GST Planning Without the Smoke and Mirrors: Benefits and Opportunities for Many Clients Overlooked by Their Estate Planners *
© Keith Schiller, 1996.
Schofield & Schiller
Walnut Creek, California
This article was published in BNA's
"Estates, Gift and Trust Journal"
May/June, 1996.
Why is it that estate planners, particularly accountants and attorneys, routinely recommend the credit shelter trust which utilizes the $600,000 exemption equivalent in order to save estate tax when the surviving spouse dies, but refuse to consider extended use of the exemption planning to this next exemption for other than the most Wealthy client? That next exemption is the $1,000,000 generation skipping transfer (GST) tax exemption 1 - which provides an enormous benefit to many of the estate planner's clients, not just the most wealthy ones..
Take away all of the "smoke and mirrors" 2 and the GST exemption is little more than a next (or subsequent) extension of the estate tax exemption. Attorneys, accountants, financial planners of- the broadest spectrum and even over-the-counter software programs include the estate tax credit shelter, trust as normal practice for clients with even mid-six-figure estates. Yet these same practitioners will largely, ignore the GST exemption in the design of living trusts or wills unless presented with a client with an estate of $2 million or more. That perspective is shortsighted - for the client as well as the estate planner.
During the past two years I regularly, have asked accountants at the California CPA Foundation courses I instruct, "At what net worth for your clients do you begin to consider generation skipping transfer tax planning as part of the estate planning equation?" 3 Overwhelmingly, the great plurality (approximately 40%) of the response from those who even consider GST planning is that they consider it for a client with a threshold net worth of about $2 million and a majority of the remaining replies use even higher amounts. Many accountants do not consider GST planning at all. Either approach is shortsighted for clients as well as for the CPA. GST tax planning can greatly benefit clients and their families with much smaller net worth than the perceived $2 million planning floor-from both a tax and nontax standpoint.
GST PLANNING OPPORTUNITIES LOST
Consider the following example:
Harry (age 60) and Sally (age 55) married when they were ages 26 and 21, respectively. They have two children, Bill (age 33) and Jane (age 30), and one or more grandchildren. By actuarial terms, Sally will likely be the surviving spouse and live 12 years beyond the death of Harry. Bill, being 22 years younger than his mother, will likely outlive her by 15 years and Jane will likely outlive Sally by 25 years (owing to the seven-year shortened- life expectancy attributed to males). Therefore, Harry's credit shelter trust would be expected to last 12 years, and, a trust for the benefit of the children will remain an additional 15 years to 25 years, based on life expectancy of Bill and Jane.
Then why do practitioners embrace the exemption equivalent trust for the spouse yet run from the exemption trust for the children?
Perhaps the answer lies in issues of control? Or is it simply that the estate planning culture has not caught up to broad-based GST planning? Is it a sense that there are not real tax savings to -be achieved? Or is it lack of professional comfort with this highly technical area of law fraught with special rules - "reverse QTIP elections,"- "estate tax inclusion period" (ETIP), "inclusion ratio," "skip persons," - "taxable terminations," "taxable distributions," "special Crummey trust considerations," "exempt" and "non-exempt" marital trusts and the like?
This article is designed to debunk the myths clouding GST planning as a valuable planning tool, to show its great benefit to a broad base of clients, and to raise awareness of the tremendous marketing and client development potential inherent with this extended exemption planning. The focus in this article is not, per se, on the most wealthy client or on concepts of "Megatrusts," "Dynasty Trusts," or strategies-to fine-tune GST planning with the most sophisticated leveraging techniques possible. Instead, the thrust is the forgotten mainstream of the upper middle class. These clients are ignored by their accountants, attorneys and estate planning advisors from consideration and application of the benefits of the GST exemption. As a result, these families are deprived of the opportunity to exploit extended exemption planning.
THE "NET" TRUST
Rather than calling a trust that lasts the lifetime of the child and avoids estate tax on the death of the child a "generation skipping transfer tax exemption trust," would it help to call it a N ext E xemption T rust (or a "NET Trust")? It certainly sounds better and avoids a belief that the benefits of the trust skip the child's generation. They do not. Only, the transfer tax is skipped. Instead, more of the family's valuable assets escape tax and stay with the family - within its "net" worth. Moreover, the GST exemption is the next exemption available chronologically in estate planning after the unified credit exemption.
