Over the River and Through the Woods: Creative Estate Planning Ideas for Grandchildren

• Citation: Vol. 15 No. 3
• Publication year: 2009

OVER THE RIVER AND THROUGH THE WOODS: CREATIVE ESTATE PLANNING IDEAS FOR GRANDCHILDREN

By Steven D. Anderson and Sinclair Hwang^*

I. INTRODUCTION

Who among us has not received the harried call from a client asking in panicked tones about the horrors of an impending distribution to a young beneficiary, with images of the next Paris Hilton dancing in the minds of the senior generation members? Gifts to descendants are fraught with problems — and opportunities — whether they involve an outdated gift trust, a custodial arrangement, or some other form of titling. It is the classic case of too much of a good thing, both in terms of distribution timing and of value.

Erecting roadblocks on a descendant's road to perdition, as well as the simple desire to transfer valuable assets efficiently, are constant concerns for estate planners in California. Additionally, at the dawn of the new decade estate planners and their clients are faced with tremendous uncertainty regarding the federal estate tax and generation-skipping transfer (GST) tax, due to the suspension of those taxes in 2010. We have not encountered since the days of Pancho Villa the ability to transfer assets at death without federal estate tax, and the federal GST tax has been a fact of life for estate planners and their clients since 1986.

Nevertheless, most practitioners still expect Congress to re-introduce some form of both taxes,¹ perhaps during 2010. At the very least, under current law both taxes are scheduled to return with a vengeance in 2011, at greatly reduced exemption levels and higher rates.²

Whether these taxes return as a result of current law in 2011 or as a result of new legislation, it is always prudent for clients of substantial means to consider techniques for transferring assets to younger generation members — and to do so in a way that fits the type of asset, the nature of the recipient, and the family values and ethos giving rise to the wealth. This article provides an overview of various familiar techniques, focusing on their use to transfer assets to grandchildren in a transfer tax-efficient manner and to address the "problem" of distributing too much too soon.

II. THE FEDERAL GENERATION-SKIPPING TRANSFER TAX

All current gifts and restructuring of previous gifts³ to grandchildren must be evaluated in light of the possible application of the GST tax. Although a comprehensive review of the GST tax is beyond the scope of this article, readers should note the following:

• The GST tax applies only to transfers to "skip persons" and not to "non-skip persons."
• The term "skip person" is not only any natural person related to the client-transferor who is two or more generations below the generation level of the client-transferor⁴ (e.g., a grandchild or a great-grandchild), but also any person unrelated to the client-transferor who is 37.5 years younger than the client-transferor.⁵
• A trust is a "skip person" if (i) all interests in the trust are held by skip persons or (ii) no person holds an interest in the trust and no distribution may be made from the trust to a non-skip person.⁶

The term "non-skip person" refers to everyone else.⁷

• The only transfers that qualify as generation-skipping transfers are (i) "taxable terminations,"⁸ (ii) "taxable distributions,"⁹ and (iii) "direct skips."¹⁰
• Thus, if a planning technique can avoid all three of these specific types of transfers,¹¹ then a GST tax will not apply.
• Although a generation-skipping transfer is also potentially subject to the federal gift tax, a properly structured transfer will avoid the federal gift tax if it:
• (a) qualifies as an annual exclusion gift under IRC § 2503(b)¹² and either (i) is made directly to a single skip person beneficiary or (ii) is made to a trust for a single skip person beneficiary which, if it terminates at the skip person beneficiary's death, is includible in that skip person beneficiary's estate;¹³ or
• (b) qualifies as a nontaxable transfer to pay medical or education expenses as provided in IRC § 2503(e).¹⁴
• Under pre-2010 law, complicated rules may automatically allocate a transferor's GST exemption amount to a particular transfer.¹⁵ Practitioners should exercise caution in analyzing GST transfers to determine whether allocation of GST exemption to a particular transfer is desired and, if necessary, should elect out of automatic allocation or affirmatively elect to allocate GST exemption. Automatic allocation presumably does not apply in 2010 under current law, and it is not clear whether or how any GST exemption can be allocated in 2010.

III. A NOTE ABOUT 2010

With respect to 2010 in particular, the current law offers potential planning opportunities despite a bounty of legal uncertainties. Specifically, the maximum federal gift tax rate in 2010 under current

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law is only 35% (compared to 45% in 2009 and 55% in 2011). The estate and GST taxes have both been suspended for this year. Nevertheless, concerns about possible Congressional action and about how the reversion to pre-2001 law will be applied after this year make planning difficult.

