Generation Skipping Transfer Tax

Transcription

1 Generation Skipping Transfer Tax Producer Guide For agent use only. Not for public distribution.

2 Generation Skipping Transfer Tax Summary The generation skipping transfer (GST) tax is a complex tax. This summary is intended to outline the basic principles of the tax; it is not intended to be a complete, in depth analysis. This summary is designed to give life insurance agents, financial planners and other non-tax professionals a basic understanding of how the GST tax works in relation to life insurance. GST Tax Overview Congress intended that the federal gift and estate tax laws would apply to transfers of wealth from members of an older generation to members of the next youngest generation (i.e. parents to children). Taxpayers learned to avoid gift and estate taxes by structuring wealth transfers so they would skip the next generation or benefit multiple younger generations through a single transaction (i.e. grandparents would create a trust to benefit both grandchildren and great grandchildren). Congress implemented the generation skipping transfer (GST) tax to plug this loophole in the transfer tax system. The GST Tax The GST tax is triggered when too much wealth is transferred to an individual defined as a skip person. A skip person is someone who is assigned to a generation that is two or more generations younger than the generation of the transferor. This generational difference can be measured by family relationship (i.e. grandparent and grandchild) or by age difference. When age difference is used, a skip person is a transferee who is more than years younger than the transferor. If the transfer is in a trust, the GST tax is triggered when all the beneficiaries qualify as skip persons or when distributions can only be made to beneficiaries who are skip persons. For simplicity and ease of understanding, we will use the word grandchild instead of skip person for the balance of this summary. Any of three types of transfers can trigger the GST tax: 1. Direct skip transfer A transfer is made directly to a grandchild and a gift or estate tax is due on the transfer. No person in an older generation has an intervening interest. For example, a grandfather makes a $1,000,000 gift to a grandchild or makes a bequest of $1,000,000 to a grandchild in his will. The gift or bequest can go directly to the grandchild or can be placed in a trust. 2. Taxable termination A parent s interest in a trust or in property ends and the interest of a grandchild begins. For example, a grandmother sets up a $10,000,000 trust to benefit a child for the balance of the child s life and at the child s death the balance in the trust is paid to the grandchild. 3. Taxable distribution A transfer is made to a grandchild of trust income or principal and is not the result of a direct skip or a taxable termination. For example, a grandmother sets up a trust that permits the trustee to make distributions to a grandchild for health, education, support or maintenance. If the trustee makes a distribution to a grandchild using this power, it is a taxable distribution and a GST tax may be due. The GST tax is a flat rate tax. It is applied in addition to any federal gift or estate tax that may be due. The rate applied depends on the year in which the transfer occurs. Under current law the GST tax rate is 40%. 1 For agent use only. Not for public distribution.

