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GST Tax Requires Special Planning

Posted by attorney John Goralka

After the estate tax was enacted, the government felt that transfers that skipped a generation or more would avoid the payment of estate tax on each generation. The Generation Skipping tax was enacted Designed to ensure that assets are taxed at each generational level, the Generation-Skipping Transfer (“GST") tax generally applies- in addition to gift or estate taxes- to transfers that skip a generation. The GST is imposed at a flat rate equal to the highest federal estate tax rate at the time the transfer is made. If you want to share some of your wealth with your grandchildren, great-grandchildren or even more remote generations, special planning is required to keep taxes to a minimum.

A Limited Time Offer?

The GST tax exemption, like the gift and estate tax exemptions, currently stands at a record-high $5.12 million ($10.24 million for married couples). But, also like the gift and estate tax exemptions as of this writing, is scheduled to drop back to just $1 million after 2012 (though, unlike the other two exemptions, the GST tax exemption will be adjusted for inflation). In addition, the top tax tier for all three taxes is scheduled to increase from 35% to 55% next year.

While it’s possible that Congress will act to extend current tax exemption amounts and tax rates beyond 2012 or make other changes, there are no guarantees. Affluent families should consider making gifts this year to minimize gift, estate and GST taxes. Keep in mind that for the transfer to be completely tax-free, you must also apply your gift tax exemption.

3 Types of GSTs

A GST is a transfer to a “skip person," such as a grandchild or other family member who is more than one generation below you. It also includes non-family members who are more than 37.5 years younger than you. A trust is considered a skip person if all of its beneficiaries are skip persons.

There’s an exception if your child predeceases his or her own children during your lifetime. Under those circumstances, the grandchildren aren’t considered skip persons.

GST tax applies to three types of transfers:

  1. A direct skip. This involves a gift or bequest to a grandchild or other skip person (including a trust that is considered a skip person).

  2. A taxable termination. This occurs when assets in a trust you establish for a non-skip person, such as your child, pass to a skip person, such as your grandchild, on the death of the non-skip person.

  3. A taxable distribution. This is a distribution of trust income or principal to a skip person.

The tax doesn’t apply to gifts that are shielded by the annual gift tax exclusion (currently, $13,000 per recipient; $26,000 for gifts split by married couples).

The Automatic Allocation Pitfall

Unlike the gift and estate tax exemptions, which apply to taxable gifts and bequests without the need for any action on the taxpayer’s part, the GST tax exemption is a “use it or lose it" proposition. In order to take advantage of the exemption, you must allocate the exemption to GSTs. However, to prevent the inadvertent loss of the GST tax exemption’s benefits, the tax code automatically allocates it to certain transfers unless you “opt out".

Automatic allocation works well if your net worth is less than $5.12 million ($10.24 million if you’re married). It ensures that your GST tax exemption protects any gifts or bequests you make directly to a grandchild or other skip person or to a trust that will potentially benefit skip persons down the road. If your net worth is significantly higher than the exemption amount, however, automatic allocation can lead to undesirable tax consequences.

For example, consider a trust designed primarily to benefit your children. If there’s a chance that the trust will result in a taxable termination or distribution to your grandchildren sometime in the future, then your exemption may automatically be allocated to the trust. If that change to the trust’s assets will go to your grandchildren is remote, then your exemption might be wasted without providing any benefit. Under those circumstances, you should consider electing to not apply the savings to the exemption to the children’s trust, and allocate all of your exemption to direct skips or to other trusts that are more likely to trigger GST taxes.

Leveraging Your Exemption

The best strategy is often a “dynasty" trust designated to benefit your grandchildren, great-grandchildren and future generations. If the trust is structured properly, it will allow you to leverage your exemption for greater overall economic benefit or tax savings.

If your trust exemption covers the value of your gifts to the trust, the trust will also shield future appreciation from not only GST taxes, but also gift and estate taxes. If your exemption covers only a portion of your gifts, then only a portion of the appreciation will be sheltered from tax.

If you have an existing trust that’s partially protected by your GST tax exemption, there may be advantages to splitting it into two separate trusts.

Splitting Your Trust

Trusts that are only partially protected by the generation-skipping transfer tax exemption are often blended trusts. A blended trust arises if you make additional gifts or transfers to a trust after you’ve exhausted or used up your exemption. A blended trust benefits both skip and non-skip persons, and there may be tax advantages to dividing the trust in two separate trusts (if permitted under applicable federal and state law).

For example, $2 million to a discretionary trust that benefits your children and grandchildren, with a $1 million allocation of your GST tax exemption. The trust has an “inclusion ratio" of 0.5, which means that 50% of any distributions to your grandchildren will be subject to the GST tax. On the other hand, splitting the trust into two trusts – with inclusion ratios of 1 and 0, respectively – permits the trustee to use the latter for distributions to your grandchildren free of GST taxes.

Review Your Plan

At this time, there is a $5.12 million dollar GST exemption. On January 1, 2013, the GST exemption falls to $1 million. There may never be a better opportunity to establish a legacy for your family. Consider establishing a dynasty trust or other generation-skipping technique before year end to take advantage of the current GST tax exemption. If your estate plan includes trusts that will or may benefit skip persons, we can assist you with tax advantaged strategies that can minimize your GST tax exposure.

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