A generation-skipping transfer (GST) tax is levied, in addition to any gift or estate taxes that apply to the transfer, on the value of life insurance (and/or any other property) transferred during lifetime or at death without adequate consideration to a transferee who is in (or who is assigned by statutory law to) a generation that is at least two generations below the transferor’s generation (such a transferee is called a skip person).1 For example, the GST tax will be imposed when an exceptionally large life insurance policy (and/or other asset) is payable to (or for the benefit of) a client’s grandchild.
The GST tax does not apply to transfers to nonskip persons, such as the client’s child, brother, or sister or to anyone in a generation higher than the transferor’s generation (e.g., a gift made by a grandchild to a grandparent). Likewise, a transfer to a trust for a nonskip person would not be subject to the GST tax. On the other hand, if all the beneficiaries of a trust are skip persons, a transfer to a trust for such people would be considered a transfer to a skip person; and, as discussed later, certain transfers from trusts to skip persons are subject to the GST tax.
The GST tax is broadly applied to life insurance transfers. It can be imposed regardless of whether proceeds are paid outright, in a lump sum, under settlement options, or in trust. The GST tax may also be imposed upon a transfer of a large policy with substantial cash values to a trust during the insured’s lifetime. The value upon which the tax will be based is the same as the value of the policy or the proceeds for gift or estate tax purposes.
In general, when life insurance (or other property) is transferred to a trust that has one or more skip persons as beneficiaries, the GST tax is imposed when distributions are made from the trust to those skip persons or when the interests of any nonskip persons terminate. For instance, if life insurance proceeds were left to a trust that provided income to the client’s son for life and then paid the income and principal to the client’s grandchildren, the tax would be imposed when the nonskip person (son) died.
The GST tax may be levied in addition to any applicable federal estate or gift tax and is imposed as a flat tax at the highest federal estate tax level, 40 percent (in 2019). Note that the GST tax rate applies regardless of the taxpayer’s actual estate or gift tax bracket.
Note that while the 2017 Tax Cuts and Jobs Act increased the amount of the unified estate and gift tax exemption to $11 million ($11,400,000 in 2019 after inflation adjustments), it did not otherwise change the mechanics of the estate tax calculation with respect to life insurance. Also, the TCJA is currently scheduled to sunset on December 31, 2025 taking with it the elevated exemption amount.
Fortunately, through careful planning it is possible to shelter all or a portion of even a very large transfer to a skip person through the use of one or both of two devices, the annual exclusion and the GST tax exemption:
GST Tax Annual Exclusion
Certain direct gifts that qualify for the $15,000 (as indexed in 2019) gift tax annual exclusion (or the unlimited exclusion allowed for direct payment of tuition or medical expenses) may also qualify for an annual exclusion that can be applied against the GST tax. This means an outright transfer of a policy or of premium dollars to a skip person will be subject to the GST tax only to the extent the value of the gift exceeds the $15,000 ($30,000 if gifts are split between spouses in 2019) annual exclusion limit. So the easiest and most certain way to take advantage of the GST tax annual exclusion is for the client to make gifts of cash each year of up to $15,000 to a skip person, who then leverages the gift by purchasing life insurance on the life of the client and/or the client’s spouse.
Example. Suppose a wealthy client, who has made large gifts and used up his gift and GST tax exemptions in prior years, gives a granddaughter a $2,000,000 policy on his life in 2019. At the time of the gift, the policy has a gift tax replacement value of $200,000. The gift would qualify for the gift tax annual exclusion and also qualify for the GST tax annual exclusion. So there would be no gift tax imposed on the first $15,000 ($30,000 if the client were married and split the gift) of value. Likewise, there would be no GST tax imposed on the same amount.
Only direct skips (outright transfers to skip persons or transfers to trusts that have only skip persons as beneficiaries and meet certain other criterion) can qualify for this GST tax annual exclusion. So, if the transfer is to a trust, it can still qualify for the GST tax annual exclusion but only if:
- all trust beneficiaries are skip persons;
- no distributions could ever be made to nonskip persons; and
- each skip person’s share is held in an account separate from the others or there are separate trusts for each.
Such entities are often called vested or subtrust trusts since the trust can benefit only one beneficiary and, at that person’s death, assets in the trust must be included in the vested beneficiary’s estate. Planners should note that the typical life insurance trust will not qualify.
