Knowing the basic rules of the Generation-Skipping Transfer (GST) tax will help reduce or even eliminate the impact of this tax. The GST tax is an often overlooked consideration when large amounts of life insurance are used in an estate planning situation.
As you read through the following, please bear in mind that the GST rules will apply to many (if not most) life insurance trusts.
The definition of a GST transfer of property is defined as an individual who is two or more generations below that of the transferor. This individual is known as a skip person. The grandchild is the most common example of a skip person; however, skip persons can include great-grandchildren, grand-nieces/nephews and even non-relatives who are more than 37 1/2 years younger than the transferor. In addition, a trust established solely for the benefit of such individuals would also be considered a skip person.
The danger with the GST tax in a life insurance trust comes about when the trust has grandchildren or other skip persons as beneficiaries. It doesn’t matter if the trust is irrevocable, or that life insurance proceeds may be excluded from the deceased estate. Three examples of GSTs that could produce a taxable distribution are as follows:
The first is a distribution of income or principal from a trust to a skip person.
Example: An Irrevocable Life Insurance Trust established for the benefit of the grantor’s daughter and grandchildren. Gifts to the trust are not GSTs, nor are distributions from the trust to the grantor’s daughter. But any distributions to the grandchildren will be subject to the GST tax.
Second, a taxable termination occurs when the interest held by non-skip persons (children) terminates, so that only skip-persons (grandchildren) are beneficiaries.
Example: Using the same example as above, at the daughter’s death the only trust beneficiaries are the grandchildren. This then creates a taxable termination and a GST has occurred.
Third, a direct skip is a transfer to a skip person subject to an estate or gift tax.
Example: The grandparent makes an outright gift of property to a grandchild. If the grandchild’s parent is alive, this will be a direct skip, subject to the GST tax in addition to the gift tax. On the other hand if the grandchild’s parent is not alive, the grandchild “steps up” to the parents generation thus doing away with the direct skip.
Direct skips within the $10,000 annual gift exclusion are exempt from GST tax.
However, gifts to a GST trust, such as gifts of life insurance premiums to an Irrevocable Life Insurance Trust with grandchildren as beneficiaries, are not exempt from the GST tax. They may however, be eligible for the $10,000 gift tax exclusion.
The next rule to remember is that the use of a Crummey clause does not exempt a life insurance trust from the GST tax. Many life insurance trusts utilize the Crummey provisions so that gifts of premium to the trust will qualify for the $10,000 annual gift tax exclusion.
Since March 31, 1988 gifts to a GST trust are no longer protected from the GST tax; even though they may qualify as a present interest gift under the Crummey provision and are eligible for the $10,000 annual gift tax exclusion.
Gifts under the annual exclusion, by themselves, will not protect the trust from a GST tax. In order to protect the trust, it is necessary to use the GST tax exemption.
A third rule to remember is that each individual is entitled to a $1 million GST tax exemption. An excellent way to leverage the exemption is by using life insurance. The tax payer must allocate the exemption by filing a timely gift tax return each time a gift of premium is made to the trust.
It is important to remember that the GST tax is imposed in addition to any estate or gift tax that may be due on a transfer to a grandchild or other skip person. The GST tax will be imposed on the net amount of the transfer after any estate or gift tax has been paid. The GST tax is imposed at the maximum federal estate tax rate, in effect at the time of the transfer.
Example: Grandfather, who is in the maximum federal estate tax bracket, makes a $1,000,000 bequest to a grandchild in 1993. He has already used up his GST tax exemption on prior transfers. The bequest is subject to $500,000 of estate tax, resulting in a net transfer of $500,000 to the grandchild. The GST tax, also of 50 percent, is imposed on the net transfer, resulting in an additional GST tax of $250,000 and an ultimate transfer to the grandchild of only $250,000 from the original $1,000,000 gift.
The key to using your GST exemption and maximizing your leverage is to have each individual make GST’s of one million dollars without being subject to the GST tax. If all of the transfers to a GST trust fall within the exemption, all distributions from the trust will be exempt, regardless of the trust value at the time the GST is made.
Life insurance is an excellent way to leverage the use of the one million GST exemption. The exemption can be allocated to the premium and not the death proceeds, if planned carefully.
By filing a timely return and using the GST exemption at the time the gift of premium is made, it is possible to exclude all of the life insurance proceeds paid to the trust, making them exemption from the GST tax when they are ultimately distributed to the grandchildren. This is due to the fact that a timely return has been filed and the exemption is based on the value of the property at the time it is transferred to the trust, not at the time it is distributed.
Example: Grandfather and grandmother transfer $100,000 dollars annually to a trust for the benefit of their children and grandchildren. The transfer is used to pay premiums on a $4,000,000 Second to Die Life Insurance Policy covering the grandparents ‘lives. Since their children are alive, the transfer is not immediately subject to the GST tax. However, any distributions from the trust to the grandchildren would be GST’s.
In order to avoid paying the GST at that time, the grandparents will file a timely tax return when the gifts are made. On the return they will allocate $50,000 of their $1,000,000 GST exemption. By doing this each year a gift is made and as long as the total premiums do not exceed the $1,000,000 exemption, the entire trust will be exempt from GST tax at the time of the distribution.
If the grandparents did not allocate their GST exemption against the $100,000 premium at the time of the transfer, the exemption would have to be applied at the time of the distribution to the grandchildren, based on the value of the distribution at that time. Thus, the amount to be allocated would be the full amount of the distribution or as much as $4,000,000. Since this would exceed the GST exemption, GST tax would then have to be paid at that time.
Effective GST planning with life insurance will maximize each $1,000,000 GST exemption. To do so the transferor will need to file a timely GST tax return each year a gift of premium is made to the trust. As you can see, instead of being able to only transfer $1,000,0000, the grandparents will have been able to transfer as much as $3,000,000 extra, thereby leveraging their GST exemption by 100 percent.