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Generation Skipping Tax & Dynasty Trusts

Generation Skipping Transfer Tax

In 1986 Congress passed a tax law which included enactment of the federal generation skipping transfer tax (GST). In a nutshell, the GST only permits an individual to pass a certain amount of money to someone more than one generation removed from him/her without incurring a tax on the transfer. The tax on the transfer is in addition to any estate tax that might have to be paid and is generally at the same rate as the estate tax rate. The purpose of the GST is to prevent individuals with large estates from escaping estate taxes by skipping generations.

The estate tax exemption is the amount that an individual can have in his or her estate at passing without paying federal estate tax. If that individual has used a portion of his or her gift tax exemption during life, then the estate tax exemption is reduced by the amount of the gift tax exemption used during life.

The GST exemption is the amount that can be passed, during life or at death, to a skipped generation without a GST tax. For example, a gift to a skipped generation would use gift tax exemption and GST exemption for the same dollars gifted. Similarly, a bequest to a skipped generation at death would use estate tax exemption and GST exemption on the same dollars bequeathed.

For 2016, the estate/gift tax exemption is $5.45 million per person ($10.9 million per couple), and the GST exemption is also $5.45 million per person ($10.9 million per couple). The gift tax, estate tax, and GST tax rates are 40% on amounts beyond the exemptions.

Planning to use the available GST exemption should always be considered. It offers the opportunity to save significant amounts of estate tax and thus preserve additional wealth within families.

Example: Illustration of Benefit of Using Available GST Exemption

Scenario #1: Parents have an estate of $10.9 million, with their entire estate after the payment of estate tax passing to Son. Son and daughter-in-law use their estate tax exemptions with their own assets and pass the inheritance from Parents to their child, Granddaughter.

Scenario #2: Parents have an estate of $10.9 million, with their entire estate after the payment of estate tax and GST tax passing to Granddaughter directly.

Scenario #1 Scenario #2
Parents’ Estate $10.9 million $10.9 million
Parents’ Estate Tax Exemption (and GST Exemption in #2) <$10.9 million> <$10.9 million>
Parents’ Taxable Estate 0 0
Estate Tax @ 35% 0 0
Inheritance from Parents to Son and Daughter-In-Law $10.9 million N/A
Son and Daughter-In-Law’s Estate $10.9 million N/A
Son and DIL’s Estate Tax Exemption (Used with other dollars) 0 N/A
Taxable Estate $10.9 million N/A
Estate Tax @ 40% $4.36 million N/A
Inheritance from Son to Granddaughter in #1 and from Parents to Granddaughter in #2 $6.54 million $10.9 million

Scenario #2 above assumes that Parents leave their entire estate to Granddaughter and bypass Son altogether. As an alternative, a Dynasty Trust could be used, as discussed below. The inheritance would be held in trust during Son’s lifetime and Son could receive income and principal from the Dynasty Trust as needed without the assets being included in Son’s estate. Granddaughter could then receive the assets of the Dynasty Trust on Son’s passing, or they could continue in trust for her lifetime as well.

Dynasty Trusts

A Dynasty Trust is a multiple generation-skipping transfer (GST) Trust designed to optimize the exemption from the GST tax. A Dynasty Trust holds assets in trust for the lifetimes of multiple generations. The income and principal from the trust can be distributed to members of the various generations. Estate tax or gift tax (or the use of exemptions) occurs at the creation of the Dynasty Trust, but the assets of the Dynasty Trust are not included in the estates of the members of the next generations so there is no estate tax at any of the next generations (until the trust terminates).

The income and principal from the trust can be distributed to the members of the various generations. Usually the assets of the Dynasty Trust are divided into separate shares for each beneficiary, but could also be administered as a single trust with multiple beneficiaries (called a pot trust). Each beneficiary or generation may also have the ability to decide if the Dynasty Trust should continue in the next generation or not, but would not have control to end the Dynasty Trust during his or her lifetime. The trust would terminate when one of the following occurs:

  1. There are no more beneficiaries of the trust living (all generations are deceased with no younger generations remaining)
  2. One beneficiary of a separate share (or all beneficiaries of a pot trust) elects to end the Dynasty Trust on his or her passing and distribute the assets to his or her children or grandchildren on his or her passing
  3. The Rule Against Perpetuities dictates that the trust terminate (In California the rule provides that trusts can last about 100 years before they must terminate. At that point, the assets will be distributed to the beneficiaries at the time of the termination or in some other way specified in the trust)
  4. The assets of the trust are exhausted

By John K. Bishop 2/19/11; updated in 2016

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