Can One Skip a Generation & Save Estate Taxes by an Irrevocable Trust?
The irrevocable trust remains a popular means of deferring estate taxes for a generation. It is only cost-effective, however, if the value of the assets held tax-free in the trust is sufficient to justify the considerable expense of trust maintenance. One 2010 change in the tax code makes the trust's benefits applicable to fewer families. Other changes reduce the overall benefits.
The Generation-Skipping Trust
The essence of the generation-skipping irrevocable trust is that whatever you put into it is forever beyond your control. In a trust, you are giving someone -- usually grandchildren when you are skipping a generation -- a gift. When the amounts contributed in a given year are in excess of the current annual limits on gifts, a gift tax becomes due, but in most instances the tax is not paid until the recipients -- your grandchildren -- "accede" to the gift -- that is, take possession of it. This may be many years from now, and meanwhile, the assets in the trust grow without taxation until transfer.
Advantages of the Irrevocable Trust
Just because the assets in the trust belong to your grandchildren doesn't mean your children can't benefit. Income generated within the trust can be accessed and used by your children -- the original assets remain in trust for your grandchildren. The same mechanism used to shield assets from taxation for a generation can be used to shield assets for several generations. Eventually, the trust is dissolved and estate transfer taxes paid, but if a substantial number of years has passed without taxation of assets, the remaining wealth accumulated within the trust after distributions will usually far exceed the taxes eventually due.
Known Disadvantages of the Trust
A known disadvantage of the irrevocable trust is the feature that makes it work: it's irrevocability. Only under uncommon circumstances can the creator of the trust exert any control over the assets -- otherwise, they become taxable. Usually the administrators of the trust are stable financial institutions. Instances of fraud or abuse of the assets are relatively rare, although they do occasionally occur. A more common problem is the trustee's effectiveness in asset management. Once the trustor dies, changing the trustee is difficult -- not impossible, but expensive. Another known disadvantage of irrevocable trusts is that trust management costs are usually considerable. Unless the amount being managed is very substantial, trustee fees can erode the trust's value.
In December 2010, the principal advantage of the irrevocable trust, its long-term deferral of estate taxes, became irrelevant for many users and potential users of the trust when Congress raised the limit of exemption on estate taxes to $5.25 million. Since the estate of the remaining spouse can claim the same exemption, $10.5 million is now exempt from estate taxes. Trusts also have less-discussed tax disadvantages. For example, when you die, the value of your assets is stepped up to current value. If, for instance, you hold $2 million in shares of Apple you bought for $300,000, when you die the current value, $2 million, passes without tax to your heirs. Gains in Apple shares in the trust, however, do not step up, and eventually are subject to whatever the tax rate may be when they are distributed.
I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.