Every person can pass up to $11,580,000 in 2020 ($23,160,000 for a couple) to his or her grandchildren without subjecting the gift to the federal generation-skipping tax which is 40% in 2020. The generation-skipping tax is in addition to any estate or gift tax also assessed on the initial transfer. The benefit of passing the amount exempt from generation-skipping taxes to the grandchildren or great-grandchildren is that it avoids estate taxation in at least one estate and possibly two or more estates.
A generation-skipping trust works well when a person wants to avoid compounding a child’s estate tax problem or when a child cannot make his or her own financial decisions.
For example, Martha owns assets worth $11,000,000. Martha has one adult child, Chris, and one grandson, Greg. Chris owns assets worth $2,000,000. Martha dies in 2020 and leaves all of her assets outright to Chris. The tax on Martha’s estate is approximately $1,452,000 in estate taxes. Chris dies in 2030. The tax on Chris’s estate will be approximately $1,561,000 in estate taxes.
In comparison, Martha leaves $11,000,000 in trust for Chris for her lifetime that ultimately distributes to her grandson, Greg, on Chris’s death. Martha dies in 2020. The tax on Martha’s death will be approximately $1,452,000 in estate taxes. Chris dies in 2030. There would be no taxes on Chris’s estate. Therefore, there is an overall tax savings of approximately $1,561,000 by using the generation-skipping trust.
Note: This example assumes no growth on Chris’s assets or the generation-skipping trust. All appreciation on the generation-skipping trust will also pass without any additional estate taxes in Chris’s estate.
1. Avoid Compounding Estate Tax Problem.
A generation-skipping trust for a child to merely avoid compounding a child’s estate tax problem can include provisions that make the trust ownership similar to outright ownership. A child can receive trust income and principal as necessary for the child’s maintenance, education, support and health. The child can act as the trustee. If the child cannot act as the trustee, the child can be given the power to remove and appoint another trustee. The trust can give the child the power to change the ultimate trust beneficiary to anyone except the child, the child’s creditors, the child’s estate, and the creditors of the child’s estate. If the child’s share exceeds the amount exempt from estate taxes, then the child usually receives the remainder outright or in a nongeneration-skipping trust.
2. Financially Irresponsible Beneficiaries.
A person worrying about a child’s financial responsibility may also consider a generation-skipping trust. The trust in that scenario may provide for an independent trustee to distribute trust income or principal as necessary for the child’s maintenance, education, support, health, travel and comfort or any other purpose designated by the person setting up the trust. The trustee can purchase a house in the trust’s name for the beneficiary. The trust can limit distributions to a beneficiary so that the distributions do not interfere with any county, state or federal assistance the child may receive. Thus, if a child receives SSI benefits due to an illness that requires hospitalization, the trustee can use the trust funds for the extra benefits for the child rather than just hospitalization costs until the trust is exhausted.
3. Protection from Creditors and Divorce.
Additional benefits of a generation-skipping trust include creditor protection and protection from division in a divorce situation. The child does not own the trust so a judge cannot divide the trust if a child divorces.
4. Rapidly Appreciating Assets.
If a person’s estate is rapidly appreciating, the person will want to consider creating a generation-skipping trust during his or her life.
For example, Martha owns an internet company that plans to go public. Before the initial public offering, she decides to utilize her amount exempt from generation-skipping taxes ($11,580,000 in 2020). She gifts stock to a trust for her daughter, Chris, and her grandson, Greg. If the stock increases in value as she expects, she will succeed in passing more than the $11,580,000 to Chris and the trust will not be included in Chris’s estate, but will pass without estate taxes on Chris’s death to Greg.
5. Lifetime Gifts to Grandchildren.
Grandparents can make gifts to their grandchildren of the annual amount exempt from gift taxes ($15,000 in 2020) without using their exemption from generation-skipping taxes. The grandchild must either receive the gift outright or in a trust that includes the following provisions:
a. The grandchild has the right to withdraw the amount exempt from gift taxes for a short period of time.
b. The grandchild is the only beneficiary of the trust income and principal.
c. When the grandchild dies, the grandchild’s estate includes the trust.
For example, David and Martha each want to make $15,000 annual gifts to their 10 grandchildren. However, David and Martha do not want their grandchildren to actually receive the gifts outright until a grandchild attains the age of 40. David and Martha create 10 trusts, one for the benefit of each grandchild. Each trust provides that the grandchild can remove up to $15,000 of a contribution each year from each donor, only the grandchild may receive distributions of trust income or principal, and the grandchild’s estate must include anything remaining in the trust. David and Martha can make all of these gifts ($300,000) each year without consuming any of their exemption against generation-skipping taxes. If David and Martha make these gifts for 18 years, they will pass $5,400,000 to their grandchildren without paying any gift taxes, estate taxes or generation-skipping taxes.
Generation-skipping gifts work well to reduce taxation in the transfer of family wealth from one generation by skipping the gift and estate taxes at one or more generations.