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Unraveling the Mysterious GST

Some see it as a cruel and complex hoax. Unfortunately, whether we like or not, the generation skipping tax is here to stay. You can run afoul of the GST even though you have a small estate and even though you don’t have grandkids (at least yet). A little understanding can help you to avoid the GST, or at least give you some gossip for your next cocktail party.

Here’s the concept. Ignoring exclusions and exemptions, you pay one gift or estate tax when you transfer property to your kids. When they later transfer the property to their children, they pay a second gift or estate tax. Instead, if you skip your kids and transfer the property directly to your grandkids, you pay the initial gift or estate tax, plus you pay a GST tax in lieu of the tax the kids would have paid.

Direct Skips

There are three events that can “trigger” the GST. The first is a “direct skip,” meaning a gift or bequest directly to a grandkid or to a trust that is solely for grandkids’ benefit. Since you obviously “skipped” the kids, it makes sense that the GST would be due immediately.

There also is an annual $10,000 gift and GST exclusion per grandchild. However, the GST annual exclusion typically applies for gifts to trusts only if all of the following requirements are met:

  • The trust can benefit only one grandchild (and no one else);
  • If the grandchild dies before the trust terminates, the property must be taxable in the grandchild’s estate (through a provision in the trust document that causes estate taxation); and
  • The transfer must qualify for the $10,000 annual gift exclusion.

The latter requirement is met only by using a “Crummey” withdrawal power (see February 1997 Advisor) or a minor’s trust. A minor’s trust must meet the first two requirements above, plus the grandchild must have the right to take the trust property upon reaching age 21.

If you fail these stringent requirements, you can avoid GST by applying part of your $1 million GST exemption to the gift or bequest. Here’s the gotcha. The exemption is applied automatically to outright gifts to grandkids and to gifts to a trust that solely benefits grandkids. For other gifts, you must affirmatively elect to apply the exemption, even though a return may not be required for gift tax purposes.

So, if you make a gift to a trust that can benefit your children and grandchildren, the GST annual exclusion does not apply and the GST exemption is not automatically allocated. What happens? Well, the plot thickens because the GST tax is delayed. Why? The government wants to subject future growth and income to the GST.

Stay with me.

Taxable Distributions

The second triggering event is called a “taxable distribution.” It occurs when the trustee makes a distribution to a grandchild. There may be both an income tax and a GST tax on that distribution. There are a couple of ways to avoid the GST tax:

  • The medical and educational exclusion applies if the trustee makes distributions directly to the institution or service provider.
  • The GST tax is avoided if all transfers to the trust were covered by GST annual exclusions or by allocations of the $1 million GST exemption.

Taxable Terminations

The third triggering event is a “taxable termination.” It typically occurs when a child dies, even though the trust may not terminate or distribute to a grandchild. The logic goes back to the GST’s purpose. Remember that it substitutes for your child’s estate tax. If you transfer property to a child, and she later dies, she pays estate tax on both the date-of-death value of the property and any income that she received through the years (assuming she did not spend it). Instead, if you put that property in trust, you skip the her estate tax. So, the GST applies to the value of the property and accumulated income in the trust at the time of the child’s death, just as if you had transferred the property to her outright.

The government may get its share even though you don’t really expect the grandkids to get a nickel. For example, assume that the trust is supposed to terminate and distribute to your kids when they turn 35. However, if a kid dies before age 35, the trust instrument’s fine print probably leaves his share to his kids. The kid’s untimely death triggers the GST. Why? If you had given the property directly to him, he would have paid estate tax upon his untimely death.

Planning Basics

The basic planning around the GST is to take the best advantage of available exclusions and exemptions. The easiest is for grandparents to pay grandkids’ educational and medical expenses. Grandparents also can make $10,000 annual gifts to grandchildren, but be careful to make sure that gifts in trust qualify for the GST annual exclusion . If trust gifts do not qualify, consider electing to apply your $1 million GST exemption.

Next, maximize the use of your $1 million GST exemption. There are three concepts here:

  • Use the exemption sooner rather than later. The reason is that the amount of exemption required to avoid GST is the value of the property at the time of the gift. Post-gift income and appreciation avoids gift, estate and GST, rather than adding to your estate for future taxation.
  • Rather than giving cash, consider transferring property with discounted values. Examples include minority interests in family business stock and family partnership interests.
  • Consider gifts and bequests to trusts that may last beyond your grandchildren’s generation. If these transfers are sheltered by the GST exemption, there is no gift, estate or GST tax on the property (or its income/appreciation) until a descendent later transfers property that she received from the trust. That’s better than gifts or bequests to grandkids who, in turn, must pay transfer tax to pass the property to a later generation.

Now you’ve got it! Of course, nothing in the tax law is quite that simple. So, always check with a knowledgeable advisor, particularly when you make gifts to trusts. And, have a drink for me as you amaze your friends with your GST prowess!

 

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