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Don’t skip over generation-skipping tax

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in Small Business Tax,Small Business Tax Deduction Strategies

Although the American Taxpayer Relief Act (ATRA) finally resolved much of the uncertainty relating to federal gift and estate taxes, you’re not out of the woods quite yet.

Strategy: Plan ahead to avoid the generation-skipping tax (GST). This low-profile but potentially very expensive tax can hit wealth transfers that “skip” more than one generation.

Here’s the whole story: The federal gift and estate tax regime has undergone a long progression since the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).

EGTRRA gradually increased estate tax exemption amounts and decreased tax rates leading up to a one-year repeal for 2010. Following EGTRRA, the estate tax was reinstated and temporary legislation allowed a $5 million exemption for 2011 and 2012 (with future indexing), while lowering the tax rate to 35%.

Under ATRA, the unified federal gift and estate tax exemption was permanently set at $5 million (indexed to $5.25 million in 2013), while the tax rate is bumped up to 40%. In addition, exemptions between spouses are “portable,” meaning an unused exemption amount can be used by a surviving spouse or a surviving spouse’s estate.

As with the estate tax exemption, the GST exemption is also set at $5 million (indexed to $5.25 million in 2013). However, unlike the estate tax exemption, GST exemptions aren’t portable between spouses. That might lead to complications.

How the GST works

The GST applies to both “direct” and “indirect” transfers to descendants that are more than one generation below you—such as your grandchildren, your great-grandchildren and so on. These transfers bypass your immediate offspring, your children.

For instance, a transfer to a trust benefiting a grandchild is an indirect transfer.

With the generous $5.25 million exemption available in 2013, GST problems may be easily avoided on most direct transfers. However, the GST could whack unsuspecting heirs when indirect transfers occur years from now.

Example: In 2013, 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, the contingent beneficiaries. Under the lifetime gift tax exclusion of $5.25 million for 2013, the entire transfer is sheltered from gift tax. And there’s no GST to worry about ... at least not now.

However, suppose when your child dies years from now, the assets have grown to $15 million. No one knows for sure what the indexed GST exemption amount will be, but your grandchildren might owe millions in taxes.

All you have to do is allocate $3 million of your $5.25 million GST exemption to the transfer. As a result, the transfer is completely sheltered from the GST even if the transferred assets appreciate dramatically in future years to $15 million or more. Your grandkids are off the hook.

Tip: The allocation is made on Form 709, United States Gift (and Generation-Skipping Trans­­fer) Tax Return.

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