Passing Assets to Grandchildren Through a Generation-Skipping Trust

Passing assets to your grandchildren can be a great way to ensure their future is provided for, and a generation-skipping trust can help you accomplish this goal while reducing estate taxes and also providing for your children.  

A generation-skipping trust allows you to “skip” over the generation directly below you and pass your assets to the succeeding generation. While this type of trust is most commonly used for family, you can designate anyone who is at least 37.5 younger than you as the beneficiary (except a spouse or ex-spouse).  

One purpose of a generation-skipping trust is to minimize estate taxes. Estates worth more than $12.06 (in 2022) have to pay a federal estate tax. Twelve states also impose their own estate tax, which in some states applies to smaller estates. When someone passes on an estate to their child and the child then passes the estate to their children, the estate taxes would be assessed twice—each time the estate is passed down. The generation-skipping trust avoids one of these transfers and estate tax assessments. 

While your children cannot touch the assets in the trust, they can receive any income generated by the trust. The trust can also be set up to allow them to have some say in the rights and interests of future beneficiaries. Once your children pass on, the beneficiaries will have access to the assets. 

Note however, that a generation-skipping trust is subject to the generation-skipping transfer (GST) tax. This tax applies to transfers from grandparents to grandchildren, even in a trust. The GST tax has tracked the estate tax rate and exemption amounts, so the current GST exemption amount is $12.06 million (in 2022). If you transfer more than that, the tax rate is 40 percent.  

The trust can be structured to take advantage of the GST tax exemption by transferring assets to the trust that fall under the exemption amount. If the assets increase in value, the proceeds can be allocated to the beneficiaries of the trust. And because the trust is irrevocable, your estate won’t have to pay the GST tax even if the value of the assets increases over the exemption amount. 

Generation-skipping trusts are complicated documents. Consult with your attorney to determine if one would be right for your family. To find an attorney near you, click here. 

Is a Grantor Retained Annuity Trust Right For You?

What is a GRAT?

Grantor Retained Annuity Trusts (GRATs) ­are a mechanism by which wealthier individuals and couples can transfer appreciating assets to their heirs and minimize gift or estate taxes. High-net-worth individuals and couples can use GRATs to freeze the value of their estates and transfer any increase in the value of their assets to their heirs, with minimal tax consequences.

Understanding the Basics

GRATs are irrevocable trusts permitted by the Internal Revenue Code. A client (grantor) transfers an asset or assets to the trust. The grantor (and only the grantor) retains a right to receive an annuity income from the GRAT over a certain period of time. The GRAT is required to pay this annuity stream no less than annually, and it must be a dollar amount or percentage of the value of the asset put into the trust. Any annuity income received is not subject to income tax due to special tax rules.

The asset that is transferred is considered a gift equal to its value reduced by how much of an annuity the grantor receives, along with any interest, as set forth in IRS guidance. Once the trust terminates, the assets transfer to beneficiaries such as a client’s children or a trust for their children.

A GRAT can be designed to result in no taxable gift and, therefore, no gift tax. However, if a GRAT cannot be set up this way, then the grantor can use any of his or her lifetime gifting exclusion to offset any gift tax.

If the grantor does not pass away during the GRAT’s term, then any assets or appreciation that pass to beneficiaries are not subject to gift tax or estate tax upon the grantor’s death. If the grantor dies during the term, then the value of the assets needed to pay the remaining annuity payments to the grantor would be included in his or her estate for tax purposes. The rest of the assets would pass without being included in the grantor’s estate.

Let’s Look at An Example

Let us say you have a stock account worth $1 million and transfer it to a GRAT. The terms of the GRAT provide that you receive 10 annual payments of $100,000, plus interest, at a rate set by the IRS from the income of the trust. If designed to be a zeroed-out GRAT, the total payments should equal the asset's present value at the date of transfer. If the stock account is appreciating, this works out very well. The trust can pay you the annuity without invading the principal, and any appreciation in value transfers to the beneficiaries of the trust, with no gift or estate tax consequences, once its term ends.

Why Consider a GRAT?

A GRAT may be especially prudent for clients that gift money regularly and may use up their federal estate and gift tax exemption. The total lifetime exclusion as of 2022 is $12.06 million ($24.12 million for married couples). A GRAT is also a helpful planning device for clients with high-value estates who may suffer serious tax consequences when the federal exemption reduces by half in 2026.

Furthermore, many states have less favorable estate tax exclusion amounts and gifting rules. New York, for example, has an exclusion of $6.11 million as of 2022. In New York, the consequences of exceeding this threshold can be harsh. If an estate is more than 5% over the exemption, the estate loses the exemption entirely, and the total value of the estate’s assets is subject to estate tax. New York also has a three-year clawback rule for gifts. So, when a person passes away, the state includes the last three years of gifts that person made in calculating the total value of their estate for tax purposes.