Estate Tax Savings
GST exemption planning is vital so that more property passes to the grandchildren -or other remote beneficiaries with minimized tax. The use of the $1,000,000 GST exemption is central to that tax savings. The exemption for mid-wealth clients who will not be making large lifetime gifts can be most easily used as part of assets passing under the living trust or will. The GST exempt trust is not subject to. estate tax on the death of the child or other beneficiary, regardless of the growth or inflation in that trust after the death of the parent-transferor. 4
Appendix I illustrates the tax savings that result on the death of a child when one or both parents utilize various amounts of the GST exemption. The amount of exemption available may vary as a result of lifetime taxable gifts as well as from the fact that the client may not have enough net worth to utilize fully the maximum exemption. If distribution is made outright to the child, the assets are added to the child's gross estate, subject to estate tax on the child's death. As Appendix I reveals, a single parent with a $400,000 net worth can achieve an estate tax savings of $153,000, or more, on the death of the child, through the use of GST exemption planning - using the NET Trust. In the situation of a married couple who undertake GST planning, the tax savings potential grows significantly where the net worth exceeds $1 million. In any event, substantial savings result even when the estate of the parent (or parents) is less than $1 million. That savings will likely increase because the growth and inflation in the exemption trust will not be subject to estate tax on the death of the child.
So, what is the "cost" of using the GST exemption? Is it lack of control for the children? While that may be an emotional answer, is it logical? Consider our initial example. The parents, Harry and Sally, were perfectly willing to provide a credit shelter trust for the other spouse to save estate tax on the death of the survivor to help the children. While there may be nontax reasons as well for a trust ( e.g. , asset management or subsequent marriage concerns) the credit shelter trust is used overwhelmingly from a tax standpoint in lieu of outright bequests to the spouse to save estate tax on the death of the surviving spouse. Why do clients reflexively use the exemption trust with the spouse but do not use an exemption 'trust. in the distribution to children? Let's consider the most likely obstacle - control.
To lend perspective to the control issue, consider the rights and benefits that the surviving spouse may receive, and is' routinely given, in a credit shelter trust when control by the surviving spouse is desired. Keep in mind that a child or other beneficiary to whom outright distribution would be preferred but for estate tax can receive all of these rights and benefits in NET trust as well. First, the surviving spouse 'can be the sole trustee. That gives the spouse power over management, investment and general administration Second, the surviving spouse can receive all of the net income from the trust. Third, the surviving spouse car have the right to withdraw principal from -the trust under an ascertainable standard, such as, "health education, support and maintenance." 5 And fourth, if that is not enough, the surviving spouse can also have a limited power of appointment exercisable on death That power can be narrowly drawn (such as' only in favor of issue) or broadly drawn (such as in favor o anyone except the surviving spouse or his or he estate, creditors, or creditors of the estate). 6 When meeting with clients, I call this the "Thanksgiving Day Dinner Power" because it prevents the children from taking the surviving spouse for granted. 7 It keeps them coming around at least on holidays and being attentive - in the event motivation is important. With this bundle of rights, the surviving spouse has virtual control; and, the children would be very reluctant to challenge the surviving parent in connection with the administration of the trust. After all, they could be disinherited - not only from this trust but from the surviving spouse's own assets as well.
The foregoing rights and benefits, or some part of them, have been very well received by surviving spouses since 1982 (and before) in order to achieve estate tax savings. The difference between outright ownership and the bundle of rights just enunciated are minor, almost nonexistent in a practical sense. 8 When viewed in relation to the estate- tax savings, clients, including clients with high mid-size estates (net worth in the "mid sixes"), overwhelmingly embrace credit shelter trusts for the surviving spouse. As Appendix I demonstrates, these same clients can garner substantial estate tax savings on the death of their children by extending exemption planning to the next generation.
Credit shelter trusts pervade the estate planning culture, and, in the case of Harry and Sally, the "bypass trust" may be, expected to last for about 12 years. The NET Trust - exploiting the $1 million GST exemption - extends the use of exemption planning to the next generation. In our Harry and Sally example, the GST exemption trust based on the life expectancies of the son and daughter will likely last another 15 to 25 years.
