Using the Generation Skipping Transfer Tax Exemption to Build a Dynasty

If you wish to preserve your wealth for generations to come, you will need to leverage your generation-skipping transfer (GST) tax exemption. Like the gift and estate tax exemption, the GST tax exemption stands at an inflation-adjusted $5.25 million, thanks to the American Taxpayer Relief Act of 2012 (ATRA).

To ensure that your GST tax exemption goes as far as possible, it is important to allocate it wisely. ATRA made permanent several GST tax-related provisions, including the automatic allocation rules. Understanding these rules — and when to opt out — will help you focus your exemption where it will do the most good. With careful planning, you can create a “dynasty trust” — a trust that continues for several generations.

How the Generation Skipping Transfer Tax Works

GST tax applies to transfers to “skip persons” — that is, grandchildren or other relatives more than one generation below you or nonrelatives more than 37½ years younger than you. (There is an exception, however, if your child predeceases you. In that case, your grandchildren by that child are no longer considered skip persons.)

The tax applies — in addition to gift and estate taxes, at the highest marginal estate tax rate (currently 40%) — to:

·         Direct skips — outright gifts or bequests to a grandchild or another skip person, or transfers to a trust whose beneficial interests are held only by skip persons,

·         Taxable trust terminations — for example, when a child with a life interest in a trust dies, causing the trust assets to pass outright to a skip person, and

·         Taxable trust distributions — distributions from a trust (other than a direct skip or trust termination) to a skip person.

The GST tax applies only to transfers that are subject to gift or estate tax. So, if you make an outright gift to a grandchild that is within the annual gift tax exclusion (currently $14,000 per recipient) or a direct payment of qualifying tuition or medical expenses on a grandchild’s behalf, there is no GST tax.

Allocating your Exemption

If your generation-skipping gifts will not exceed the $5.25 million exemption amount, allocation is not an issue. But if you do not have enough exemption to go around, you should allocate it in a way that maximizes the tax savings.

Irrevocable Trust

A powerful tool for leveraging the exemption is an irrevocable trust. You need to allocate only enough of your exemption to cover your contributions to the trust for any future growth to be shielded from GST taxes — thus creating a “dynasty.”

Suppose, for example, that you transfer $5 million to a trust for the benefit of your grandchildren and allocate $5 million of your GST exemption to the trust. If the trust’s value grows to $20 million over the next 20 years, the entire amount will be exempt from GST taxes.

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