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Generation Skipping Trusts

Before the Tax Reform Act of 1976, taxpayers attempted to create trusts to successively skip the estates of children and grandchildren, thereby not subjecting the trust assets to federal estate taxes for several generations.

To prevent such skipping, a new tax was created in 1976 called the generation-skipping trust tax. In 1986 that tax was repealed retroactively and replaced by a similar tax called the generation-skipping transfer tax.

The generation-skipping transfer tax may not be imposed by (1) placing the property in a trust that is exempt from the generation-skipping tax or (2) causing the trust property to be taxed in the trust beneficiary’s estate for estate tax purposes, thereby obtaining the exemption from tax of the unified credit amount. The first solution is limited to the amount of the generation-skipping exemption for each donor (approximately $11,400,000 in 2019). The second solution is achieved by giving the beneficiary a general power of appointment over the trust property, that is, a right to give the trust property on the beneficiary’s death to anyone the beneficiary chooses.

Gifts to Generation-Skipping Trusts may be made during lifetime or at death.

Characteristics

The Generation-Skipping Trust often provides as follows:

  1. The child for whom the trust is held acts as trustee of their own trust, when they reach a designated age of maturity.
  2. The income of the trust is accumulated and added to principal.
  3. The accumulated income and the principal of the trust may be distributed to the child for whom the trust is established for that child’s health, maintenance, support, and education.
  4. The child has the right to use any residence in the trust rent-free.
  5. The child has a special power of appointment allowing them to designate the beneficiaries of the trust on their death.
  6. If the special power of appointment is not used, the remainder of the trust will be distributed to the child’s descendants, if any, and, if none, then to their parents’ other descendants.
  7. The donor/parents can choose how the income tax burden of the trust will be borne. If a “non-grant-or” form is elected, then the income earned by the trust is typically taxed to either the trust or to the beneficiary. If the “grantor” trust design is selected, then the income earned by the trust is taxed to the donor/parents on their own income tax returns, even though the income remains in the trust.

Advantages

  1. The children retain virtually full control of their trusts during their lifetimes.
  2. None of the assets of the Generation-Skipping Trust are includable in the estate of the child on their death and pass free of estate tax and generation-skipping tax to their children or designated beneficiaries.
  3. The assets of the trust are the separate property of the child and are not as readily commingled with their spouse’s assets.
  4. There is some degree of creditor protection associated with having the property in the trust rather than owned outright.
  5. If the “grantor” trust design is selected, there is a financial benefit to the trust and the donee/child without the parents incurring a gift tax.

Disadvantages

  1. The attorney’s fees for drafting the trust are more expensive than those associated with outright gifts to the child.
  2. There is the additional administrative burden of operating the trust and perhaps preparing accountings.
  3. If the non-grantor design is selected, there is an additional administrative burden of annual income tax returns for the trust and the tax brackets for trusts may result in a high income tax rate for the trust.
  4. If the grantor design is selected, the income tax paid by the parents may be at a higher rate than would have been paid by the trust or the beneficiary, depending upon circumstances. In addition, the amount of income tax payable by the parents may be larger than expected.

B|O|S maintains an estate planning glossary that further defines many of the terms used in this memo. If  you wish to receive a copy of the glossary, please contact your a member of your wealth management team.

Updated February 2019

Disclosure:

This white paper is for informational purposes only and is not intended to be used as a general guide to investing or financial planning, or as a source of any specific recommendations, and makes no implied or express recommendations concerning the manner in which any individual’s account should or would be handled, as appropriate investment strategies depend upon the individual’s specific objectives. It is the responsibility of any person or persons in possession of this material to inform himself or herself of and to seek appropriate advice regarding any investment or financial planning decisions, legal requirements, and taxation regulations which might be relevant to the topic of this white paper or the subscription, purchase, holding, exchange, redemption or disposal of any investments.

The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed and inherent in any investment is the potential for loss.

This white paper does not constitute a solicitation in any jurisdiction in which such a solicitation is unlawful or to any person to whom it is unlawful. Moreover, this white paper neither constitutes an offer to enter into an investment agreement with the recipient nor an invitation to respond by making an offer to enter into an investment agreement.

Opinions expressed are current opinions as of the date appearing in this material only and are subject to change. No part of this material may, without the prior written consent of Bingham, Osborn & Scarborough, LLC, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

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