This is the first of a series of Articles about the Generation Skipping Tax, one of the more complex taxes that most people will come up against and which is often overlooked in Estate Planning. The goal is to introduce the non-practitioner to the concepts of the Generation Skipping Tax so the planning options and techniques which we will explore together will make more sense. I find that some clients have avoided estate planning techniques which would save their families potentially millions of dollars, because they are uncomfortable with their understanding of the taxes being discussed. My hope is that after reading these articles my clients will have a working knowledge of the Generation Skipping Tax and, with as much enthusiasm a non-tax geek can have, embrace planning techniques that help reduce or even avoid the Generation Skipping Tax.
My first professor in the NYU Law School LLM tax program was a famous Estate Planning attorney who could have stepped right out from central casting; a tall, handsome, distinguished man, old enough to have seen it all but young enough to still be a charming addition to your Upper East Side cocktail party. He held himself with a quite reserve that convinced you that he knew all the estate planning answers, or for that matter, the answer to whatever question was being discussed.
His course was a general introduction to Estate Planning, and I, a lowly Lieutenant in the U.S. Navy JAG Corp who had bluffed my way into the NYU tax program, would hang on his every word. As the course progressed we finally made our way through the syllabus to an introduction to the Generation Skipping Tax. He stood before the class and said (I paraphrase) “The Generation Skipping Tax, or GST Tax, is a tax created to prevent the wealthy from passing large amounts of assets to their grandchildren in an attempt to avoid the Estate Tax when their already-rich children die”. My pencil was moving frantically to write down these pearls, so imagine my surprise when his next sentence was, “I don’t understand this tax, in fact I think there are only 2 or 3 people in New York that understand it, and I refer all my clients with GST issues to them. It will not be on the test.”
As my education continued, I began to understand my professor’s comment. Fully understanding the GST Tax takes dedication, hard work and a strange fascination with complex rules and regulations. That being said, what does a client who wishes to reduce or avoid the tax, but not necessarily live and breath the tax, need to know?
What is the Generation Skipping Tax?
First, think of the GST tax as two things; a Transfer Tax and a Loophole Closing Tax.
Transfer Tax: The Generation Skipping Tax is a tax on the transfer of assets from one person to another person. The person receiving the gift is called a “Skip Person”, which means a person who is at least two generations below the gift-giver’s generation. A typical scenario is a gift from a grandparent to a grandchild. The grandchild is a “skip person” to his grandparent. Another typical estate planning scenario is if a grandparent forms a trust only for his grandchildren and transfers money into that trust. Because all potential beneficiaries of the trust are Skip Persons, the transfer to the trust is also subject to the GST.
Loophole Closing Tax: I find that any tax makes more sense when you understand why it was created. Think of the GST as a loophole closing tax. Congress first created the Estate Tax, which is a transfer tax on the value of assets owned by a deceased on the date of death that pass to someone else. Once the Estate Tax was created, clever estate planning lawyers advised their clients to transfer assets to children before their deaths. If the gift was made before death, then the client didn’t own it at death and would avoid the transfer tax. Clever, but congress saw that loophole and created a Gift Tax aimed at taxing the gifts that were made to avoid the Estate Tax. With one loophole closed, quick thinking estate planning attorneys than advised their clients to leave their fortunes to grandchildren, “skipping” their children. Why skip children? This estate planning technique worked when children already had plenty of money. If the parent died (Estate Tax #1) and gave money to the child, the child wouldn’t spend it but would then die (Estate Tax #2) and give it to the grandchild. By “skipping” the child at the first death and giving the fortune to the grandchild at the grandparent’s death, the family avoided the Estate Tax at the child’s death (Estate Tax #2 above). The tax could reach 55%, so you can see that by avoiding one generation of tax, the family could save huge sums.
Enter the Generation Skipping Tax.
As a loophole closing tax, the GST was not created to tax just any transfer to a grandchild, it was designed to only tax the transfers that were being made to avoid the Estate Tax and potentially the Gift Tax. But determining which transfers to tax and which to not tax was a complex matter. For example, who is a skip person? Congress had to decide if a skip person was to include only grandchildren or if a skip person also included great nephews or even non-family members that were the same age as a grandchild. For that matter, congress had to decide if they should include transfers from an 85 year-old man to his 30 year-old wife, who was younger than his grandchildren. They had to reason through other common estate planning transfers, such as in trusts, which benefit both children and grandchildren. The more questions, the more potential answers and the more complex the provisions of the Generation Skipping Tax became.
It took congress years to create and, in its first version was so complex that even dedicated tax-geeks could not understand its terms. The GST went back to the drawing board, was retooled, and returned to us in its present form. Its goal, to identify transfers to Skip Persons either during a person’s lifetime meant to avoid the Gift Tax or at death to avoid the Estate Tax and tax them in such a way that the gift-giver has a choice; pay a tax now, or just give the money to your child so it is in the child’s estate at death and doesn’t “skip” a generation (ie: pay the IRS now, or pay the IRS later). Most people prefer deferring taxes as long as possible, so the end result that congress was aiming for was to stop what they saw as transfers taken for tax avoidance.
Now you know in general terms what the Generation Tax is and why the Generation Skipping Tax exists. Do you want to know even more? If so, look for my following articles which will delve into even more detail. Perhaps you will even become a tax geek?