Skip a Generation of Estate Taxes

Most anybody that has wealth has heard the expression “generation skipping”. However, very few people truly understand what “generation skipping” means and its power to transfer wealth from one generation to another. Most people when they hear the concept falsely believe that “generation skipping” means when you die, you “skip” your children and pass the wealth to your grandchildren. If that version was true, this strategy isn’t going to be a pleasant one to explain to your kids. What “generation skipping” really means, is to “skip the IRS out of a generation worth of Estate Taxes”.

Basically, the IRS is very greedy. They want to assess an Estate Tax at each generation. When mom and dad die and pass wealth to the children, they want an Estate Tax. If a child dies the next day, the IRS wants another generation worth of Estate Taxes, and if a grandchild dies the very next day, they want a 3rd level of Estate Tax. All on the same wealth. I like to equate this greed of the IRS to “biting the apple”. The IRS will clearly get to bite the apple on the 1st generation of wealth. You have to use either your Gift/ Estate Exemption early to get growth and appreciation going in a Green Box to reduce or eliminate the Transfer Tax to Generation 1. But, with proper planning, that same wealth can now pass for 3 or 4 more generations without any further Gift/ Estate Tax or any further planning.

The Generation Skipping Tax is actually the 3rd member of the Federal Transfer Tax system. There is a transfer tax assessed at death passing wealth to a child. (this is called an Estate Tax) If there wasn’t a companion “Gift Tax”, then the Estate Tax would have no teeth. So, the Federal Gift Tax is the 2nd member of the Transfer Tax family. And the Gift Tax and the Estate Tax share the same Exemption. The IRS doesn’t care whether you use the Exemption while you are alive by gifting to a “Green Box”, or whether you use it when you die by transferring your assets into a “Green Box”. Although the Gift Tax and Estate Tax use the same Exemption, the smart client will prefer to use the Gift Exemption on a lifetime gift, rather than an Estate Tax at death. The reason for this is that using the Exemption now also removes future growth and appreciation from the Taxable Estate. For example, if a 50 year old client gives $10 million to a “Green Box” while he or she is alive, and that $10 million doubles every 10 years, then the Green Box has grown to $80 million by the time the client dies at age 80.

The Generation Skipping Tax is the 3rd member of the Transfer Tax system, and it has its own Federal Exemption. That Exemption amount is generally equal to the Federal Estate Tax Exemption, which is currently $13,600,000. The “GST Exemption” doesn’t reduce the amount of Estate Taxes that are owed when a client dies. But instead, it dictates the amount that can go into a Multi Generational Trust that won’t pay any Transfer Taxes for 500 years. (Arizona’s Rule Against Perpetuities) So, when you transfer wealth into a Green Box, during life, you allocate your Federal Gift/ Estate Exemption to that transfer to avoid the Gift Tax. And, if you transfer that wealth into a GST Trust, (multi-generational Trust) then you also allocate your Federal GST Exemption to that transfer. Now that Trust is free of any further Transfer Taxes from generation to generation for 500 years. We will call this multi-generational “Green Box” a “Blue Box”.

So, in the example above, when the client dies at age 80, the GST Trust has $80 million in it for the benefit of his or her children to live off of for their lifetime. (remember, GST doesn’t mean we are skipping the kids, we are skipping the IRS. The kids still get to use the economic benefit of the Trust during their lifetime) Now, lets assume that wealth continues to double every 10 years inside of this “Green/ Blue” box and the child (Generation 2) lives on that Trust 30 more years after the clients death (Generation 1) That means that when Generation 2 dies, and passes the wealth to Generation 3 that the wealth has grown to $640 million. Wow, that is powerful. And I promise you that these numbers are realistic. The nice thing about having practiced law for 40 years, I have experienced that growth with my clients and we are now working with Generation 3 on some of these Trusts. And I promise you that I have clients that have hundreds of millions in these GST Trusts.

So they say that “compound interest” is the 8th wonder of the world. I say that Generation Skipping is the 9th wonder of the world.

Now, lets take that same 50 year old client that doesn’t set up a GST Trust, and dies with an Estate of $80 million, and for discussion, lets just assume that the Federal Exemption for Estate Taxes is $10 million to make my math easier. So, when client dies, $70million is subject to a 40% tax, a 40% “haircut”. So, Generation 2 inherits $52 million. And that child dies a day later and so that $52 million is subject to Estate Taxes again. (the 2nd bite of the apple) Using again a $10 million Exemption, that leaves $42million subject to a 40% Estate Tax. That shrinks the inheritance to Generation 3 by another $16,800,000. The wealth is down to $35,200,000. Wow, we are going the wrong way. This client isn’t getting the benefit of either the 8th wonder of the world or the 9th wonder of the world.

If your Estate Planning lawyer is not talking to you about “generation skipping planning”, then you have the wrong lawyer. You have a lawyer that understands mainstream Estate Planning for the masses. Not a lawyer that understands Estate Planning for the wealthy. As I have said in many other articles, there is a big difference in planning for the wealthy client rather than planning for the masses. Someone who brags that they have done thousands of Trusts is not the right lawyer for you. You want someone who can talk about the number of wealthy clients that they have.

Why is “generation skipping” such a mystery to most lawyers? I can think of a couple of good reasons. First, as previously mentioned, that lawyer doesn’t encounter it that often because that lawyer’s client only has an average net worth of maybe $2million to $3million. That smaller client doesn’t need this multi-generational planning. And, Second, GST Planning is extremely complex with lots of ways to “stub your toe”. It’s not worth the average Estate Planning lawyer’s time to try to study and keep up with the complexity because that lawyer doesn’t have the clients that need it.

For me and my practice, I believe it is “malpractice” not to have GST Planning as a central theme to your Estate Plan. You have always understood the value of compound interest. Now unleash the power of multi-generational planning.