“Our kids are wealthier than we are!” Some of my clients emphasize the wealth of their children as we customize their multi-generational estate plan. “How can we help our grandchildren instead?”
As noted in a recent Wall Street Journal article, many wealthy families are implementing plans to lock in current federal exemption amounts to save estate and gift taxes at multiple generations. One strategy is to implement a certain type of trust, known variously as a generation-skipping transfer trust, a dynasty trust, or a GST Trust. Contrary to what may be inferred by these monikers, a GST Trust can be a blessing in disguise to the very children who are ostensibly skipped by the GST Trust. In this month’s update, I summarize the benefits and costs of the GST Trust planning strategy.
The GST Trust Structure
A GST Trust could be created either (i) as an irrevocable trust during the trust creator’s lifetime or (ii) as a testamentary trust following the trust creator’s death. The distinguishing characteristic of a GST Trust is that distributions to the child-beneficiary are limited to a standard of “health, education, maintenance and support.” While trust assets could be distributed to a child according to this standard, the assets don’t need to be distributed to the child. The child-beneficiary would not be considered an owner of the undistributed trust assets, even if the child-beneficiary is also the trustee of his or her GST Trust.
The Benefits of a GST Trust
Briefly, a GST Trust might achieve four benefits:
- Minimize a Child’s Estate Taxes
First, a GST Trust avoids estate taxes at the child’s generational level. GST Trust assets are not considered to be owned by the child at the child’s death, and therefore do not add to the child’s personal estate tax liability at death.1
- Accomplish Laudable Purposes
Second, the GST trust assets can be utilized for laudable purposes. Depending on the life circumstances, the marginal utility of a trust transfer to a grandchild might be higher than a transfer to a child. For example, the GST Trust could provide for specific expenses of a grandchild, such as education, even while the child is living.
- Protect the Assets from the Child’s Creditors
Third, a beneficiary’s personal creditors cannot reach the undistributed assets of a GST Trust. A child could therefore protect her inherited assets from a divorcing spouse or a personal business creditor by leaving assets in a GST Trust.
- Direct Remaining Assets to Grandchildren
Finally, the GST Trust could be structured so that assets remaining in the GST Trust assets at the child’s death must be distributed to grandchildren. The trust creator is thereby assured that the assets “stays in the family” for the next generation.
The Costs of a GST Trust
Two costs of a GST Trust are noteworthy:
- Administrative Hassle and Challenges
First, the implementation of a GST Trust requires that the inherited GST Trust assets be owned and managed separate and apart from a child’s individual assets. Establishing separate accounts in the GST Trust creates more ongoing administration, including the filing of annual trust tax returns.
- Income Tax Liability
Second, based on current trust income tax rates, the income taxes on the earnings of undistributed GST Trust assets are higher than the same earnings on individually-owned assets. If a trustee makes trust distributions to the child-beneficiary equal to the trust’s taxable income, the child-beneficiary would pay income taxes, not the trust. 2 However, these distributions would contravene the benefits outlined above. In most cases, therefore, the benefits achieved through a GST Trust come at an increased income tax cost.
If your children are like mine, each of your children have vastly different skills, temperaments, and life circumstances. Families considering GST Trust planning should envision how the planning structure would benefit each child and the child’s family, given their unique situation.
1 A GST Trust is called a “generation-skipping transfer trust” under the internal revenue code because it effectively “skips” one generational level of estate taxes.
2 The trust distributions are deemed to “carried out” the distributable net income of the trust to the trust beneficiary when distributions are made.