The estate tax typically applies only to property owned by an individual or property over which the individual holds a general power of appointment. In simple terms, a general power of appointment is a right held by an individual to convert the property subject to the general power of appointment to their ownership.
The estate tax does not typically apply to property gifted to an individual by another party in which the individual has the right to receive income or the right to receive principal, as long as the right to receive principal is subject to an ascertainable standard such as health, support, education, and maintenance.
Therefore, to avoid repeated exposure to estate tax liability at each generation as property passes from generation to generation, estate planners have utilized Generation Skipping Trusts (“GSTs”).
GSTs continue beyond the lifetimes of one or more generations to avoid having the estate tax erode family wealth on those generations.
For example, a grantor can create a GST either during their lifetime or upon their death such that the property stays in trust initially for the benefit of their child during the child’s entire lifetime, with income and principal payable to the child as necessary for the child’s health, support, education, and maintenance. The grantor can also give the child a limited power of appointment over the GST property whereby the child can appoint the property to whoever the child desires either during their lifetime or upon their death, as long as the power of appointment cannot be exercised in favor of the child, the child’s creditors, the child’s estate, or the creditors of the child’s estate.
The child can even serve as the trustee of the GST, as long as the trust is carefully drafted to ensure that the child does not hold any powers as trustee that would force the inclusion of the trust property in the child’s taxable estate.
Using this type of GST, the child can receive the benefits from the GST property if needed for their health, support, education, or maintenance.
The child can control who will receive the future benefits of ownership of the GST property. Additionally, as a trustee, the child can control how the GST property is invested. All of this is accomplished without having the GST property included in the child’s taxable estate and subject to estate taxes at the time of the child’s death.
There are limits to the amount of property that can skip a generation. In 1986, Congress enacted a generation-skipping tax that applies to GSTs or other direct gifts where one or more generations are skipped. Currently, the GST exemption is equal to the applicable exclusion amount, or $2 million.
Assuming that the size of the applicable exclusion amount continues to increase, GSTs will likely be used less frequently; however, for families owning significant wealth, GSTs will remain an essential part of their overall estate planning.