GRATs can help avoid many of these issues. So why not plan ahead now? Contact your attorney to determine whether a GRAT is a good fit for you. 

Issues When Gifting Unequal Shares to Children

As a strong recommendation that I consistently encourage clients to adopt, parents overwhelming choose to leave their children equal shares of their estate, but due to personal circumstances this is not always the case. If you plan to provide more (or less) for one child in your estate plan, understanding the consequences is key. 

It is natural for parents to want to treat their children equally in their estate plan. However, there are special circumstances in which a parent might choose to leave children unequal shares. For example, if one child is providing caregiving of an elderly parent in lieu of pursuing a career, a parent might understandably want to compensate that child for their lost income earning potential. Alternatively, if one child is overwhelmingly financially better off than another child, then the parent might want to provide more for a child who has a greater need for the funds. 

In a different context, the decision of how to allocate funds amongst a parent’s children may be due to one child having special needs or if there is a family business that one child has adopted as a career and wishes to succeed their parents after they are gone. It’s also possible that the parents have already provided more for one child during their lifetime, perhaps by advancing funds to pay for higher education or providing funds to assist with the purchase of a house. 

Whatever the reason for leaving your children unequal shares, the important thing is to discuss your reasoning with the children. Sit down with them and explain your decision-making process. If you feel like the conversation could be difficult and contentious, you could hire a mediator to help facilitate the discussion. These circumstances can frequently result in misunderstanding and feelings of favoritism or jealously by children who have been provided less. The classic example is the caretaking child who stays with mom or dad and provides full time care as parents age, and non-caretaking children assume theft or self-dealing is occurring due to the regular interaction with an aging parent. And even more unfortunately, these accusations, true or not, can frequently cause lifelong estrangement of the affected children.

In an ideal situation, your children may be understanding of your decision, but if you are concerned about certain children disagreeing and/or potentially suing to challenge your estate plan after you die, you may want to take additional steps: 

• Draft your will and estate plan with the assistance of an attorney and make sure it is properly executed. Find an attorney near you. To avoid accusations of undue influence, do not involve any of your children in the process.

• Explain in detail your reasoning in your estate planning document and make it clear that it is your decision and not the influence of the child who is receiving more.

• Include a no-contest clause (also called an "in terrorem clause") in your will. A no-contest clause provides that if an heir challenges the will and loses, then he or she will get nothing. You must leave the heir enough so that a challenge is not worth the risk of losing the inheritance.

Learn more about how to prevent a will contest.

Love in the Time of COVID-19

One of the world’s greatest novelists, Gabriel García Márquez, wrote the famous novel “Love in the Time of Cholera” in 1985. The theme of the book, while not expressly addressing a pandemic like COVID-19, compared the similarity between lovesickness and the cholera pandemic disease that was occurring in the years between 1880 and 1930. While it was in essence a novel about love and loss, written in prose reflecting Marquez’ latin romance sensibilities, it also addressed its character’s contemplation of their own death and reflection on their history and legacy.

It is a timely reminder then, as we all experience the isolation of the current pandemic, and the regular news regarding the pandemics breadth and depth, to begin considering how we can ensure the safety and security of our family, friends and loved ones — and to take care of our affairs, including our relationships, our finances, legal needs, or otherwise.

After personally experiencing the loss of a relative recently who did not have an estate plan, the necessity of planning has come into clear relief - namely, the enormous task of dealing with his possessions, his legal and financial affairs, and comforting and informing his family.

Accordingly, in order to provide some detail of what a proper comprehensive estate plan consists of, below I will illustrate ways in which certain documents can considerably ease the stress that will inevitably fall on your living family members upon your death.

Revocable Living Trust

Unlike a “Last Will and Testament”, which only addresses property that is owned in a persons individual name (and not property owned in joint accounts, joint tenancy (including joint tenancy or community property with right of survivorship), or beneficiary designated property(i.e. Life Insurance, 401k, IRA, etc.)), a Revocable Trust is a new vehicle that becomes the legal owner of an individual or couple’s assets.

By creating a Revocable Trust, a “Trustor” (the person creating the trust) transfers or beneficiary designates all of their assets to a “Trustee” (typically in a Revocable Trust the initial Trustee is also the Trustor). The Trustee holds the assets for the benefit of the Trustor(s) during their life, and then upon the Trustor(s) death, depending on the trust terms, the Trustee distributes or hold the assets for the benefit of the Trustor(s) chosen beneficiaries.