If the parents are inclined to making outright distribution to the children and are only considering a trust for tax purposes, each child could have his or her own trust. Each child would be able to enjoy the same powers and bundle of rights that the surviving spouse enjoyed - including the limited power of appointment - so that the child cannot be taken for granted.
A tax consideration which can mitigate against use of the- GST exemption is the carryover basis that applies to assets on the death of the' child for those assets that are not included in the gross estate of the child. 9 In situations in which the capital gains tax arising from the difference between the fair market value of the assets and the adjusted basis is greater than the estate tax would be if the assets are included in the estate of the child or other beneficiary, then use of the GST exemption trust may not save money. Of course, tax-deferred exchanges that can avoid recognition of income as well as the likelihood that significant appreciation in the asset will create a higher estate than income tax in any event should offset this consideration in most mid-wealth estates.
Nontax Benefits
So far, the focus of this article has only been on the tax savings benefits of the NET Trust. 'There are powerful nontax reasons as well to distribute assets to children 'in trust as opposed to outright. Primary among them, even for the most responsible child, is the fact that the marriages of one-half of the children will end in divorce. Distribution in trust makes much easier the tracing of the separate property of the inheritance than would outright ownership, which can be more easily commingled with marital property. In community property states, this ease of tracing can be extremely important.
Second, trusts can provide additional creditor protection for the beneficiary-child. State law should be consulted on the effect of "spendthrift clauses" and the rights and protections afforded beneficiaries. 10 Given the uncertainty of the economy, layoffs, as well as the potential for uninsured losses in a highly litigious society, the extended trust can retain assets within the child-beneficiary's "net."
Flexibility is one of the great qualities of GST exemption planning. Consider the following true-life estate planning example:
A wealthy client (a doctor named Marilyn) had an elderly mother (Elizabeth) who had a net worth of about $800,000. Elizabeth also had a son (Richard) who is a school teacher of modest circumstances. Elizabeth loved both her children. Richard much preferred outright distribution, even with estate taxes taken into account. Marilyn, on the other hand, wanted to save estate tax on her death (about $200,000 or more) while enjoying the benefits of the inheritance and the controls that an exemption trust offered. As a result, Elizabeth's living trust was changed so that Marilyn's share went into a GST exemption trust (our NET Trust) and Richard's share passed outright. Marilyn, by the way, paid for the estate planning and the estate planner ended up with Elizabeth as a new client. (In this situation, the planner should take special care to explain any conflicts the representation may involve.)
If control is not ofprimary concern, the clients can increase the flexibility of a trust through accumulation or sprinkling powers. In order to avoid an inadvertent general power of appointment under §2041 or inadvertently becoming subject to the income tax grantor trust rules, a third-party or independent trustee may be necessary, depending upon the powers and discretion permitted in the trust instrument. 11
From the standpoint of the estate planner - accountant or attorney - seeking to expand his or her practice, GST exemption planning offers an excellent opportunity. First, it serves the interests of many clients - far more than is considered in ordinary practice. Second, it provides the accountant the opportunity to prepare fiduciary income tax returns for many more years (and possibility decades) beyond the term of the estate tax credit trust alone. Third, it provides the opportunity to attract new clients. Practitioners who shun GST planning from lack of comfort will lose clients to those who stay current. 12 Moreover, GST related discussions often include considerations of the plans of family members in older or younger generations. Perhaps, those family members will need assistance as well.
Appendix II provides a sample introduction letter to clients to explain the $1,000,000 GST exemption, its use on death, and its relationship to extended exemption trusts. The letter encourages further discussion between the client and estate planner.
CONCLUSION
Whether called by any other name, the GST exemption trust provides a valuable estate tax savings opportunity - not only for the most wealthy clients, but for many of your good mainstream clients. The tax savings revealed in Appendix I plus the additional savings generated from untaxed growth and inflation are treasured benefits that should not fall through the family's estate and financial planning net.
* © 1996. Schofield & Schiller;
1. §2631. All section references are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder, unless otherwise indicated. If the decedent made lifetime gifts subject to the GST tax system, these gifts may reduce the amount of the $1 million GST exemption. Rules respecting use of the §2503(b) $10,000 annual exclusion, special requirements on lifetime gifts in trust for "skip persons" in relation to the annual exclusion and transfers which may or may not affect the $1 million exemption may influence how much of the exemption is available on death. Gift planning, which is not the subject of othis article, provides additional opportunities to reduce estate tax on the death of the child as well as on the death of the parent-donor.
