Although the federal estate tax is back for 2011 and beyond, the 2010 Tax Relief Act includes several favorable estate and gift tax changes, at least for two years. But there’s yet another estate-planning concern for wealthy individuals.
Strategy: Don’t forget about the generation-skipping tax (GST). This tax applies to most transfers that “skip” a generation or two or three. If you don’t address the GST, your heirs could be walking into a major tax disaster.
Fortunately, you can dodge adverse tax results with some planning.
Here’s the whole story: Under the 2010 Tax Relief Act, the federal estate tax exemption is $5 million for 2011 and 2012 (indexed for inflation in 2012), with a top tax rate of 35%. The exemption is scheduled to revert to $1 million with a top tax rate of 55% in 2013. Exemptions between spouses are “portable,” meaning an unused exemption amount can be used by a surviving spouse’s estate. In addition, the new law reunifies the estate tax exemption with the lifetime gift tax exemption.
As with the estate tax exemption, the GST exemption for 2011 and 2012 is also $5 million (indexed for inflation in 2012) with a flat tax rate of 35%. But the GST exemptions aren’t portable between spouses. Furthermore, the exemption is scheduled to drop to $1,380,000 in 2013 with a tax rate of 55%.
The GST applies to both “direct” and indirect” transfers to descendants such as your grandchildren, your great-grandchildren and so on. In other words, these transfers bypass your immediate offspring, your children.
1. Direct transfers: This refers to gifts or other transfers that go right into the hands of a grandchild or to a trust with a single grandchild named as the sole beneficiary. The transfer may be either a lifetime gift or a testamentary transfer by will.
2. Indirect transfers: An indirect transfer includes those made to a trust where grandchildren are named as the contingent beneficiaries or the primary beneficiaries of the trust with your child or children. As with direct transfers, indirect transfers can be made during your lifetime or by a bequest upon your death.
With the generous $5 million exemption in place for 2011 and 2012, you might easily avoid GST problems on direct transfers.
However, if you’re not careful, the GST could whack unsuspecting heirs when indirect transfers occur years from now.
Example: Let’s say you have $5 million in assets. In 2011, you transfer $3 million to a trust and name your sole child as the primary beneficiary. After your child dies, the remaining assets will be split evenly among the child’s three children (your grandkids), the contingent beneficiaries. Under the lifetime gift tax exclusion of $5 million for 2011, the entire transfer is sheltered from gift tax. And there’s no GST to worry about ... at least not yet.
However, suppose when your child dies years from now, the assets have grown to $15 million. Even without knowing the GST exemption amount and tax rate in the future, it’s sure to cost the grandchildren millions of dollars. Worst of all, this tax catastrophe could have been easily avoided.
All you have to do is allocate $3 million of your $5 million GST exemption at the time of the transfer. As a result, there will be zero GST tax when your grandchildren inherit the $15 million in assets.
The allocation is made on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. Your tax pro can provide any assistance you need.
Tip: A similar allocation for bequests can made by your executor on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.
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