Make more, save more. Whether helping clients build wealth or preserve it, financial advisors share a common goal: money in clients’ pockets, rather than Uncle Sam’s coffers.
While estate planning is a time-honored discipline that dovetails with this mission, strategies in the field evolve along with the tax climate and political landscape. Things have changed—so what’s the new frontier in estate planning of which financial advisors should be aware? The Generation-Skipping Transfer tax (GST).
GST is a second-layer tax typically imposed on asset transfers to grandchildren or any other generation beyond one’s children. Unlike the estate and gift tax exemption amounts, the GST exemption is non-portable, even between married couples, so it’s essential to plan for total deployment of the amount through a last will and testament, revocable living trust or with lifetime gifts.
The effective rate of GST—called the “applicable rate”—is determined by multiplying the “inclusion ratio,” which essentially is the percentage of the property to which GST exemption has not been allocated, by the maximum federal estate tax rate (currently 40 percent).
For example, an individual transfers $750,000 to a trust for her descendants and allocates $250,000 of GST exemption to the trust. As a result, $500,000 of the $750,000 transferred to the trust (or two-thirds of the trust—the inclusion ratio) isn’t shielded from GST tax. A trust wholly protected from the tax by allocation of GST exemption has an inclusion ratio of zero. A trust not at all protected has an inclusion ratio of one, resulting in tax of 26.7 percent on that transfer.
Back in 1976, Congress set its sights on the perceived abuse of using trusts to benefit multiple generations while avoiding federal estate tax at each level of descent. Previously, assets in trust weren’t subject to estate tax at the federal level, which allowed an enormous amount of wealth to move down generations and grow in an asset-protected, tax-free environment. In 1986, the law was repealed, and a new version (the current version) of the GST law was, ultimately, enacted.
In 2001, Congress passed new tax laws that brought about the dawn of automatic allocation, giving the IRS the power to automatically allocate GST exemption to annual exclusion gifts made to certain types of trusts (of note, one can only opt out of future automatic allocation, but not retroactively for previous gifts made). If the use of GST exemption isn’t tracked, it might be assumed that the full GST exemption amount is waiting to be utilized when, in reality, less is available because of automatic allocation. Whereas certain transfers, such as tuition paid directly to the education institution and medical care paid directly to the healthcare provider, aren’t subject to GST tax, gifts made to a life insurance trust that isn’t included in the estate of a child upon the child’s death to cover premium payments will have GST automatically allocated. Since the proceeds of any policy owned by the trust don’t normally pass to a so-called “skip generation” and, generally, are used to provide liquidity to cover immediate expenses, as well as to assist in paying estate taxes, the GST exemption amount is wasted on such transfers.
In order to preserve one’s GST exemption for larger lifetime transfers that may experience significant growth off the balance sheet, gift tax returns should be filed for annual exclusion gifts in trust. No tax will be due, but the opportunity to control allocation of the GST exemption will be afforded, maximizing the potential for tax-efficient wealth transfers to grandchildren and generations beyond.
At the end of 2012, the American Taxpayer Relief Act (ATRA) updated GST legislation, and the IRS clarified trust implications, issuing private letter ruling PLR-107217-13. As a result, the GST, estate and gift tax exemption amounts are now unified at $5.34 million for 2014, and modified trusts are allowed to preserve the GST tax exemption (however, President Obama has publicly stated his intent to reduce the exemption amount to $3.5 million by the end of his term).
Despite the complexities, you can help clients maximize their GST exemption, often in ways that are already familiar. Irrevocable life insurance trusts (ILIT) and annual exclusion gift trusts, both estate planning staples, are examples of common strategies that impact the availability of GST exemption due to the automatic allocation rules. Filing an annual gift tax return and not electing to deploy GST exemption on the transfer for small gifts preserves the exemption for larger lifetime transfers.
Our advice for accountants filing gift tax returns? Read a copy of the trust agreement and have a discussion with the client’s estate planning firm to understand the intended deployment of the GST exemption. Maintain your clients’ trust by avoiding problems in the first place and preventing the need to fix those problems at a greater cost down the road.
Using the same map for the new frontier will ensure that estate planners and investment professionals alike arrive at client satisfaction. When approached about transferring wealth to grandchildren, don’t hesitate to reach out and collaborate with the estate-planning attorney to best navigate the GST tax.
John O. McManus is the founding principal of the tri-state area law firm McManus and Associates.