Even if the transfer otherwise qualifies for the gift tax annual exclusion, if a trust benefits beneficiaries other than skip persons, it will not qualify for the GST tax annual exclusion. For example, assume the same facts as above, but the gift is made to a trust for the benefit of the client’s son (a nonskip person) for life and then granddaughter. Even if the granddaughter is given a valid Crummey power and $15,000 of the gift to her qualifies for the gift tax annual exclusion from gift taxes, it will not qualify for the GST tax annual exclusion.
To leverage the annual exclusion, an irrevocable life insurance trust receiving the client’s money could purchase life insurance on his life using the entire contribution as the policy premium. During the client’s lifetime, neither federal gift tax nor GST tax would be imposed on the cash used as premiums. At the client’s death, there would be neither federal estate tax nor GST tax imposed on the policy proceeds.
Either split dollar or the use of survivorship type contracts (or both techniques) can be used to pack the trust and squeeze in as much GST tax free life insurance as possible to maximize the leverage of the nontaxable gift technique. The trust can purchase insurance on the life of any person on whom the beneficiaries have an insurable interest, including parents as well as grandparents. Insuring a younger/healthier life than the beneficiary’s grandparent would further the packing possibilities (at the cost of a potentially longer wait for the proceeds). But such sophisticated planning requires extremely careful drafting and the use of highly competent counsel in order to achieve all of its tax and personal objectives.
Another way to compound the advantage of the annual exclusion is to have the transferor’s spouse make an identical gift or to have the transferor split the gift with his spouse.
Disadvantages to Using the GST Annual Exclusion
There are downsides to qualifying for the GST tax annual exclusion:
If the beneficiary dies before the client-grantor, the cash values of the policies in the trust will be included in the beneficiary’s estate. Of course, if the beneficiary survives the insured and then dies, the proceeds shielded from the GST tax may still generate significant federal estate tax in the beneficiary’s estate. However, the estate tax at a lower generational level may not be a significant disadvantage where the older generation possesses substantially greater wealth than the lower generation.
Many Crummey power techniques, such as the hanging power, will not qualify for the GST tax annual exclusion, since there can be no indirect skip (i.e., the trust beneficiaries must include only skip persons). If nonskip persons, such as the client’s children, are beneficiaries of the trust, this GST tax exclusion is denied. So, where there are several generations of beneficiaries and some are nonskip persons, the nontaxable gift exclusion is not available, and the client should use the GST tax exemption described below.
This exclusion requires undue dispositive rigidity. In other words, this exclusion, though appealing, will only work where the client is willing to set up a separate trust or allocate separate shares for each beneficiary and therefore precludes the flexibility inherent where a trustee is given discretion to spray principal or sprinkle income within a family unit. As a practical matter, few transfers will qualify for the GST tax annual exclusion and few clients will use the exclusion, even if they could qualify, because of these inflexible and impractical rules.6 Most clients must therefore place all or most of their planning efforts on the next level of defensive measures.
The trust can’t provide financial security for the intervening skipped generation, since the client’s contributions to the trust must pass directly to the skip person.
GST Tax Exemption
Over and above any allowable annual exclusion from the GST tax, each transferor is allowed to make a total of $11,400,000 (in 2019, as adjusted for inflation) of generation-skipping transfers and pay no tax. This exemption can be used during lifetime or at death. If a married client makes a generation-skipping transfer during lifetime, gift splitting (similar to the way gift tax split-gifts works) is allowable. This enables a doubling of the $11,400,000 exemption to as much as $12,800,000 (in 2019) even though the transfer was made only by one spouse.
How the GST Tax is Triggered
Three situations can trigger a GST tax: (1) a direct skip; (2) a taxable termination; and (3) a taxable distribution.
A direct skip could occur when a client writes a check payable to a skip person, gives property outright during lifetime, leaves property by will directly to a skip person, or names a skip person as a direct beneficiary of a life insurance policy. Therefore, if a client assigns an existing life insurance policy on his life to a grandchild, that gift would constitute a generation-skipping transfer. Assuming the entire transfer is taxable, the GST tax would be imposed on an amount equal to the policy’s interpolated terminal reserve plus any unearned premium (less any gift tax payable on the transfer). Likewise, if a client died and the $1,000,000 proceeds of a policy on the father’s life were paid to the grandson and the full $1,000,000 was taxable, a 39.6 percent tax would be imposed (after reducing the $1,000,000 by the estate tax also payable on the transfer, see the following).
