“The only difference between Death and Taxes
is that Death doesn’t get worse every time Congress meets!”
~ Will Rogers
Introducing the Generation Skipping Transfer Tax
Just when you thought that Congress and the IRS couldn’t invent another way to tax your money, along comes the Generation Skipping Transfer Tax (GST).
The GST is a tax that was designed to ensure that assets transferred between two or more generations are taxed at each generational level. Prior to enacting the GST, you could avoid being taxed at each generational level by one of two techniques:
(1) The Trust Transfer method – Place all assets in a trust for the benefit of your children during their lifetime, and at their death, it could pass on to your grandchildren, thereby only paying Estate Tax when it passed to the children (and not when it passes from your children to grandchildren); or
(2) The Direct Skip method – Transfer assets directly to your grandchildren thus bypassing the Transfer tax that would ordinarily happen between your children and grandchildren.
Clearly, Congress and the IRS couldn’t allow such transfers to continue with impunity – so they invented the GST.
How it Works
The GST applies to the two situations described above in two different ways:
(1) In the Trust Transfer method – Assets that distribute to a person two or more generations below you (“skip persons”) will be hit with the GST Tax at the time the transfer is completed, assuming your credit against this tax is exceeded. If the recipient “skip person” is alive, there will not be an Estate Tax on this transfer. If the distribution is to the “skip” person’s estate, an Estate Tax may apply as well. This is known alternatively as a taxable termination or taxable distribution.
(2) In the Direct Skip method – Your assets are taxed by the Estate Tax and the Generation Skipping Transfer Tax in addition to the Estate Tax. This double tax is justified because you thought you would skip one of the two taxes owed to the IRS by cutting out the middle generation – and the GST is needed to bludgeon you into submission. Shame on you for even thinking about this!
Remember, it’s not how much the IRS taxes you, it’s how much they let you keep!
With that tongue-in-cheek maxim in mind: the GST kicks in at the highest Estate Tax rate, which in 2011 is thirty-five (35%) percent. [In 2013, this rate increases to 50%, unless Congress takes further action.]
In the Direct Skip situation described above, the GST is assessed against the after-tax net amount received by the beneficiary. This is known as “tax-exclusive”, and the resulting effective tax is less.
Therefore, if you had attempted to Direct Skip $1,000,000 without GST planning, the GST Tax would be around $500,000, which is 33.3% of the gift plus the GST tax on the gift ($1,500,000).
See there? And you thought the Government was being unreasonable!
How can You Avoid Paying this Tax?
There are three exceptions to the Generation Skipping Transfer Tax, which we will discuss in turn:
(1) Pre 1985-Trusts – Trusts that were irrevocable and in existence on September 25, 1985 (the date that the GST was first introduced in Congress), including those that were extended by exercising powers of appointment;
(2) Gifts not subject to Gift Tax – Gifts that fall below the Annual Exemption amount ($13,000 in 2011) are not subject to GST (but technical requirements must be satisfied to apply this to gifts in trust).
In addition, gifts that are paid directly to a school for educational purposes or paid directly to a hospital, doctor, HMO for medical purposes, are not subject to either Gift Tax or GST Tax.
Warning: if they are indirectly paid, i.e. the grandchild is reimbursed for these expenses, then the exemptions do not apply – and Gift and GST Taxes may kick in.
(3) The Lifetime Exemption from GST Tax – Each individual has a lifetime exemption from GST Tax for a certain amount – in Year 2011, that amount is adjusted for inflation, starting with $5,000,000 as the base amount. [In 2013, this amount decreases to $1,000,000, unless Congress takes further action.]
This exemption applies either to Transfers in Trust made to children and grandchildren or it applies to Direct Skips- shielding that amount from GST Tax.
Where GST Planning Kicks In
In the midst of all of this negative tax news, a few planning opportunities do exist. Assets that are placed into a trust that are exempt from GST Tax are always exempt from GST Tax – even if they have appreciated in nature after your death. Therefore, it is important that the trusts that you leave for your grand-children (or other “skip” persons”)are divided into either exempt or non-exempt trusts, and that assets that are expected to appreciate the most are placed in the exempt trusts.
If you are still awake at this point, you should consult competent legal counsel to see how this Generation Skipping Transfer Tax may apply to your situation.
We welcome the opportunity to meet with you in person to discuss your Estate Planning needs.