The estate tax system assumes that assets are inherited by one generation and then the next, and are taxed upon the death of each succeeding generation. In the past, one way wealthy families avoided estate taxes was by passing on assets directly to grandchildren or great-grandchildren, thereby minimizing the number of times assets were subject to estate taxes. In order to prevent this practice, a special generation skipping tax is imposed whenever assets are passed down more than one generation at a time. The tax is at the highest marginal estate tax rate (40% in 2015) and is in addition to the normal estate tax. However, every individual is granted an aggregate $5,430,000 (in 2015, increased in future years for inflation) lifetime exemption from the generation skipping tax. This means they can pass on a total of $5,430,000 to grandchildren or great-grandchildren without incurring the generation skipping tax.
This exemption is often used with larger estates where children already have sufficient assets to provide for all of their anticipated needs. If the children inherited additional assets, those assets would probably never be needed or used by the children during their lifetimes and would ultimately pass through the children’s estate to the grandchildren. The assets would be subject to estate taxes in both the parents and the children’s estates.
To avoid this, each of the parents at their death can pass on the lifetime exemption amount directly to their grandchildren, thereby preventing the assets from being taxed in the children’s estates, and the transfers will not be subject to the generation skipping tax. However, the assets will still be subject to tax as part of the parent’s estate.
This can be done by each of the parents making direct bequests totaling the lifetime exemption amount to their grandchildren. Or, the parents can establish irrevocable trusts providing that the children have the right to all income from the trusts while they are alive, with the principal passing to the grandchildren upon the children’s death. The bequests can also be incorporated into marital deduction or by-pass trusts.
We at Bingham, Osborn & Scarborough, LLC (BOS), are ready to work with clients, their attorneys and tax professionals on the merits and specifics of these and other investment and financial planning options. For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by BOS, please visit our website at www.bosinvest.com.
Updated July 2015
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