How to avoid taxes on gifts to grandchildren
Most people are aware that any gift exceeding $10,000 per year constitutes a taxable gift and that once lifetime taxable gifts exceed $675,000, gift taxes are imposed on additional taxable gifts.
Taxable gifts made to grandchildren or others who are considered more than one generation removed from the donor, are subject to a second tax, the generation-skipping transfer, or GST, tax. This tax is imposed on taxable gifts exceeding the lifetime exemption amount of $1,030,000 (as of 2001, indexed annually for inflation).
Early planning can yield great benefits with the generation-skipping transfer tax exemption. You might want to consider creating a trust, which can be used for funding and owning a new business. First, the trust can be funded with cash; the trust can then purchase a business interest. This strategy avoids valuation challenges if the business interest appreciates rapidly and minimizes the initial GST tax-exempt allocation.
Other GST tax planning opportunities include:
* Maximize the direct payment of college and medical expenses that are exempt from gift tax and disregard them when computing the $10,000 annual gift tax exclusion.
* Consider making as many $10,000 annual exclusion gifts as possible. A powerful way to use the annual exclusion is to take advantage of Section 529 qualified state tuition programs. A grandparent may give up to $50,000 per grandchild and spread this amount over five years and shield the gift from tax by using the annual exclusion. The income on a qualified state tuition program account grows tax-free, and the grandchild is taxed when he or she withdraws the funds for college education expenses.
* Use the $1,030,000 GST tax exemption during your lifetime and focus on leveraging the transfer with assets with the greatest potential for appreciation.
Long-term GST trusts should be created for the exclusive benefit of grandchildren, if the parents can afford to forgo the income. If children need trust income, consider making them discretionary, rather than mandatory, beneficiaries.
The optimal trust term to defer transfer taxes is a trust that will end on the expiration of the period established by the Rule Against Perpetuities limitation. Alaska, Delaware and other jurisdictions that have abolished the rule make excellent jurisdictions to establish dynasty trusts, designed to build up as much trust corpus as possible for future generations.
When designing a dynasty-type trust, a trustee should have broad discretionary powers, including the power to make distributions. To optimize a transfer of wealth to future generations, a trust should purchase assets, such as a business or a home, for grandchildren’s use. Senior family members should consider loaning money to a GST trust to invest in new business opportunities.
Charitable lead unitrusts are also useful in GST tax-exemption planning. Charitable lead unitrusts are more attractive, because a GST tax exemption can be allocated when the trust is funded; the GST tax exemption can be allocated only after the charity’s income interest has expired for a charitable lead annuity trust.
A charitable lead unitrust should be considered only if it is estimated that trust assets will perform at a rate of return in excess of the Section 7520 rate, which is computed on the value of partnership interests, after any relevant discounts are considered.
A possible strategy to exceed the Section 7520 rate is to first place assets in a family limited partnership, or FLP, and contribute partnership interests to a unitrust.
The prohibitions against self-dealing apply to charitable trusts. Charitable trusts should not purchase an asset from a related party, including the grantor’s FLP or closely held business. Also, the self-dealing rules apply if a beneficiary uses trust property.
John McIntyre is senior tax manager at Mikunda, Cottrell & Co.