I’m guessing your estate plan eventually leaves all of your hard-earned wealth to your children in one form or another. Unless, of course, you’re someone who drives around with the bumper sticker “I’m out spending all of my children’s inheritance!” There’s nothing wrong with that of course.
When you leave amounts in continuing trusts for your children, whatever is left in those trusts upon your children’s deaths may end up benefiting your grandchildren. In that case, the trusts are usually drafted to consume something known as your “generation skipping transfer tax exemption.” When a trust is generation skipping transfer tax (GSTT) exempt, it will never be estate-taxed again, even if it grows to enormous sums and continues on for generations.
Note that in my example the children weren’t skipped as beneficiaries. The GSTT exemption speaks to a “tax shield” covering the assets in the trust such that as each generation passes away, the federal government cannot impose an estate tax. Think about the Kennedy family compound in Hyannisport or the Bush family compound in Kennebunkport. Both have been with their respective families for generations and likely have great value. The reason those compounds remain within the families is because they are likely held in generation skipping tax exempt trusts.
To understand what the generation skipping tax is, you first have to understand that it is a “transfer tax” like the gift and estate tax. You may be aware of your approximately $11 million federal estate tax exemption. You can leave that large of an estate to anyone of your choosing without the imposition of federal estate tax. That estate tax is a tax on your balance sheet at the time of your death. It is a tax on the net equity that you possess. It has nothing to do with income taxes.
If you make a taxable gift during your lifetime, generally defined as a future interest gift or a present interest gift, in excess of $15,000 to any beneficiary during a calendar year, then you decrease your total transfer (gift and estate) tax exemption from that $11 million amount. So if I make a taxable gift of $100,000 during 2017, then I have $5.39 million of exemption remaining upon my death.
The generation skipping transfer tax is an additional tax imposed on top of the estate tax. It is imposed on either direct skips or skips in trust that either terminate or distribute to a beneficiary more than one generation below you (grandchildren being the most prominent example). Back in 1976, Congress noticed attorneys leaving amounts in continuing trusts for many generations, so they added the GSTT in an effort to limit the amount of assets that could be placed in continuing trusts without those assets ever being subject to estate tax again.
The GSTT is imposed at the highest estate tax rate (currently 40%) after the estate tax has been calculated. The exemption is the same amount as the federal estate tax (currently $5.49 million).
So if I have neither estate tax exemption remaining nor any GSTT exemption remaining at my death, and my estate bequeaths $1 million to my grandchildren, then the first 40% ($400,000.00) pays the estate tax leaving $600,000.00. Since that $600,000 is designated to my grandchildren, assuming that I have already consumed all of my GSTT exemption, then another 40% GSTT is applied ($240,000.00), leaving my estate with a net amount of $360,000.00 of the original $1 million for my grandchildren. So you can see how the GSTT is extremely punitive in nature.
The concluding thoughts about all of this is that you would generally want to leave amounts in continuing GSTT exempt trusts for your children to the extent possible. Those trusts serve to protect the inheritance from creditors, predators and divorcing spouses. They can even be drafted to give the child control as trustee of his or her own trust share.
If you have an estate large enough that would trigger GSTT, if you left it either in trust or otherwise that would eventually distribute to or for the benefit of that next generation below your children’s, then you want to do something to make sure that those non-exempt amounts are included in your children’s estate for estate tax purposes. That way no GSTT would be due to the government.
This can be accomplished any number of ways. One is to have an outright distribution to your children of the amounts that would not be exempt from GSTT. The other is to include the trust amounts in your children’s estates by giving them something known as a “general power of appointment.” There are also “intentionally defective general powers of appointment” that you could use that serve to limit the class of beneficiaries that could end up with the trust funds.