Estate Planning Opportunity Under the 2010 Tax Act

Estate Planning Opportunity Under the 2010 Tax Act

With the enactment on December 17, 2010 of the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” (“The 2010 Tax Act”), the wealthy and the relatively wealthy are presented with a unique but fleeting opportunity to take advantage of shifting their wealth at minimal tax cost. This opportunity involves avoiding the Generation-Skipping Transfer Tax, known as the “GST Tax.”

Generally, the GST Tax is to be avoided at all measures. It is imposed when a grandchild or a trust for a grandchild receives an inheritance or a gift. It is also imposed when a trust makes a distribution to a grandchild.  The GST Tax rate is equal to the highest estate tax rate. Without proper planning a single gift or inheritance could be exposed to both the GST Tax and either the gift or estate tax at the same time. When a trust is involved, it is also possible for the GST Tax to be triggered multiple times, even when there is no distribution.

The simplest way to avoid the GST Tax is to use “GST Exemption” which as a result of The 2010 Tax Act is now $5 million per person. But after 2012, Congress will have to act or else the GST Exemption will go down to slightly more than $1 million per person.

For the last eight years, the GST Tax rate hovered just under 50 percent.  For 2011 and 2012, as a result of The 2010 Tax Act, the GST Tax is 35 percent. For 2010, however, the GST Tax is zero percent. This zero percent rate presents a unique opportunity for the remainder of 2010.

1.    Large Gift to Grandchildren

If a large gift is made to a grandchild in 2010, there is no need to use any GST Exemption in order to avoid GST Tax because the rate is zero percent. Moreover, if grandparent has unused gift tax exemption, some or all of the gift tax would be avoided.  A large gift over $1 million would trigger gift tax. But as explained later, this may not be so bad.

If the large gift is delayed until after 2010, GST Exemption must be used to avoid the GST Tax.  On the other hand, grandparent’s gift tax exemption will increase to $5 million, less whatever exemption had previously been used, so a large gift in 2011 avoids gift tax unless the gift exceeds this new gift tax exemption.

2.    Large Gift to Trust

Another opportunity arises if the large gift is made to a trust. Under the tax rules, if only grandchildren are beneficiaries of a trust when the trust is created, the grandchild magically takes on the status of a child for purposes of future distributions from the trust. This is known as the “Move Down Rule” and avoids a GST Tax from being imposed on all future distributions to the grandchild, as there is no GST Tax on distributions to someone deemed to be a child. But despite the Move Down Rule, grandchild is still the grandchild for purposes of the funding of the trust, and so a GST Tax is triggered when a gift is made to the trust.

Ordinarily, when a gift is made to a trust for a grandchild, GST Exemption must be used to avoid a GST Tax. But for a gift in 2010, there is no need to use GST Exemption because the GST Tax rate is zero percent. Moreover, when distributions from this type of trust are made to a grandchild, there is no GST Tax because of the Move Down Rule. So if a trust is funded in 2010, between the current zero percent GST Tax rate and the Move Down Rule, the GST Tax is always avoided.

To make this type of planning even more appealing, it is possible to add children as beneficiaries after the trust is created, without affecting the Move Down Rule. So, if children are added at some future date, the children can receive distributions from the trust, and clearly these distributions will avoid GST Tax.

3.    Economics of a Gift in Trust

Consider a grandparent with a $24 million estate who has already fully used his gift tax exemption. He would like to gift $4 million to a trust for his child and grandchild, to be distributed when child dies. By establishing a trust now, for the sole benefit of grandchild, grandparent can take advantage of the Move Down Rule. In two years, child will be added as beneficiary, at which point the trust can benefit both child and grandchild.

If the gift is made in 2010, grandparent would make a taxable gift. But come 2011, his gift tax exemption (and importantly his estate tax exemption) would be restored to the new $4 million exemption. Because the GST Tax rate is zero percent this year, grandparent’s entire $5 million GST Exemption is preserved. Let’s say that in 25 years, child dies and grandchild receives the entire trust. At that time, there is no GST Tax.  The Move Down Rule treats this as a distribution to a child.

The benefit of making the gift in 2010 is twofold.  First, grandparent will preserve his entire GST Exemption, which can be used to further shelter taxes at death.  Second, grandparent will also have a significantly larger estate tax exemption at death.  The cost of making the gift in 2010 is the payment of gift tax. But paying gift tax now means the dollars use to pay the gift tax will not be subject to estate tax at death, if grandparent lives three years. The end result is that a larger size estate will pass to his family.

Compare the outcomes if grandparent, who has already used his existing $1 million gift tax exemption, has a $24 million estate.  If a $4 million gift is made now and grandparent dies in three years with a $20 million estate and the estate tax rate is 35 percent:

Paying gift tax now results in higher net wealth passing to the family because the gift tax is imposed on what the recipient received, whereas the estate tax is imposed on the entire estate before payment of the tax. 

What happens if estate tax rates return to 45 percent, as they were in 2007, 2008, and 2009?  The difference in results is even greater:

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