Estate planning pitfall
You haven’t planned for GST tax traps

The federal generation-skipping transfer (GST) tax can be hazardous to your tax bill, so it’s critical to discuss GST tax issues with your advisors when planning your estate.

The GST tax is a flat tax, in addition to the estate tax, imposed at the highest marginal estate tax rate. It applies to certain transfers to “skip persons,” which include your grandchildren and other family members who are two or more generations below you, as well as nonfamily members who are more than 37½ years younger than you. The GST tax applies to direct gifts to skip persons as well as to certain trust distributions.

The tax code provides a GST tax exemption — currently $3.5 million — but the rules regarding allocation of that exemption are fraught with pitfalls. Suppose, for example, that at your death you contribute $3 million to a trust for the benefit of your children and grandchildren, allocating $3 million of your GST tax exemption to the trust. The trust assets are protected against GST tax even if their value grows to $5 million by the time they’re distributed.

This rule doesn’t apply to typical grantor trusts, though. Absent special circumstances, assets held in a grantor trust are included in your estate, and you can’t allocate your GST tax exemption to those assets until your death, based on the trust’s value at that time. Using the $5 million from the previous example, even if your entire $3.5 million exemption is available, the $1.5 million excess will be subject to GST tax.

Another potential hazard is the IRS’s allocation rules, which automatically allocate your exemption to certain “GST tax trusts.” The problem is that, in some cases, a trust that’s intended to benefit your children may be treated as a GST tax trust if there’s a possibility, no matter how remote, that your grandchildren will benefit. Unless you opt out of the automatic allocation rules, your GST tax exemption may be wasted on trust assets that don’t really need its protection.

Finally, keep in mind that the GST tax is scheduled to be repealed for 2010 only along with the estate tax. But, as with the estate tax, it’s likely that Congress will pass legislation this year reinstating the GST tax. Check with your estate planning advisor for the latest information. •