(Dow Jones) While this year's one-year lapse in the estate tax hogs the spotlight, a lesser-known gap is offering many affluent older people a tax-free way to pass on some of their wealth to grandchildren.
Gifts have to meet certain conditions to get a break on the generation-skipping transfer tax, or GST, which also has been repealed for 2010. Only outright gifts qualify as opposed to, say, putting money in a trust, but the definition of a gift is broad enough: Someone who sets up a partnership and gives away units in it can get the tax break, for example.
David Pratt, managing partner of the personal planning department of the Boca Raton, Fla., office of law firm Proskauer Rose, says his firm is doing a lot of planning for gifts to grandchildren using family limited partnerships. The idea of putting a gift into a vehicle like this is to keep a youngster from getting control over assets all at once and possibly squandering them.
The generation-skipping tax is separate from income, estate and gift taxes. Its purpose is to keep people from transferring property too many generations out without paying tax. The tax is imposed if the transfer avoids gift or estate tax.
Take the example of a man who dies with a multi-million dollar estate, leaving his property in a trust with income payable to his children. On his death, trust assets are to go to the grandchildren. The man's estate would owe estate tax, but on the death of his children, the trust property would not be taxable in their name, so the family would have skipped a generation of estate tax. Therefore, the generation-skipping tax would apply.
The tax applies not just to grandchildren but to all so-called "skip" persons, including unrelated heirs at least 37-and-a-half years younger than a donor.
This year's donors still must pay the gift tax, at a top rate of 35%. That is the lowest level since 1934. The lifetime exemption this year on the gift tax is $1 million. Next year, unless Congress acts, the gift tax will rise to 55%, where it was before the Bush tax cuts of 2001 started taking effect.
Each donor is allowed to exempt up to a certain amount in generation-skipping gifts. Last year it was $3.5 million, and next year will be in the neighborhood of $1.06 million. (The government has not yet confirmed the new amount for 2011.) So, a donor will not owe generation-skipping tax on the first $1.06 million or so in 2011, but will owe the gift tax and the GST on any amount over that.
J.P. Morgan, in a recent analysis on taxable gifts, found that the net benefit to a recipient from a $1 million gift made in 2010, as compared to 2011, would be $305,565. That benefit grows proportionally to the assets' growth.
Making a taxable gift to a grandchild or other skip person, even in 2011, is still a smarter tax move than simply leaving the same amount to the person through the estate, according to J.P. Morgan. For every $100 of a gift in 2010, the grandchild gets $74, as compared to $42 in 2011.