If you ask most people, they can easily tell you the names of their grandparents, and in some cases, their great-grandparents. But it might surprise you how many people do NOT know the names of their great-great-grandparents or generations older than that. However, if your great-great-grandparents had left you millions of dollars in trust, it is much more likely that you would remember (fondly) their names! But it’s difficult to leave large sums of wealth to generations beyond your own children without generating unreasonable levels of taxation.
Any transfers you make to your grandchildren (or generations younger than your grandchildren), whether during your lifetime or at your death, may be subject to the generation skipping transfer tax (“GST Tax”). The GST Tax differs from the estate and gift tax in that the GST Tax is taxed at a flat rate at the highest marginal estate and gift tax rate. The estate and gift tax are taxed at graduating rates. Therefore, it is almost always more favorable to pay an estate tax than it is to pay a GST Tax. Moreover, a transfer to your grandchildren will not escape any gift tax that may apply to the transfer (as indicated, gift tax applies on gifts in excess of the gift tax exemption). Thus, you could end up paying both a GST Tax and a gift tax on the same transfer.
The reason there is a GST Tax is so that the IRS can collect a transfer tax at each generational level. For example, when you make a gift to your grandchild, the property gifted will escape estate tax when your child (your grandchild’s parent) dies. In order to make up for this lost revenue and assure taxation at each generational level, Congress enacted the GST Tax.
The good news is that each individual is required to pay a GST Tax on transfers to grandchildren only to the extent the transfers exceed the GST Tax exemption. In 2016, like the applicable exclusion for the estate tax, the GST Tax exemption will exempt up to $5.45 Million of property from the GST Tax. Therefore, there is no GST Tax unless you transfer more than $5.45 Million to your grandchildren, great-grandchildren, or younger generations. The GST Tax exemption will apply to both lifetime transfers and to transfers at death. So, if you’ve made $450,000 in lifetime gifts to your grandchildren, you can use your remaining unused GST Tax exemption to exempt up to $5 Million in property passing to your grandchildren at your death. With proper planning, married couples can exempt up to $10.90 Million in lifetime and death transfers from GST Tax in 2016 ($5.45 Million X 2).
You can utilize your GST Tax exemption to plan for several generations and build enormous wealth. This type of planning is known as Dynasty Planning. The concept of Dynasty Planning is to pass the maximum amount of wealth possible to your grandchildren and subsequent generations in a Dynasty Trust without subjecting the transfer to the GST Tax. In so doing, you can exempt the trust property from future GST and Estate taxation. Allocating your GST Tax exemption to the Dynasty Trust for your grandchildren will cause the trusts to be exempt from GST Tax. Since wealth that is not taxed grows much faster than wealth that is taxed, the property transferred to a Dynasty trust will accumulate and grow more rapidly than wealth transferred outright.
There is no question that Dynasty Planning can account for enormous growth in wealth over several generations. And using this tool, you are likely to be remembered not only by your great-great-grandchildren, but by generations beyond!