The estate tax is governed by some of the most complex and obscure rules in the tax code. Any additional complexity increases the chances of potential gains or losses depending on your situation. Unfortunately, when you combine the estate tax with the gift tax and strange government logic, wealthy grandparents lose, in the amount of a potential 96% tax on gifts to their grandchildren. This is all thanks to the Generation-Skipping Transfer Tax, or GST.
The GST is an additional tax on top of the gift tax that only applies on gifts to related individuals two or more generations younger than the giver (or unrelated individuals 37.5 years younger). Like the gift tax, the first $13,000 of annual gifts to any individual are exempt. Also like the gift tax, it taxes gifts from individuals, not households, so each spouse of a married couple may give $13,000 tax-free to each child. Once a gift to a grandchild exceeds that limit, the GST kicks in. The GST tax rate is equal to the top gift and estate tax rates. Under the American Taxpayer Relief Act, that will be 40% for 2013. Again, this tax is in addition to the gift taxes paid. This would yield a potential tax of 80% on a gift to a grandchild (40% as the top gift tax rate + 40% GST).
For some mysterious reason, the amount of GST you pay is also considered a taxable gift. This actually requires you to pay tax on your taxes. For wealthy grandparents at the top gift tax rate, this yields an additional 16% tax on their original gift, as the 40% GST tax is subject to the 40% top gift tax. All together, this means 96% of the value of their original gift is owed to the government. For perspective, a gift of $500,000 would incur a tax of $480,000. This cannot be avoided by contributing money to a trust that would then distribute it to grandchildren – that is considered an “indirect skip” and GST must still be paid.
There is one element of good news, however. Like the gift tax, there is a certain amount of credit each person can use throughout their lifetime to offset GST taxes. For 2013, the “lifetime exemption” is $5.25 million, increased by the American Taxpayer Relief Act to keep pace with the rise in lifetime estate tax exemptions. This means that a person would have to make over $5.25 million in gifts to a single grandchild over their lifetime to be caught in the 96% gift tax/GST trap. While it may seem so unlikely that it is not worth worrying about, I encountered a very generous client who was about to fall prey to these punitive taxes.
The logic behind this tax seems absurd. Congress seems to be of the opinion that when grandparents make gifts to their grandchildren, the government is being cheated out of two rounds of estate tax – grandparents should never make gifts to their grandchildren, but hold on to all their money, die, pay the punitive estate tax as it passes to their children, who then should spend none of it, die and pay estate tax again as it goes finally to the grandchildren. The gift tax already accounts for the fact that money is transferred away from the grandparent’s estate while they are alive, and the gift tax rates match the estate tax rates. To require another 40% to be paid when the recipient of a gift is a grandchild is ridiculous and to count a tax paid to the government as a gift of value to the grandchild is simply twisted. Realize also that if the estate tax rate rises by 5%, the gift tax and GST rates will keep pace and the penalty for gifts to grandchildren will exceed 100% (45% gift + 45% GST + 20.25% gift tax on GST). A 110.25% tax rate should make everyone uncomfortable – the government would get more than the grandchildren.
While the lifetime exemption probably makes some feel more comfortable, since the tax will only catch the very wealthy, it presents an extremely discriminatory line where one year a person can owe $0 to the government one year, and the next year easily $100,000 or more. It also means a minority of the population – the very wealthy – are heavily exploited in a way most citizens are not. It is injustice, merely of a popular sort.
Why should rich grandparents not be allowed to give money to their grandchildren just like everybody else? Why does the government have the right to decide who taxpayers can or cannot give to? Why is death a taxable event in the first place? Losing a family member is bad enough without having Uncle Sam come around with a collection cup at the funeral.
Though the estate tax rate is onerous at 40%, paying it is better than falling prey to GST rates. With gift taxes and GST rates more than doubling the estate tax, it is hard to transfer money directly to grandchildren, even through a trust. But a more efficient plan than spending down your assets and succumbing to the estate tax is to find another way to transfer assets to your family, such as contributing to a 529 plan for your grandchildren’s education. While these harsh laws remain, it would be wise to consult estate planners, wealth managers, and tax professionals to make sure that your money reaches the people you choose.