A taxable termination occurs when there are no more nonskip persons ahead of the skip person. In essence, the client’s generation-skipping transfer to the skip person is deemed to occur at the moment nothing stands between the skip person and the transferred cash or other asset. Assume, for example, that a client creates a life insurance trust that provides, “Income from this trust is to be paid to my three children for life. At the death of the last survivor, principal is to be distributed to my six grandchildren.” When the last nonskip person’s (children’s) interest terminates (in this example, by death), the property in the trust is subjected to the GST tax.
A taxable distribution occurs when either income or principal is distributed from a trust to a skip person. Such a distribution can occur while nonskip beneficiaries are still alive. For example, suppose a client created a life insurance trust that directed the trustee (during the lifetime of the client’s three children) to pay income and principal to the client’s three children and to the client’s six grandchildren. The payments made by the trustee to grandchildren while the children were still alive would be considered a taxable distribution. Again, the taxable event occurs at the moment nothing stands between the skip person and the property transferred by the client.
Computing the Taxable Amount
The taxable amount is computed differently depending upon the type of taxable transfer involved.
In a direct skip, the amount subject to the GST tax (i.e., the taxable amount) is generally equal to the value of the transfer reduced first by the estate tax imposed on it.
Example 1. A client dies and a $4,000,000 policy is payable directly to his grandson. Assume the property would bear the estate tax and the GST tax. Assuming the client’s estate was large and pushed the proceeds into the 40 percent federal estate tax bracket, the estate tax would be $1,600,000. The 40 percent GST tax would be imposed, not on $4,000,000, but on the $2,400,000 left after the federal estate tax ($4,000,000 proceeds less $1,600,000 federal estate tax imposed on the proceeds). The GST tax would be $685,715 [(($2,400,000 × 0.40) ÷ (1 + 0.40)) where transfer bears GST tax]. In total, the federal taxes levied would amount to $2,285,715 ($1,600,000 + $685,715)! The grandson receives a net transfer of $1,714,285 ($4,000,000 – $2,285,715).
Example 2. Assume, instead, that other property would bear the estate tax and the GST tax and that only $1,925,926 of the proceeds would be payable to the grandson. At a 40 percent federal estate tax bracket, the estate tax on $4,000,000 would be $1,600,000. The 40 percent GST tax would be imposed on $1,714,285 (there is no reduction for estate tax since the transfer to the grandson does not bear the estate tax). The GST tax would be $685,715 ($1,714,285 × 0.40). In total, the federal taxes levied would amount to $2,285,715 ($1,600,000 + $685,715)!
Thus, different methods are used to determine the GST tax depending on whether or not the GST bears the estate tax and the GST tax. However, as can be seen, the amount of the total tax ($2,285,715) on the direct skip is the same for the same net transfer ($1,714,285).
Of course, transfers to grandchildren made during the client’s lifetime will also be subjected to the GST tax.
Example. Suppose a wealthy client who has made many large taxable gifts in prior years gives his granddaughter a policy on his life in 2015. Assume it is a policy with a face value of $4,000,000 and a replacement value of $400,000. The GST tax would be imposed on $400,000 at a 40 percent rate (in 2019). The GST tax would be $160,000 (0.40 × $400,000). For gift tax purposes, the $400,000 gift is increased by the amount of the GST tax imposed on the transferor to $560,000 ($400,000 + $160,000). The gift tax on the gift (assuming the transfer is taxed at a 40 percent federal gift tax bracket in 2019) would be $224,000 ($560,000 × 0.40). Federal taxes would therefore total $384,000 ($160,000 + $224,000).
In a taxable termination, the amount on which the tax is computed is the value of the property to which the termination pertains.
