 3.5%. That 3.5% is actually slightly lower than the average inflation rate in the United States since 1933 when Franklin Roosevelt reneged on the government’s pledge to exchange dollars for gold at a fixed rate. (Click here to order our book on the history and causes of inflation.)
In contrast, if the two estate taxes — one at year 30 and another at year 60 — could be avoided, Gen 4 would receive not $111 million, but $254 million!
How to Save $143 Million Dollars
Using the same facts as the above example, but avoiding the two incidences of the estate tax, Generation 4 would have an additional $143 million when it inherits.
And avoiding those estate taxes is exactly what a properly structured Generation Skipping Trust does.
In addition to avoiding confiscatory estate taxes, a properly structured Generation Skipping Trust can provide asset protection, provide for multiple generations, offer the family (or whoever the grantors determine are the right people) significant flexibility and control to adapt to situations as they develop in the future.
Customizing the Solution
There are many potential customizations that advisors, clients, and attorneys may employ. We mention only three here that may be slightly less common.
Distribution Trustee
All generation skipping trusts are irrevocable. A so-called spendthrift provision is common in irrevocable trusts.
A spendthrift provision protects the trust’s assets from being seized by creditors of a beneficiary. But the spendthrift won’t help if the beneficiary receives a payment from the trust. When the beneficiary receives a payment, a creditor of that beneficiary may be able to seize or lien the funds that have just come into the beneficiary’s hands.
Suppose a beneficiary is his own trustee. While that might sound like a good thing, if the beneficiary has a creditor, it could turn out to be a bad thing. The creditor may be able to compel (through the courts) the beneficiary to distribute assets to himself, that the creditor would then legally take.
Attorneys and advisors who are cognizant of this type of risk might use a Distribution Trustee. A distribution trustee is a trustee whose only role is to decide, in that trustee’s sole and absolute discretion, whether, when, and how much to distribute to a beneficiary. In the case of a beneficiary who has a creditor waiting to pounce on cash or assets distributed to the beneficiary, it may be much more difficult to compel a distribution trustee to distribute assts to the beneficiary.
Trust Protector
Some states allow a trust to have a role called trust protector. Depending on the law and how the trust is drafted, the trust protector can have the ability to hire and fire the trustee, without actually being the trustee.
Master LLC
A Master LLC is not part of a trust. Instead, it is an LLC that may own part of or all of the assets of the trust.
This can be useful for a variety of reasons. A Master LLC can have a single person, who is not a trustee, effectively manage the assets of the trust. It can be administratively easier to administer the assets of the trust via an LLC, as opposed to having the trust directly own assets. Even if a trust has multiple sub-trusts (e.g. a subtrust for each sibling or other family member), the assets held in a Master LLC can all be managed together.
Asset Diversification Trust
A generation skipping trust helps with estate, gift and GST tax avoidance, but on its own does little or nothing for income taxes. A tax-exempt asset diversification trust can hold part or all the assets of a generation skipping trust, and there is no income tax on those assets as long as the assets are owned in the asset diversification trust. For more on the use of various asset diversification trusts, ask us for an Advisor Guide.
Financial Advisors
Financial advisors want to (and are required to) do what’s best for their clients. Saving taxes, keeping family assets intact from generation to generation, and protecting assets from creditors are not by any means the only goals of clients. With good planning, those goals can be achieved while also achieving other client goals.
In addition to being good for clients, this kind of effective wealth protection and growth planning is also good for advisors. It’s good for at least three reasons:
- It helps an advisor differentiate what he does from what many advisors do
- It enhances the advisor in the eyes of the client, which may lead to more referrals
- It helps the advisor grow assets under management, and retain more assets, compared to planning that results in higher client taxes and less wealth accumulation
To Learn More
Please call 703 437 9720 and ask for Connor or Katherine – or email [email protected] to learn more. We look forward to hearing from you.
[1] Tax-free with respect to the gift, estate, and generation-skipping taxes. Any income taxes that might be associated with the asset, such as capital gains, will not be eliminated. The general rule in a case like this is that the recipient of the gift inherits the giver’s tax basis for purposes of capital gains taxes.
[2] For thoughts on how to defer income taxes, please ask us for a copy of one of our Advisor Guides to tax-deferred compounding.
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