2. On December 27, 1995, the IRS published final GST Regulations T.D. 8644, 60 Fed. Reg. 66898 (12/27/95). Discussion of these regulations, which present considerable important technical considerations ( i.e. , smoke and mirrors) is beyond the intended scope of this article.
3. This question was posed to over 1,000 certified public accountants in the last two years in the courses of Estate Planning for the Wealthy Client and Using Trust with Income and Estate Planning. Accountants who were in practice before 1976 recalled using trusts which were not subject to estate tax on the death of the child as a more routine approach to estate planning. That routine evidently ceased with the enactment of the first GST tax in 1976, later repealed retroactively when the 1986 GST tax was added to the Code. To illustrate, the 1965 edition of "California Will Drafting" published by the California Continuing Education of the Bar includes a trust that would escape estate tax on the death of the child-beneficiary among its standard types of trusts and clauses.
4. If a surviving spouse is the beneficiary and the GST exemption is allocated to a QTIP trust, that trust will be subject to estate tax on the death of the surviving spouse. §2044. In those situations, consideration should be given to making a reverse QTIP election (to be certain that all of the deceased spouse's exemption is used to the extent available), keeping only GST exempt property in that marital trust, and directing that estate tax arising from the GST exempt marital trust on the death of the surviving spouse be paid from nonexempt assets. §2652.
5. §2041 (b)( 1 )(A); Regs. §20.2041-1 (c)(2).
6. §2041(b)(I).
7. "How much sharper than a serpent's tooth it is to have a thankless child." King Lear , Act I, Scene V.
8. In the event the enumerated rights and powers are not sufficient, the beneficiary can also be given a so-called "five or five" noncumulative annual withdrawal power under §2041(b)(2). The potential additional estate tax effect of this power would be to subject up to 5% of the value of the exemption trust to estate tax on the 'death of the beneficiary.
9. §§1014 and 2654(a)(1); Regs. §1.1014-2.
10. In California, for example, see Probate Code §§15,300 et seq. for the statutory rights of creditors to enforce recovery against a beneficiary debtor, the obligations of trustees and the beneficiary protection and distribution rights.
11. §§671-678.
12. For example, the IRS published final regulations on December 27, 1995, but technical corrections are expected in the near future.
APPENDIX I
Estimated Tax Savings on Death of Child Arising With Use of $1 Million GST Exemption
Unmarried Parent or Estates Where Husband and Wife Do Not Have Similar Beneficiaries (such as children from different marriages)
| Amount Net of Estate Tax Distributed to Child from Parent's Estate | Child's Estate Exclusive of Inheritance From Parent's Estate | Estate Tax on Child's Death on Estate Child Inherits from Parent | Additional Sum Grandchild Receives with GST Exempt Trust |
| --------------- | --------------- | -------------------- | --------------- |
| $400,000 | $600,000 | $153,000 (38.25%) | $153,000 |
| $600,000 | $400,000 | $153,000 (25.5%) | $153,000 |
| $1,000,000 | $250,000 | $255,500 (25.5%) | $255,500 |
| $1,000,000 | $500,000 | $363,000 (36.3%) | $363,000 |
| $1,000,000 | $1,000,000 | $435,000 (43.5%) | $435,000 |
| $2,000,000 | $600,000 | $886,000 (44.3%) | $478,000 |
| $2,000,000 | $2,000,000 | $1,060,000 (53%) | $550,000 |
GST Exemption Used for Married Couple with Common Plan for Distribution
| Amount Net of Estate Tax Distributed to Child from Parent's Estate | Child's Estate Exclusive of Inheritance From Parent's Estate | Estate Tax on Child's Death on Estate Child Inherits from Parent | Additional Sum Grandchild Receives with GST Exempt Trust |
| --------------- | --------------- | -------------------- | --------------- |
| $400,000 | $600,000 | $153,000 (38.25%) | $153,000 |
| $600,000 | $400,000 | $153,000 (25.5%) | $153,000 |
| $1,000,000 | $250,000 | $255,500 (25.5%) | $255,500 |
| $1,000,000 | $500,000 | $363,000 (36.3%) | $363,000 |
| $1,000,000 | $1,000,000 | $435,000 (43.5%) | $435,000 |
| $2,000,000 | $600,000 | $886,000 (44.3%) | $886,000 |
| $2,000,000 | $1,000,000 | $945,000 (47.25%) | $945,000 |
| $2,000,000 | $2,000,000 | $1,060,000 (53%) | $1,060,000 |
Notes:
-
The column "Additional Sum Grandchild Receives with GST Exempt Trust" represents estate tax savings based on existing rates with assets from parent otherwise added to estate of the child.
