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ESTATE PLANNING FOR OUR PARENTS

By Reeve E. Chudd

When our clients come to us for estate planning advice and the preparation of wealth transfer instruments such as wills and trusts, on of our highest priorities is normally the reduction of potential estate taxes resulting from the passage of wealth at their own deaths; however, consideration of the impact of a potential inheritance from their own parents, even if it is currently estimated to be of modest proportions, may provide important tax savings. For the purposes of this discussion, the following family abbreviations will be used:

P = The parents of our client, C

C = Our client

GC = Our client's child

Generally, current estate and gift tax law is designed to extract a federal estate or gift tax from each generation (except for certain specific gift and estate tax exemptions), thereby decreasing the size of dynastic estates such as those of the Kennedy's and Rockefellers which developed early in this century. One of the ways such dynasties perpetuated their wealth in the past was to transfer wealth in a manner which would skip a wealth transfer tax (gift or estate taxes) at C's level, such as when P makes a gift directly to his or her grandchild, GC, instead of making the gift first to C who, upon death, might later pass the gift to GC. By P's making the gift directly to GC, C would never own the gift and, therefore, would neither be subject to gift tax (as C might be if, upon receiving the gift from P, made the same gift to GC ) nor to estate tax at C's death (as he might be if he received the gift from P and retained ownership in it for his lifetime).

Another and, in fact, more commonly used method of these families to reduce estate taxes payable at C's death was for P to create a trust which would, at P's death, provide for C's needs for C's lifetime but, upon C's death, would be held in trust for GC or distributed to GC. At C's death, C would not be deemed to own the trust; therefore, the trust would escape estate taxes at that time. All of these transfers, which skip gift taxes from C or estate taxes at C's death, are sometimes called "generation-skipping" transfers.

Nearly two decades ago, Congress introduced a new tax on such "generation-skipping" transfers in order to make up for the estate taxes not collected at the C's death. Called the Generation-Skipping Transfer Tax ("GSTT"), this tax applies to direct gifts from P to GC and from P to a trust for GC, whether or not C receives benefits from the trust. Unlike estate and gift taxes (which are assessed at graduated marginal rates, like our income tax), the GSTT tax rate is a flat 55%, and is assessed when the gift is made by P, if C does not receive any benefit from the gift (direct gifts or gifts to a trust for which GC, but not C, is a beneficiary), or at the death of C, if the gift is made to a generation-skipping trust as described above.

There are exceptions and exemptions from GSTT:

1. If C is not living at the time that P makes a gift to or a bequest in trust for GC, the transfer will not be a "generation-skipping transfer" subject to the GSTT.

2. Any outright gift (but not a gift to a trust) which either qualifies for the $10,000 gift tax annual exclusion or is a qualified educational or medical expense payment (paid by P on behalf of GC directly to a provider of medical care or an educational entity), is not a generation-skipping transfer subject to the GSTT. Therefore, such a gift by P to GC (1) reduces the estate tax owed at P's death because P has removed the gift from his or her taxable estate, (2) reduces the estate taxes owed at C's death because C never owns the gift and (3) is exempt from GSTT.

3. More important, each person has a $1 million exemption during GSTT which may be applied during lifetime or at death. Therefore, if P, even after estate taxes are paid, will have multi-million dollar wealth to pass on to C, then P should consider creating a generation-skipping trust with his or her $1 million exemption from GSTT, rather than giving all of the wealth outright to C. Such a trust could pay income and principal to C for the C's health, support and maintenance, C could even be the Trustee, and the trust would endure for C's lifetime (and beyond, if desired). Upon C's death, the trust, regardless of its value at that time, will escape estate taxes, since C will not be deemed to own the trust, and will also be free from GSTT.

In particular (and this is the real point of this article), if C has significant wealth (more than $675,000), even if P is not a millionaire (or even close), C may benefit by P's use of a generation-skipping trust. As an illustrative example, suppose that C has a current net worth of $2,000,000 and has made no taxable gifts during his lifetime so that his own $675,000 lifetime exemption from gift and estate taxes is still entirely unused and available. Were C to die today and leave all of his wealth to C, his net worth of $2,000,000 would be subject to estate tax and, taking into account his lifetime exemption, this estate tax would be $560,250, which puts his estate in the 49% marginal estate tax bracket.

Now suppose that C's father, P has a net worth of $250,000. Normally, because P's estate is less than $675,000, the threshold amount below which there is no estate tax, P may not believe that he needs sophisticated estate planning; however, if he dies and leaves his wealth entirely to C, this additional $250,000 will merely be added to C's wealth, already taxed at a 49% bracket at C's death, for an additional estate tax of $122,500 ($250,000 x 49%).

What can be done? P could change his estate plan such that, upon his death, his wealth is placed in a trust with (i) C acting as the Trustee, (ii) C receiving the trust's net income and principal to the extent necessary to satisfy C's needs for health, support, education and maintenance (all within the discretion of the Trustee who is C). Under current estate tax laws, to the extent that this trust created by P is still intact at C's death, regardless of its value at that time, the trust will not be deemed owned by C and will not be subject to estate tax at that time. Further, because the value of the trust at the time of P's death was less than $1,000,000 and, therefore, was within P's GSTT exemption, when the trust passes to GC at C's death it will also be free of GSTT. Simply put, this generation-skipping trust technique in P's estate plan prevented P's wealth from being subjected in C's taxable estate to a 49% estate tax rate. In summary, C will have virtually all of the benefits of ownership (control of investment, receipt of income, availability of principal and even, if desired, the ability to determine the ultimate recipients of the trust upon C's death), without death tax.

Although children often find estate planning to be a difficult subject to discuss with their own parents, potential estate tax savings of this magnitude are a significant incentive for opening the conversation, and we invite our clients to send this article to their parents in order to broach the subject.

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Reeve E. Chudd is a senior partner in the Taxation Law and Estate Planning, Probate and Trusts Department, where his areas of practice include estate planning, individual income tax, probate and trust administration.

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