Unlike an irrevocable trust, a revocable trust can be changed and amended at any time (unless the Trustor is incapacitated due to dementia or another mental or physical ailment that makes them legally unable to deal with their financial affairs). Also, unlike an irrevocable trust, a revocable trust itself provides no specific tax or creditor protection features; however, if properly created and funded, it can avoid the need for an expensive and time consuming probate proceeding with the courts.

This “probate avoidance” feature is why a revocable trust has become the new centerpiece of most individuals estate plans in place of a traditional Last Will and Testament (because of the limitations of a Last Will and Testament discussed below).

Last Will & Testament

While most people generally understand the necessity of having a “Will”, most do not understand the a Will’s limitations, and/or steps that will be required to ensure that the wishes of a “Testator” (the creator of a will) are followed.

As discussed above, a Last Will & Testament only deals with assets that are owned in a person’s individual name (i.e. a bank account owned only by John Doe) - it does not deal with jointly owned property, or property that has a beneficiary designation. Further, even if a deceased person has a Last Will and Testament, a probate proceeding in the probate court (and the attendant arcane procedures, significant expense (which is typically greater than the cost of a well created estate plan with a revocable trust), and time consuming efforts) to transfer the deceased person’s assets to their chosen beneficiaries.

However, when a person creates a Revocable Living Trust, a Last Will and Testament is also created, with the distinction (from a plan that contains only a Last Will and Testament) that any property that was not legally transferred and funded to a Revocable Living Trust should be transferred to the Trustee to distribute pursuant to the terms of the trust. If assets are not funded to the trust during the deceased person’s life, a probate proceeding will be required to ensure that your assets will be distributed pursuant to the terms of your trust.

It should also be noted that a Will is typically where families with minor children make choices regarding who will be the Guardians and caretakers of their minor children if both parents are deceased.

Note: this document is different than a “Living Will”, which is discussed further below.

Durable Power of Attorney

A Durable Power of Attorney is a legal document that allows an “agent” to deal with your financial affairs while you are unable to do so, specifically when you are incapacitated or unable to communicate your wishes. With a Durable Power of Attorney your agent can continue to pay your bills, deal with investments and the like to ensure that your financial affairs are taken care of while you are unable to do so.

A Durable Power of Attorney is “durable” because it continues through any loss of capacity (whether a physical injury or disability or a mental disease, such as dementia).

One distinction that is poorly understood is that a Durable Power of Attorney ceases at the moment of the “principal’s death. Thus, while an agent may have had power of attorney during a person’s life, this power is extinguished at the moment of the principal’s death. After a death, an executor (known in Arizona as a “Personal Representative”) or Trustee will step into the shoes of the deceased person to deal with their financial affairs.

Another issue to be aware of is that many financial institutions are skeptical of Durable Powers of Attorney and may require further bank specific documentation before they will honor a Durable Power of Attorney.

Advanced Health Care Directive

While most Arizona attorney’s choose to create separate “Health Care Powers of Attorneys” and “Living Wills”, we prefer a form called an “Advanced Health Care Directive” that deals with all issues related to a person’s health care situation — from being alive and healthy, through sickness and final illness, along with wishes regarding the disposition of deceased person’s remains.

Like a Durable Power of Attorney, an Advanced Directive allows an agent to make both physical and mental health care decisions on your behalf when you are unable to do so yourself. An advanced directive also addresses your wishes regarding how you wish to be treated when you have a terminal or irreversible disease (typically known as a “Living Will”)

While this is necessarily the “scariest” document in an estate plan since it requires you to contemplate your own demise, it is a fundamental document in a well rounded estate plan because it allows a person to make their express wishes known to their family or other decision makers.

In a Nutshell

One of the most common refrains that estate planners hear from the public and our clients is that they do not want to discuss planning because it requires the contemplation of their own death - a “morbid subject”.

The bottom line is that while thinking about death is certainly a grim topic, the truth is that we all will eventually die, and engaging in estate planning allows you to get your affairs in order and spare your family the added grief of determining what you may have wanted rather than empowering them to follow your guidance about what you actually want. The reality is that without an estate plan, people knowingly or unknowingly place the significant burden of dealing with a person’s affairs squarely on their relatives or loved ones, which compounds the difficulty and grief surrounding a person’s death.

In other words, estate planning is a gift of LOVE to your family — not a boring, unnecessary or morbid exercise.

These thoughts are particularly true during this period we are currently experiencing with COVID-19 which spares no age group, gender, ethnicity, class of wealth, or otherwise.

Like the theme of the novel, this period intrinsically makes us take account of our life, and our preparedness for the unknown.