3 Avoiding the GST Tax Not all transfers that skip a generation trigger the GST tax. Several types of transfers may avoid the tax. The transfers from a grandparent to a grandchild that may avoid the tax include: payment of a grandchild s qualified medical expenses, payment of a grandchild s qualified tuition expenses, transfers that qualify for the predeceased ancestor exception, some gifts to a grandchild that qualify for the gift tax annual exclusion, and transfers to grandchildren to which a grandparent elects to allocate all or part of his GST exemption. 1. Qualified Medical Expenses Under IRC section 2503(e) grandparents can transfer unlimited amounts of money to qualified medical providers to pay for a grandchild s medical expenses. Gifts under this provision are free of both gift tax and GST tax. 2. Qualified Tuition Expenses IRC section 2503(e) also permits grandparents to transfer money to qualified education institutions to pay tuition expenses for a grandchild. Any amounts transferred are free of both gift and GST tax. Unfortunately, this provision only applies to tuition payments. Room, board, travel and books and other non-tuition expenses are not covered. 3. Predeceased Ancestor Exception The GST tax does not apply to some transfers from a grandparent to a grandchild that take place as a result of the death of one of the grandchild s parents. If the parent s death results in the grandchild being reassigned to the same generation level as his deceased parent for purposes of the transfer, then a GST tax will not be due. For example, a grandparent makes a bequest to a parent in his will. The will provides that if the parent does not survive the grandparent, the bequest is to be divided among the deceased parent s children. If the parent dies before the grandparent, those children are elevated to a higher generation (the parent s generation) for GST tax purposes; consequently, no generation is skipped and no GST tax is due. 4. The GST Annual Exclusion Some transfers to grandchildren that qualify for the gift tax annual exclusion may also be exempted from GST tax. Gifts directly from a grandparent to a grandchild that are gifts of a present interest (direct skip gifts) are currently GST tax free up to $14,000 yearly. This exception is used when a grandparent makes a present interest gift to a grandchild through a Section 529 plan account. When a grandparent makes an annual exclusion gift to a grandchild through a trust, three conditions must be met to avoid GST tax through this exception: (1) The grandchild must be the only beneficiary of the trust, (2) during the grandchild s life no other person may benefit from the trust, and (3) at the grandchild s death, the trust assets must be included in the grandchild s estate. The first condition is usually met by structuring the trust so it has a sub-trust for each participating grandchild. Dividing the trust into sub-trusts may be simpler than creating a separate trust document for each grandchild. Most gifts to irrevocable life insurance trusts (ILITs) do not qualify for the annual exclusion to the GST tax. They fail to qualify for either of two reasons. First, most ILITs have several levels of beneficiaries and they are usually from different generations (i.e. children and grandchildren); they do not provide for a direct skip to the grandchild. Second, ILITs that do skip directly to grandchildren are seldom drafted to create separate shares for each grandchild. The assets are usually managed as a single fund for a period of time. The trustee is often empowered to distribute any part of this fund to any beneficiary as needed for health, education, support and maintenance. Thus, provisions of most ILITs usually violate one or more of the requirements needed to qualify as present interest gift for the GST annual exclusion. ILITs can be drafted so that the annual exclusion gifts to grandchildren qualify for this exception to the GST tax. However, such an ILIT would be relatively inflexible. The ILIT could only benefit grandchildren and each grandchild s share would have to be segregated from all others. Further, each grandchild s share would have to be paid out to his estate at the time of his death and it would be subject to claims of the grandchild s creditors. Many grandparents prefer to make their ILITs more flexible; they avoid the GST tax by allocating part of their lifetime GST exemption to their gifts to the trust. For agent use only. Not for public distribution. 2

4 The Lifetime GST Exemption Every US citizen has a lifetime exemption that can be allocated to exempt transfers of property from the GST tax. The exemption is automatically applied when the transfer is a direct skip gift (it goes directly to the grandchild). In all other cases, the GST exemption must be specifically allocated by the grandparent or his/her executor or guardian on a 706 or 709 tax return. Allocating the lifetime GST exemption is the strategy that will most often be used to exempt assets from the GST tax. The GST exemption is indexed for inflation annually. Thus, the amount of the GST exemption changes yearly. Each grandparent has a separate lifetime GST exemption. Working together they can coordinate their wealth transfer plans to make sure both their GST exemptions are used. This can be accomplished through split gifts (in which both grandparents agree to allocate their GST lifetime exemptions) or through separate transfers to grandchildren during life or at death. When a grandparent creates an ILIT to benefit grandchildren, it is usually advisable to allocate GST exemption to every gift that goes into the trust. The allocation of GST exemption to all gifts funding the trust makes any distributions from the trust to beneficiaries GST tax free, regardless of the amount distributed. If the gifts to the trust are used to pay life insurance premiums, then the death benefits that are delivered to the trust should be both GST tax-free and estate tax free. For example, a grandparent sets up an ILIT that purchases a $4,000,000 policy on the grandparent. The grandparent gives $70,000 to the trust annually subject to Crummey withdrawal rights for children and grandchildren. After 10 years the grandparent dies. If GST lifetime exemption was allocated to each $70,000 annual gift, then the entire $4,000,000 death benefit is estate tax free and GST taxfree at the grandparent s death. Only $700,000 of the grandparent s lifetime exemption was allocated to the ILIT. The remaining GST exemption can be allocated to other transfers to the grandchildren from the grandparent s estate. The allocation of GST exemption allows all or part of a transfer to pass free of GST tax, as determined by the inclusion ratio. The inclusion ratio is simply one minus the fraction produced by dividing the amount of GST exemption allocated to a transfer by the amount of the transfer. The amount transferred is multiplied by the inclusion ratio to determine if any GST tax is due. Suppose that a grandparent transfers $1,000,000 to a grandchild and allocates $250,000 of GST exemption to the transfer. Under these facts, the inclusion ratio is 1 ($250,000/ $1,000,000) or 1 1 4, which is 3 4. As a result, GST tax will be imposed on 75% of every distribution the trust makes to any grandchild. Proper calculation and management of the inclusion ratio is a matter for the grandparent and his/her legal and tax advisors. These are some important points to remember about the inclusion ratio: No GST tax will be due (and part of the grandparent s lifetime GST exemption has been used) if the inclusion ratio for a transfer is 1. GST exemption is used automatically if the transfer is a direct skip to a grandchild; in all other cases the grandparent or his/her executor must make a tax filing with the IRS to use the exemption. Notice to the IRS that GST exemption is being used is given by filing Form 709 for lifetime transfers and Form 706 for transfers at death. Grandparents who are married and who elect to split gift, will each be deemed to have made 50% of the gift and each may choose to allocate part or all of his/her GST exemption to his /her 50% of the gift. If no GST exemption was allocated at the time the gift was initially made, the grandparent can make a late allocation by filing the proper gift tax return. In an ILIT, the late allocation of GST exemption will have to be large enough to cover the cash surrender value of the policy at the time of the allocation in order to protect all the death benefits from the GST tax. 3 For agent use only. Not for public distribution.

