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For many people, estate planning focuses on minimizing gift and estate taxes and maximizing the property ultimately passing to a spouse and children. But the transfer-tax system includes a third tax — the generation-skipping transfer tax — which is imposed on gratuitous transfers to or for the benefit of grandchildren or more remote descendants. And this GST tax is potentially the most expensive federal transfer tax in effect. Consequently, failure to plan for the GST tax can lead to substantial taxes upon gifts to grandchildren or upon the death of a child or grandchild. Conversely, proper planning for the GST tax provides an opportunity to pass property to children, grandchildren, and even great-grandchildren without the imposition of tax at each generation. BASICS OF THE TAX The GST tax is, in general, imposed on transfers that skip a generation without being subject to the gift or estate tax. The simplest example would be a gift to a grandchild or to a trust for the sole benefit of a grandchild. Such a “direct skip” transfer would be subject to both the gift tax and the GST tax because there was no transfer tax imposed at the intervening generation. The GST tax is also imposed in more subtle situations. For instance, assume a father creates a trust under his will that provides that income will be payable to his daughter during her life, and on her death, the trust property will be distributed to her children (that is, the father’s grandchildren). If the trust is drafted properly (so that the daughter does not have too much control over the distribution of the trust property), the trust assets will not be included in the daughter’s estate for tax purposes. The GST tax, however, will be imposed on the trust property at the daughter’s death because the trust property will pass to the grandchildren without imposing a tax at her generation. This GST tax could be imposed decades after the initial creation and funding of the trust at the father’s death. The GST Exemption: Everyone has an exemption from the GST tax available that can be allocated to property, making it exempt from the GST tax. The exemption was originally $1 million and, before 2004, was indexed for inflation. In 2004, the GST exemption was set to equal the current federal estate-tax exemption. This amount is $2 million through 2008 and is set to increase to $3.5 million in 2009. For 2006, therefore, a mother can establish a trust, either during life or at death, and fund it with $2 million. The trust could be for the benefit of her children during their lives and then for her grandchildren for their lives, with a remainder to her great-grandchildren. She will pay either a gift tax (if the trust is funded during life) or an estate tax (if the trust is created under her will and she does not have her full $2 million estate-tax exemption available). If the mother’s entire GST exemption is properly allocated to the trust (on a timely filed gift- or estate-tax return), however, the trust would be exempt from the GST tax. If properly drafted, it would also avoid the estate tax at the death of the children and grandchildren, regardless of any subsequent appreciation in the value of the trust property. Rate of GST Tax: The GST tax is a flat tax. The tax rate imposed on a generation-skipping transfer is a function of the highest federal estate-tax rate in effect at the date of the transfer (the rate is currently 45 percent) and the amount, if any, of the GST exemption of the donor or the decedent allocated to the transfer. By allocating the GST exemption to a trust, an “inclusion ratio” is derived. For example, by timely allocating $900,000 of the donor’s GST exemption to a $900,000 gift made to a new trust, an inclusion ratio of 0 is derived and the trust is fully exempt from the GST tax, regardless of any subsequent appreciation in the trust’s value. If $450,000 of the donor’s GST exemption is allocated, an inclusion ratio of 0.5 will be derived, and the tax rate imposed on any GST from the trust will be 22.5 percent (one-half of the 45 percent maximum federal estate-tax rate). Similarly, if no GST exemption were allocated to the trust, the trust would have an inclusion ratio of 1, and distributions from the trust to a grandchild would be subject to a flat 45 percent GST tax. Thus, the key to ensuring that a trust for the benefit of children and grandchildren is not subject to the GST tax is to allocate timely an amount of the GST exemption to the trust equal to the value of the property transferred to the trust. PLANNING FOR EXEMPTIONS Importance of Reviewing Wills and Revocable Trusts: If the assets of an individual taxpayer or a couple will not exceed $2 million (after estate taxes) at her death or, in the case of a couple, at the death of the surviving spouse, the assets will be covered by the GST exemption even without a change in the taxpayer’s estate-planning documents (if the taxpayer or couple have not used the GST exemption during life). If the total assets of a couple are worth between $2 million and $4 million (after estate taxes) at the death of the surviving spouse, all of the assets can be exempt from the GST tax, but only if the couple’s wills or revocable trusts are drafted with this tax in mind and their assets are titled correctly. So if the taxpayer’s or couple’s total assets exceed $2 million (after estate taxes) or the value of the available GST exemption, it is important to analyze their estate-planning instruments. Because the $2 million GST exemption is not freely transferable between spouses, it is important to ensure that each spouse has adequate assets in his or her sole name (or in his or her revocable trust) to use their respective GST exemptions, regardless of order of death. Finally, it might be desirable to leave more property to children and not to skip directly to the grandchildren once the $2 million exemption is used. Efficient Allocation of the GST Exemption: One of the goals of GST planning is to try to allocate GST exemption to derive an inclusion ratio of 0 for an irrevocable trust containing assets that will appreciate. If the exemption is timely allocated to the trust, the trust will remain exempt from the GST tax, regardless of the amount of the appreciation that occurs in the trust property. The benefit of such an arrangement can be maximized by having the trust continue for as long as allowable under state law so that the transfer tax can be avoided for multiple generations. Because many states have repealed the rule against perpetuities, GST-exempt trusts in those jurisdictions can continue without a time limit. Careful Allocation of the GST Exemption: The GST exemption is allocated to lifetime gifts on a federal gift-tax return and to transfers at death on the decedent’s federal estate-tax return. The rules for effective allocation of a donor’s or decedent’s GST exemption are complex, and such allocations should be made only with competent legal or accounting advice. Further, under certain circumstances, the Internal Revenue Code automatically allocates the GST exemption to a transfer unless a timely election is made. Care must be taken, because under some circumstances, such an allocation is not desirable. Use of Gift Tax Exemptions: Each person is allowed to give $12,000 in “annual exclusion” gifts each year to an unlimited number of beneficiaries, as long as the gift is of a present interest in property. Further, if a married couple files gift-tax returns consenting to “gift split” (that is, have the gifts made by one spouse be treated as being made one-half by each spouse), a total of $24,000 can be transferred by the spouses, even though they used only one spouse’s property. Outright gifts to grandchildren that qualify for the annual exclusion are also exempt from the GST tax, without the need to allocate the GST exemption. On the other hand, a transfer in trust that qualifies for the $12,000 annual exclusion will, in most cases, still require allocation of the GST exemption to ensure that the tax does not apply. Careful planning is required to determine whether the GST exemption needs to be allocated to such a trust. Protect Grandfathered Instruments: Generation-skipping transfers under instruments that were irrevocable on Sept. 25, 1985, are generally exempt from the GST tax to the extent that the transfers are made from property that was placed in the trust by that date. Further, if generation-skipping transfers occur under a will or a revocable trust that was executed before Oct. 22, 1986, and if the testator died before Jan. 1, 1987, all generation-skipping transfers under the will or trust are exempt from the GST tax. To preserve this grandfathering protection, it is critical that no property be added to and no amendments are made to such trusts. The GST tax, imposed at a flat 45 percent, is the most expensive federal transfer tax currently in effect. The availability of a $2 million exemption provides an opportunity to make substantial transfers for the ultimate benefit of grandchildren and more remote descendants free of the tax. Planning to take maximum advantage of the GST exemption, however, involves integration of a lifetime-gifting program and estate-planning documents.
Douglas L. Siegler and Lloyd Leva Plaine are partners in the Washington, D.C., office of Sutherland Asbill & Brennan, where they specialize in individual tax planning.

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