(This article appeared previously on Marketwatch.)
Leaving lots of money to grandchildren, and skipping the generation in between, used to be a nifty way to beat the federal estate tax.
That way, the money was subject to estate tax just once, when the grandparent left it to the grandchild. Otherwise, it would have been taxed when the grandparent left it to his child, and then again if that child preserved the money to pass along to his own children (the grandkids).
Eventually Uncle Sam realized he was being deprived of his second bite of the estate tax apple. And in 1986, the generation skipping transfer tax, or GST tax, was created. It makes sure the IRS gets that second bite after all.
(MORE: Yessir, That's My Grandbaby)
So even after you’ve set things up to take advantage of the various gift and estate tax loopholes, your job isn’t quite finished. You still have to take a step back and make sure you’ve successfully avoided the GST tax as well.
GST Tax Basics
If you have no intention of ever leaving any money or assets to your grandchildren, great-grandchildren or generations after, you can probably quit reading this article. The GST tax only hits wealth transfers to individuals more than one generation below you (such as grandkids and great grandkids). But beware, that can include wealth transfers to grandkids (or great grandkids) who happen to be primary or contingent beneficiaries to any trusts you create.
For example, say you set up a trust that names your adult son as the sole primary beneficiary. If he passes on before the trust fund is exhausted, the remaining money goes to your son’s children. In other words, your grandkids are contingent trust beneficiaries. Guess what? You have a potential GST tax problem, even though your grandchildren aren’t necessarily expected to actually get any of the trust money.
(MORE: Obamacare and Your Taxes)
Here’s the really bad part: When the GST tax kicks in, the rate is 40 percent. And this is over and above any gift or estate taxes on the same transaction. So we are talking about some absolutely horrific tax levels, because the gift and estate tax rate is also 40 percent. Piling the 40 percent GST tax on top is truly adding insult to injury.
Avoiding the GST Tax with Direct Gifts
You can also run afoul of the GST tax if you make direct gifts to your grandchildren (or great-grandchildren and beyond). Direct gifts are those that go straight into the hands of your grandchild or into a trust with a single grandchild named as the sole trust beneficiary.
However you have to be a really generous person before direct gifts will cause any GST tax problems. Why? Because you have a $5.43 million GST tax exemption for 2015. Your spouse has an exemption too. That means you and your spouse can together make up to $10.86 million in direct gifts to grandchildren and lower generations without any GST tax worries. Your GST tax exemption will shelter all your direct gifts until the exemption has been used up.
Here’s a way to cut your GST tax exposure through direct gifts. You and your spouse could each give up to $14,000 annually to each of your three grandchildren. This could be via outright gifts or gifts to Crummey trusts set up for each grandchild. Each grandchild must be the sole beneficiary of his or her Crummey trust. Under this arrangement, each grandchild can be given up to $28,000 each year without any GST tax or gift tax and without using up any of your $5.43 million GST tax exemption or any of your $5.43 million unified federal gift and estate tax exemption. That way, both you and your spouse can preserve your exemptions to shelter future gifts and bequests you intend to make under the terms of your wills.
You can also avoid both GST tax and gift tax issues when you make direct gifts to cover a grandchild’s tuition (not room and board or books) or medical expenses. These are a great wealth-transfer tools, because there is no limit on the amount you can give. For example, say you decide to pay your granddaughter’s $40,000 tuition to attend Duke University. As long as you make the payment directly to the school, no GST or gift taxes are due. And, if you wish, you can still make annual $14,000 tax-free gifts to your grandchild to cover other expenses.
Indirect Gifts are Trickier
A whole book could be written about how the GST tax can unexpectedly come into play when you make indirect gifts or bequests to trusts. But you probably wouldn’t want to read it. So here’s the gist.
By indirect gift or bequest, I mean when you give or leave money to a trust with your grandchildren named as contingent beneficiaries. Or when your grandchildren are primary beneficiaries of a trust, along with one or more other persons from an older generation. When money or assets come out of one of these multiple-beneficiary trusts to a grandchild, watch out! The GST tax will generally be due, unless you or your estate’s executor has affirmatively allocated (used up) some or all of your $5.43 million GST tax exemption to cover the initial gift.
For gifts, you make an affirmative exemption allocation on Form 709 (the federal gift tax return) filed for the year you make the gift. To make the GST-tax-saving allocation, you must file Form 709 even if you don’t actually owe any GST or gift taxes for that year. For bequests, your executor can make the allocation as part of handling the estate tax return.
Let me give you a very simple example of how an indirect gift can cause big-time GST tax problems.
Say you give $4 million worth of stock in 2015 to a trust set up for your adult daughter. She is to receive all the trust income for her life. Whatever’s left in the trust goes to her two children (your grandchildren) after she dies. So far, so good. There’s no gift tax, because your gift is well under the $5.43 million federal gift tax exemption. And there’s no current GST tax, because your grandkids are only contingent beneficiaries (they get nothing until your daughter passes away). So when you set up the trust, you fail to allocate any of your GST tax exemption to the gift because you don’t see any problems. Wrong! Years later when your daughter dies, the stock is worth $15 million. So the trust is liquidated, and your two grandchildren receive $7.5 million each. Unfortunately, they will have to pay a GST tax bill amounting to several million dollars. Why? Because they are treated as receiving a $7.5 million gift from you under the GST tax rules. Had you simply allocated $4 million of your GST tax exemption back when you funded the trust in 2015, there would be zero GST tax due when your grandchildren get their millions.
As you can see, the GST tax is a nasty trap for well-off but unwary individuals. And this area of the tax law is very unfavorable turf for do-it-yourselfers. I recommend consulting with a competent — make that very competent — tax adviser anytime you are thinking about doing anything that could conceivably benefit your grandchildren or great-grandchildren. You’ll spend some money on professional fees. Consider it a wise investment.
Bill Bischoff covers tax and retirement issues for MarketWatch.
Next Avenue Editors Also Recommend:
Next Avenue brings you stories that are inspiring and change lives. We know that because we hear it from our readers every single day. One reader says,
"Every time I read a post, I feel like I'm able to take a single, clear lesson away from it, which is why I think it's so great."
Your generous donation will help us continue to bring you the information you care about. What story will you help make possible?
This article is reprinted with permission from MarketWatch.com. © 2015 Dow, Jones & Co., Inc. All Rights Reserved.