5 A GST ILIT An irrevocable life insurance trust (ILIT) that has one or more grandchildren, great grandchildren or younger beneficiaries is a GST ILIT. Life insurance can be an effective financial tool for the trust, because the death benefits have the potential to pay to the trust significantly more than the total premiums paid. And these death benefits will be income tax free. The trust can be designed so that the death benefits can be used to benefit children as well as grandchildren. The trustee can be authorized to use discretion to distribute funds to children for their health, education, support or maintenance. The fact that younger generations are entitled to receive some or all of the trust distributions may not prevent the trustee from using significant amounts of trust assets to pay benefits to children rather than grandchildren. The current GST exemption of $5,000,000 per person creates an opportunity for grandparents to shelter substantial sums from GST tax through multi-generation trusts. If the grandparent allocates GST exemption to all lifetime gifts to the trust, including all gifts used to pay life insurance premiums, the entire policy death benefit and all other trust distributions will be exempt from GST tax. There may be a potential problem when a Crummey withdrawal power is used with annual exclusion gifts to a GST ILIT in excess of $5,000 per beneficiary. Here s the potential problem: Crummey withdrawal powers are used to create the present interest needed to qualify a gift for the annual exclusion. By design, beneficiaries seldom exercise their Crummey withdrawal powers. When such a power is not exercised, the tax law says every beneficiary who had the power has made a gift back to the ILIT to the extent the amount subject to the power was greater than $5,000 or 5% of the trust assets. This has always been a potential problem in an ILIT. When the ILIT is a GST ILIT, there are two new potential consequences: 1. If the ILIT will last for several generations, the beneficiaries may need to allocate some of their own GST exemption to keep the trust GST tax free; and 2. Annual exclusion gifts of greater than $5,000 or 5% of trust assets may need a double GST exemption allocation to keep the ILIT GST tax free. For agent use only. Not for public distribution. 4

6 Split Dollar Arrangements The amount of lifetime GST exemption allocated to the GST ILIT to keep the death benefits GST tax-free may possibly be reduced if premiums are paid by a third party (a business or other individual) under a split dollar arrangement. This is a complex premium paying arrangement, but in some cases grandparents may find it beneficial in passing wealth on to grandchildren and great grandchildren. From a GST tax standpoint, it is not necessary to allocate any GST exemption to the policy premium. Instead, only GST exemption in the amount of the one-year term insurance value of the death benefit need be allocated to the transfer to keep the death benefits GST tax-free. This amount may be potentially less than the actual premiums paid during the course of the tax year. Conclusion Most clients want to protect their wealth and keep it free from the IRS and creditors. A multi-generation life insurance trust (ILIT) can be an effective way to keep money in the family for future generations. An ILIT may be able to leverage a grandparent s GST tax exemption into a sum of money that can be distributed to several future generations income, estate and generation skipping transfer tax free. An understanding of the GST tax is essential in deciding how to formulate financial strategies that may create and control family wealth for years into the future. For more information, contact your Voya Life Companies representative or call , option #4. Log in to Voya for Professionals at voyaprofessionals.com May Lose Value Not A Deposit Of A Bank Not Bank Guaranteed Not FDIC/NCUA Insured Not Insured By Any Federal Government Agency These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situation. Life insurance products are issued by ReliaStar Life Insurance Company (Minneapolis, MN), ReliaStar Life Insurance Company of New York (Woodbury, NY) and Security Life of Denver Insurance Company (Denver, CO). Variable life insurance products are distributed by Voya America Equities, Inc. Within the state of New York, only ReliaStar Life Insurance Company of New York is admitted and its products issued. All are members of the Voya family of companies. For agent use only. Not for public distribution Voya Services Company. All rights reserved. CN /01/2014 Voya.com