A. Possibility of Retroactive Changes

There is much speculation about whether Congress, having failed to act before the end of 2009 to prevent the "repeal" of the estate and generation-skipping taxes, may enact legislation reinstating those taxes during 2010. If so, the taxes might be effective only on or after the date of introduction of the legislation or the date of enactment, or perhaps might be retroactive to January 1, 2010. This uncertainty creates a serious tension between taking action quickly, to take advantage of planning opportunities while the current law remains in effect, and waiting until there is more clarity about what the 2010 law is or will be.

If a revival of the estate and generation-skipping taxes is made retroactive, there undoubtedly will be constitutional challenges. Nevertheless, clients considering voluntary transfers in 2010 before any Congressional action is taken must consider whether they are willing to risk a change in the ground rules in the middle of the game.

B. Application in 2011

Another area of uncertainty that is particularly relevant to planning for transfers to grandchildren is what effect actions that are taken during 2010, when the generation-skipping tax provisions of the IRC are not applicable, will have in 2011 and later years. The sunset provision of the 2001 law¹⁶ states that "[t]he Internal Revenue Code [including the GST tax] . . . shall be applied and administered to . . . [generation-skipping] transfers [after December 31, 2010] . . . as if the provisions and amendments [of EGTRRA in 2001] had never been enacted."¹⁷

Since generation-skipping transfers made in 2010 may have effects long after 2010, this sunset provision creates a number of uncertainties. For example, it is not clear at this time what GST exemption (if any) may be allocated to a transfer made in 2010 to a generation-skipping trust. The transfer itself in 2010 will not trigger a GST tax (absent retroactive legislation), but taxable terminations and taxable distributions in future years may result in GST tax as the interests of non-skip persons end or distributions are made to skip persons. Will allocations of GST exemption during 2004 - 2009 (above the 2011 amount of $1 million increased by inflation) be respected, or treated as if those allocations had never occurred? Will qualified severances made during 2001-2009 be respected after this year? Will GST trusts created during 2010 be grandfathered and treated as GST exempt in 2011 and later years, treated as entirely nonexempt, or . . . ?

C. Planning Approaches

Despite these many uncertainties, 2010 may be an excellent time for grandparents to make lifetime gifts to grandchildren because such gifts under current law (i) would be subject only to a maximum gift tax rate of 35% (after full utilization of the grandparent's $1 million lifetime gift tax applicable exclusion) and (ii) would not be subject to GST tax and would not utilize any GST tax exemption amount.

Similarly, this same environment might make certain remedial planning less problematic from a transfer tax perspective. For example, an existing trust with multi-generation discretionary beneficiaries could make distributions in 2010 to grandchildren without triggering GST tax on taxable distributions. Those distributions could then be transferred into the "protect me from myself" trusts described below in section V.H. of this article.

A more cautious approach in 2010 might entail lifetime gifts, but limited to no more than the $1 million lifetime applicable exclusion amount (in order to avoid any gift tax rate surprise), or limited to no more than an assumed $1.34 million 2011 GST exemption amount (still risking a gift tax rate surprise, but likely avoiding inadvertent triggering of GST tax).

A lifetime gift might use any of the strategies discussed in the balance of this article, but any gift other than an outright transfer to a grandchild faces uncertain GST treatment in 2011 and beyond. Furthermore, it could be prudent to wait until Congress provides some clarity regarding whether any changes to 2010 tax law may be enacted (e.g., until mid to late 2010). The most cautious approach of all for transfers in 2010 might assume the form of low interest rate loans as described in section IV.E. of this article.

This article focuses on transfer techniques under the law as it existed in 2009 or will exist in 2011, but some special 2010 issues are noted.

IV. NON-TRUST TRANSFERS TO GRANDCHILDREN

Trust complexity is not a pre-condition to effective planning for grandchildren. Several methods to transfer assets currently (by gift, sale or loan) produce the benefits of immediate estate reduction and simplicity.

A. Uniform Transfers to Minors Act Account

A California Uniform Transfers to Minors Act (CUTMA)¹⁸ account offers the advantages of simplicity and flexibility. A client can open this type of account at any financial institution...