Leveraging the GST Tax Exemption

Estate Planner Sept-Oct 1998

The type of assets you transfer to your grandchildren and other heirs –and the means you use to transfer them — can make a difference in the amount of generation skipping transfer (GST) tax that will have to be paid. A 55% GST tax is imposed — in addition to the applicable estate tax — on transfers of property to people who are two or more generations below that of the property owner. Fortunately, an exemption from the GST tax exists. For 1998, this exemption is $1 million, but it will be indexed for inflation beginning in 1999.

Each individual’s exemption is allocated, either automatically or by specific allocation, to a particular transfer or transfers. How this allocation is made can greatly leverage the value of assets exempted from the tax. By allocating the GST exemption to a trust, you can ensure that the entire trust will never be subject to GST tax, even when assets pass out of the trust to multiple generations.

Leveraging With Discounts

Leveraging assets that would be exempt from the GST tax enables you to increase the value of these assets to your heirs. One form of leveraging is the transfer of discounted assets, such as stock in a closely held corporation where minority interest and lack of marketability discounts are available. Let’s look at an example. Sam gifts his 20% interest in ABC Corporation to his granddaughter. ABC is valued at $1 million, but the gift might be valued at $140,000 ($200,000 less 30% minority and lack of marketability discounts). Thus only $140,000 of GST exemption needs to be allocated. If the business is sold for $1 million, Sam’s granddaughter will receive $200,000. If the business appreciates to $2 million and is then sold, she will receive $400,000. Although, for GST purposes, Sam has only given her $140,000. The increased value in her hands occurs with no additional gift or GST tax, even though she now has an asset of much greater value.

Leveraging With Life Insurance

Another type of asset that allows for some of the greatest leverage is life insurance. You can create an irrevocable trust to hold an insurance policy on your life and make gifts to the trust to pay the premiums. The GST exemption can be allocated to the premiums and not to the death benefit. This offers great leverage. A late allocation of GST exemption based on the values of trust assets as of the date of allocation can result in less exemption being used. You must, though, adhere to complex rules ensuring proper allocation of the exemption.

Grandfathered Trusts

Trusts that were irrevocable on Sept. 25, 1985, are grandfathered from the GST tax unless additions were made to the trust after that date. With these trusts, you can obtain even more leverage by using trust assets to purchase a life insurance policy. For example, assume a grandfathered trust has $2 million in assets. The trustee, exercising the trustee’s power to invest in a variety of assets, purchases a policy on the life of the grantor, or perhaps even better, on the life of the spouse, child or grandchild of the grantor. When the insured dies, the insurance trust will collect proceeds which will remain exempt from GST tax. However, if additional contributions have been made to the grandfathered trust, it would lose its grandfathered status in whole or in part. The result is that a portion of the trust would be subject to GST tax upon distribution out of the trust to a skip-person. Again, be careful when purchasing life insurance to avoid adverse or undesirable estate or income tax consequences.

How Should You Leverage Your GST Tax Exemption?

Determining how to best leverage the GST exemption is complex. It requires the careful analysis of options. Please let us know if you have any questions about this or any other estate planning topics. We would be glad to help you maximize the value of your estate for your heirs.

The Return of Dynasty Trusts

Many states have repealed the rule against perpetuities, making it possible to extend the life of a trust indefinitely. Through the creation of such a trust that is exempt from GST tax, huge amounts of wealth can pass down through the generations free from transfer tax. Even if the rule against perpetuities has not been repealed in your state of residence or that of the trust beneficiaries, you may be able to establish nexus with another state and take advantage of the repeal. Nexus is the term used for the right that states have historically had to impose taxes on any company that’s had adequate contact with the state. You have to look into the tax codes of each state you deal with to stay on top of nexus.