-
Additional estate tax savings can result from appreciation in the GST Exemption Trust which is not taxed when the child dies.
-
When the child's estate is augmented by $2 million from the parent(s), the grandchild receives a greater sum when the parents have a common plan for distribution because two $1 million GST exemptions are available.
Appendix II
Introduction Letter to Client for GST Planning
Re: Generations of Estate Tax Savings
Dear ________________________________:
The estate tax has been called the "most unfair" of all taxes because it is imposed against your estate on which you have already paid income tax: The IRS imposes an estate tax between 37% and 55% on estates valued over $600,000. I would like to review how you can reduce or eliminate estate tax that will arise on your child's death on property you leave to your child.
Property on your death left outright to your child is added to all of the other assets in the child's estate. That inheritance, plus the growth and inflation after your death, will again be taxed at rates between 37% and 55%. In fact, if your estate and that of your children are taxed at maximum estate tax rates, the IRS will receive 80% of your estate after it has gone through two generations of estate taxation! The tax savings can be considered with even more modest estates. For example, if a parent with a net worth of $500,000 (including life insurance) leaves that property to a child who has a net worth of $1 million, there could be an estate tax of $225,000 or more on that inheritance when the child dies. A parent with an estate of $600,000 and a leaving property outright to child(ren) (each) with an estate of $400,000 will cause $153,000 or more to be sliced off the inheritance of the grandchildren. That tax can be avoided. I am enclosing for you an illustrative chart on estate tax after being charged through two generations of a family. For example, with a parental estate of $__________ and a child's estate of $__________, the basic transfer tax savings is approximately $__________. The savings will be even larger if the trust assets grow in value after your death. [ Practitioner: Insert figures from the chart that are close to that of your addressees. ] Therefore, your children receive benefits but the estate tax bypasses their deaths.
You can successfully reduce or eliminate the estate tax on your child's death from property your child inherits through the use of your Generation Skipping Transfer Tax (GST) exemption. This exemption can eliminate estate tax on the death of your children, grandchildren and other loved ones on $1 million of asset value on your death PLUS all of the inflation and growth on that exempt property on the death of your children and possibly other beneficiaries as well. Action is needed in your estate planning to take advantage of this savings. It extends to the children and later generations the same tax savings principal most of our clients already use with their $600,000 credit shelter trust for a surviving spouse. In other words, it extends exemption benefits to the "next" generation(s). Consider use of your GST exemption as a type of "Next Exemption Trust" - the next one to follow use of your estate tax exemption. It does not save any extra tax on your death or death of your spouse. It can, however, save tremendous amounts of estate taxes when your children die.
For example, rather than leaving property outright to a child, consider leaving your child's share of your GST exemption in trust. Your child could have control over the trust as the trustee. The child could receive all of the net income from the trust, and, in addition, principal for health, education, support and maintenance needs. In addition, the child could have a power to direct distribution of whatever remains in the trust on the death of the child according to workable guidelines you establish. If that power is not exercised, the trust would go as you direct. This formula is only an example. This extended exemption that can be designed to meet your wishes in many ways.
In addition, this extended exemption trust can help your child protect assets from creditors. The trust can be a valuable aide in keeping separate property distinguished from community property; and, reduce litigation in the event of a divorce over what is or is not community property. With 50% of all marriages ending in divorce, this benefit may be important to your loved ones.
The letter provides a summary of one use for your GST exemption. If you would like to keep more of your estate within your family for succeeding generations, please, call me to review fully the use of your GST exemption and other tax-savings approaches.
|
Very truly yours, Your Concerned Accountant/Attorney |
