Have you heard of a Generation Skipping Trust before? Have you been told that it’s a trust that will cut out your children from your inheritance and leave everything to your grandchildren? That’s what the name sounds like, but this isn’t exactly true. It’s a common misunderstanding. So what is a Generation Skipping Trust?
A Generation Skipping Trust is a trust that we sometimes refer to as a Dynasty Trust or a Legacy Trust because it is designed to leave a legacy that will protect your assets for your family line including your children, grandchildren, and more remote descendants. That sounds fancy, right? The big secret is: You don’t have to be a multi-millionaire to enjoy the benefits of a Generation Skipping Trust. And you certainly don’t have to disinherit your children either.
To understand why we call it a Generation Skipping Trust, we have to first understand the various Transfer Taxes collected by the IRS. These are the Estate Tax, the Gift Tax, and the Generation Skipping Transfer Tax.
Estate Tax: This is the tax imposed on our assets after we pass away. If you are wealthy enough, your estate must pay 40% to the IRS and from 5% to 16% to the State of Hawaii Department of Taxation. Thankfully there are a few exemptions and deductions. There is an exemption this year for the first $5,430,000 of your estate ($5M adjusted for inflation each year) that is not subject to tax. The exemption for Non-US Citizen, Non-Residents is only $60,000. For those of you with more than this amount, we have many techniques to legally reduce and sometimes even eliminate this tax completely. However, most of our clients do not have more than $5,430,000 in total assets when they pass away so the Estate Tax isn’t their biggest concern.
Gift Tax: After creating the modern Estate Tax system in 1916, creative lawyers figured out that their wealthy clients could avoid the Estate Tax completely simply by giving away all of their assets during the client’s lifetime tax free. So, in 1932 Congress created the Gift Tax to prevent this from happening. As of now, you can give away $14,000 each year ($10,000 adjusted for inflation) to as many people as you want without incurring a gift tax. If you give away more than $14,000 in any year to a child, grandchild, friend, or anyone else, you start to use up your $5,430,000 Estate Tax Exemption and apply a portion of it to the gifts you make during your lifetime. There are certain exceptions for gifts to a spouse, charitable organization, tuition payments, and/or medical expenses.
Generation Skipping Transfer Tax: After the creation of the 1932 Gift Tax, creative lawyers came up with new strategies to legally shelter some of the assets of wealthy clients. Instead of leaving Grandpa’s inheritance to his children directly, they created trusts that would hold Grandpa’s assets after his death, and pay out the income from the trust to his sons and daughters each year to live on—but not actually give out the trust principal (assets) to the sons’ and daughters’ possession. So, when the children passed away, they didn’t actually own Grandpa’s assets—the trust did—and they didn’t have to pay any estate tax on Grandpa’s assets at their deaths. The trusts could eventually give all the assets to the grandchildren, or it could just pay income to them as well and finally pay out the principal to great-grandchildren or later generations. This was a big loophole as it meant that large estates could theoretically only be taxed once instead of at every generation! So, with the Tax Reform Act of 1976, Congress created rules to prevent this from happening. These rules were ultimately replaced in 1986 to establish the current Generation Skipping Transfer Tax, which, in addition to the Estate Tax, taxes any transfers to a person two generations below you (or if not a family member, someone 37½ years younger than you), whether directly or through a trust. There are a bunch of complicated rules relating to the Generation Skipping Transfer Tax. However, for people who have less than $5,430,000 is assets, there is an exemption—similar to the one for the Estate and Gift Tax.
How to Benefit: This exemption provides us with a HUGE planning opportunity to put up to $5,430,000 of your assets into a Dynasty trust at your death with no Estate Tax and no Generation Skipping Transfer Tax. This Dynasty trust can provide for your children so that your children could use up the entire inheritance if necessary, but whatever they don’t use can be protected from their creditors, divorces, and from their own estate taxes. Even if they invest your inheritance wisely and grow your assets to multiple millions—or hundreds of millions—of dollars, the assets in your trust can continue to be exempt from Estate and Generation Skipping Taxes, and can be protected against your beneficiaries’ divorces and creditors forever. These assets stay in trust after your children’s deaths if they haven’t used it all up, and the assets are available to provide for your grandchildren, great-grandchildren, or theoretically continue forever as long as your beneficiaries haven’t used up all of the assets.
You don’t have to be a multi-millionaire to benefit from a Dynasty Trust. One national expert I spoke to recommends this type of trust to every client who has at least $100,000 to leave to each beneficiary to protect them from divorces and creditors even if they won’t have an estate tax.
OKURA & ASSOCIATES, 2015
Honolulu Office (808) 593-8885
Hilo Office (808) 935-3344
Ethan R. Okura received his Doctor of Jurisprudence Degree from Columbia University in 2002. He specializes in Estate Planning to protect assets from nursing home costs, probate, estate taxes, and creditors.
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This column is for general information only. The facts of your case may change the advice given. Do not rely on the information in this column without consulting an estate planning specialist.
© OKURA & ASSOCIATES, 2015