Cannon Financial Institute

Generation Skipping without Skipping a Generation

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Generation skipping transfer tax can be confusing. I get it. But understanding generation skipping enables another level of planning that can save families millions, even billions of dollars. And generation skipping is actually simpler than most people realize, and it does not even involve skipping a generation.

Let’s take a quick tour from the start. Generation skipping transfer tax is a “transfer tax” as its name states explicitly. So “generation skipping” is about skipping a tax, not skipping people or leaving people out of the plan. My spouse can be a beneficiary of my generation skipping trust, as can my children. This is one of the most frequent misunderstandings that I run across with generation skipping transfers. Another is that these trusts are perpetual, which can be true, but is not a requirement, it just enhances the potential benefits. Likewise people often mistakenly believe that a generation skipping trust, since it is irrevocable is thus inflexible, and thus unable to adjust to the changing needs of future generations. Finally, generation skipping transfer tax is often perceived as expensive, when actually it is cheaper to generation skip, at least for the first $5 million or so. And after that, the tax is the same as the estate tax. Why so many misunderstandings? Well, there is a lot of history here, but let’s just say that understanding generation skipping transfer tax and taking advantage of it can dramatically enhance a client’s estate planning. It is not our objective here to teach the law, just to understand how to take advantage of it.

Virtually all irrevocable trusts have the possibility of skipping a generation.  This is simply due to the fact that in any irrevocable trust with standard beneficiary language like “issue per stirpes” creates the possibility that the assets will pass further down the family tree than one generation. As a result, whether generation skipping is intended or not, it can occur, and so the executor or trustee should be aware of and take advantage of it, even when not intended or planned for. Sadly, many non-professional trustees and executors are not advised or aware enough to catch what could happen, as opposed to what was explicitly stated. But beyond the constant possibility of an accidental skip, there is reason to plan to skip, on purpose, in virtually every family estate plan. Let’s discuss why that is.

Irrevocable trusts can make the income and assets of the trust available to the beneficiaries of the trust and yet, with proper planning, the beneficiary will not be treated as the “owner” of the trust. This results in a fundamental layer of both creditor protection and estate tax protection that can be very powerful. Imagine a few family scenarios in which this may be desirable.

  • In a second marriage, the first spouse to die desires to leave any monies not needed by the surviving spouse to their children of a prior marriage
  • When one’s children are enjoying financial success and may not need the inheritance it can be available to them in an emergency, but pass with less taxes to the next generation if not needed
  • If children are in professions or positions that may draw claims of liability, to have their inheritance asset protected
  • If children were to get divorced to keep the inheritance from being split as an asset of the child
  • If children may not be able to handle the money due to disabilities, addictions, poor choices, etc.

Note that none of these has some greater objective to pass assets down multiple generations, but enables that to happen where appropriate. By taking advantage of the generation skipping transfer tax exemption, a well designed plan fully funded (about $5million) could save over $2 million. So what is the trade-off? How restrictive does the trust have to be in order to not treat the beneficiary as the owner of the trust? Here is the maximum amount of access the beneficiary can have and still not be treated as owner of the undistributed assets of the trust. First, they may have access to any or all of the Income of the trust for any reason. Having the right to income does not make you the owner of the underlying assets. Second, the beneficiaries can have as much, or all of, the Principal (assets) as they need. Some sort of “filter” has to be in place to determine that need, usually one of three things: language that defines the reasons permitted for distribution (ex. health, education, support), approval of an adverse party, or use of an independent trustee (i.e. a corporate trustee). Third, the beneficiaries can be given to adjust the rights and interests of the future beneficiaries, for example, cutting out a wayward grandchild or increasing the share of a grandchild subject to a disability. This last power must be done within a predefined class of beneficiaries, but can be very broad, such as “among my descendants”. I think we can agree that, while being subject to these powers is not the same as receiving the money outright, that the powers combined can appear quite generous and yet restrictive enough to provide the Creditor protection and estate tax protection desired.

A particular type of marital trust has risen to prominence in this area as well: the QTIP (Qualified Terminable Interest Property) trust. QTIP trusts are particularly useful in our new era of portability of the estate tax exemption between spouses, and carry the added advantage that they can be likewise used to claim the generation skipping transfer tax exemption of the first spouse, which is not portable, while still delaying the portability decision until the death of the first spouse.

Client Summary: So as you can see, the generation skipping transfer tax exemption is worth pursuing if it can still give an acceptable level of access to your beneficiaries, and provide the creditor protection and estate tax protection benefits worth potentially millions of dollars in savings. Often misunderstood due to the name of the tax, generation skipping definitely does NOT have to involve skipping a generation. See your estate planning professional to see how designing your estate plan to take full advantage of the generation skipping transfer tax may benefit you.

Advisor Summary: So as we see, the generation skipping transfer tax exemption is worth pursuing for our clients if it can still give an acceptable level of access to their chosen beneficiaries, and provide the creditor protection and estate tax protection benefits worth potentially millions of dollars in savings. Often misunderstood due to the name of the tax, generation skipping definitely does NOT have to involve skipping a generation. Make it a point to consider which clients may benefit from the estate tax protection and asset protection benefits to heirs of a generation skipping arrangement.

To learn more about this topic, register for our Generation Skipping Transfer Tax Workshop.

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