Example. Assume a client dies and $4,000,000 in policy proceeds are paid to a trust providing income to the client’s son for life. At the son’s death, the entire amount in the trust is to be paid to the client’s grandson. Assuming the client’s estate was large and pushed the proceeds into the 40 percent federal estate tax bracket, the estate tax would be $1,600,000 ($4,000,000 × 0.40). Assume this estate tax is paid by the trust and reduces the net proceeds in the trust to $2,400,000. In addition, when the son’s interest terminates on his death, that taxable termination generates a GST tax equal to 40 percent of the assets paid to the client’s grandchild (ignoring for illustrative purposes the GST tax exemption). Assuming no growth or loss in the funds, the tax on the $2,400,000 termination would be $960,000 (0.40 × $2,400,000). The total federal tax on the $4,000,000 proceeds would be $2,560,000 ($1,600,000 + $960,000).
In a taxable distribution, the amount upon which the tax is computed is the value of the property the transferee receives.
Example. A client dies in 2019 and $4,000,000 in policy proceeds are payable to a trust providing that the trustee can sprinkle income or spray principal to either the client’s son or grandson or both. The federal estate tax on the $4,000,000 (assuming the client’s estate was large and pushed the $4,000,000 into a 40 percent bracket) would be $1,600,000. Assume this estate tax is paid by the trust and reduces the net proceeds in the trust to $2,400,000. Also, assume the trustee immediately distributes the entire $2,400,000 to the client’s grandson. In addition, a $960,000 GST tax would be payable (0.40 × $2,400,000); a total federal tax of $2,560,000 ($1,600,000 + $960,000)!
Technically, the amount of a generation-skipping transfer that is subject to the GST tax is found through an inclusion ratio. The formula is:
1 – [AMOUNT OF EXEMPTION ÷ TOTAL VALUE OF GIFT (or BEQUEST)]
If a transfer to a trust, for example, has an inclusion ratio of zero, no future distributions or terminations from that trust will generally ever be subjected to the GST tax. However, if a trust beneficiary were to be treated as a transferor because property in the trust is included in his estate or the person is treated as making a taxable gift, a new inclusion ratio based upon the new transferor’s GST tax exemption may be required.
Example. If the value of the gift was $1,500,000 and there were no exemptions or exclusions available, all of it would be subject to the GST tax. If the client had only $400,000 of his $11,400,000 per grantor exemption remaining (in 2019), the inclusion ratio would be 0.977 [1 – ($400,000 ÷ $11,400,000)]. Almost 98 percent of the transfer would be subject to the GST tax. If the value of the gift was $11,400,000 and the amount of the exemption was also $11,400,000, the inclusion ratio would be 0. This would mean, not only that none of the transfer is taxable at the time it is made, but also that the transfer (indeed, whatever it grows to by the date it is actually distributed to the skip person) will generally never be subjected to the GST tax.
This inclusion ratio concept has enormous leverage implications with respect to contributions of cash to irrevocable life insurance trusts. Assuming the annual exclusion is not sufficient or is for some reason not available to shield a transfer from the GST tax, clients should consider allocating a portion of the GST tax exemption to any transfer involving life insurance. The reason is that, once the exemption shields a gift of life insurance premiums or a gift of a life insurance policy, the proceeds generated by those protected premiums or policy will not be subjected to the GST tax when paid out. Applying the exclusion against the discounted future dollars represented by the premiums can save a client’s estate literally millions of dollars.
Example. Assume an irrevocable trust for a client’s grandchildren purchased a $20,000,000 policy on his life. If his premium outlay is $100,000 a year for ten years and he allocates $100,000 of his GST tax exclusion against each year’s premium payments, the inclusion ratio would be zero [1 − ($100,000 ÷ $100,000)]. None of the $20,000,000 proceeds would ever be subjected to the GST tax. Had the client not allocated the exemption to protect the premiums from inclusion, the proceeds would have been subjected to the GST tax and the client’s personal representative would be able to exclude only $11,400,000 (assuming death in 2019) of the $20,000,000, a difference in tax of $3,440,000 (0.40 × $8,600,000)!
In the example, the client retained a zero inclusion ratio each year and guaranteed total exclusion of the policy proceeds by using a policy that became paid up before the transfers to the trust exhausted the GST tax exemption. The use of limited payment life insurance is essential in this regard. Had the premium payment period continued beyond the protection of the GST tax exemption, the inclusion ratio would have grown year by year with more and more of the proceeds becoming subject to the GST tax each year.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM