People can give property directly to their grandchildren and keep the property out of their children’s taxable estates. Because of this, Congress enacted the generation-skipping tax on lifetime or death gifts that skip a generation. There was a $5,340,000 exclusion in 2014. Married couples can treat a transfer as made by one-half by each spouse. In effect, this doubles the exemption. Over the exempt amount, the rate of tax is 40%.
Additionally, often gifts that would qualify for the annual exclusion under the gift tax are not subject to the generation-skipping transfer tax. There are additional rules for getting this exemption when the gift is made to a trust. The tax is in addition to the estate tax.
The tax applies to any transfer from a “transferor” to a “skip” person. A skip person can be an individual or a trust. Individuals who are two or more generations below the transferor are skip persons. This includes grandchildren and great grandchildren and also grandnieces and grandnephews. A trust is a skip person only if a non-skip person holds an interest in it and only if no non-skip person may receive a distribution. If a transferor’s child dies before the transferor, the predeceased child’s descendants are moved up by one generation.
The transferor is generally the decedent or donor. However, concerning a marital deduction trust that pays after the surviving spouse’s death to other people, the surviving spouse is the transferor.
The tax applies to three types of transfers. One is a taxable termination. This is a transfer to a skip person upon the termination of a trust. Another is a taxable distribution. This is any other transfer from a trust to a skip person. Finally, there is the direct skip which is a transfer directly to the skip person.
The exemption from the tax can be allocated amongst transfers. For instance, if $10,680,000 is going to be transferred in trust, it can all be put in one trust with $10,680,000 of assets. Then $5,340,000 of the exemption can be allocated to the transfer. All taxable transfers from the trust to a skip person will incur tax at 50% of the GST tax rate. However, $5,340,000 could be put in one trust (A) and $5,340,000 in another (B). Then $5,340,00 of the exemption could be allocated to Trust A. Trust A would then be exempt, and all distributions from it would be free of the tax. However, if made to a skip person, all distributions from Trust B would be subject to the full tax. This is because trust A would be set up for skip persons (grandchildren), and Trust A would be for non-skip persons (children).
Usually, trusts for skip persons are set up to be entirely exempt. Therefore, non-skip persons should not be included. Otherwise, the exemption can be wasted. If some of the beneficiaries of the trust are non-skip persons, unnecessary GST has been incurred. Also, the exemption has been wasted if a distribution is later made from the trust to a non-skip person.
For these reasons, when trusts are used to plan this tax, a separate trust is set up for the grandchildren and other skip persons. This trust is funded with assets up to the amount of the exemption and no more. Additional funds for the skip persons would be put in a separate wholly taxable trust, and a separate trust would be set up for non-skip persons.
The $5,340,000 exemption is not portable from one spouse to another. That is, the amount unused by the first to die can not be added to the $5,340,000 exemption available to the second to die.
Illinois Estate Tax
The Federal estate tax is used to allow a credit for state death taxes. The Illinois estate tax was the amount of the credit allowed under Federal law. Under this scheme, the total Illinois and Federal tax were the same as the total Federal tax before the credit.
The Federal law has been changed, and the credit for state death taxes was phased out. However, the Illinois estate tax is still based on the old Federal credit for estate taxes. The Illinois estate tax is the amount that would have been allowed as a credit for state death taxes under the Federal tax before 2002. The net effect is a substantial increase in the total of Illinois and Federal estate taxes.
The Illinois estate tax is based on the Federal adjusted taxable estate. Therefore, the Illinois estate tax is based on amounts over the exclusion amounts. However, Illinois and Federal law have different exclusion amounts.
The Federal exclusion amount was $5,250,000 in 2013, but Illinois limits the amount to $4,000,000.
The Illinois estate tax is computed concerning the Federal taxable estate. However, the Illinois estate tax is a deduction in computing the Federal taxable estate. Thus you have interrelated computations. The Illinois Attorney General’s office has software to calculate, which you can find on their site at www.illinoisattorneygeneral.gov.
Many estate plans avoid federal estate tax by saying the marital deduction gift is the least amount, resulting in no federal tax. Thus the marital gift is everything over the exclusion amount. However, the Federal and Illinois exclusion amounts are different, so this estate plan will result in no federal tax but some Illinois tax. This could be avoided by increasing the amount of the marital deduction gift to the least amount that will result in no federal or Illinois tax.
Unlike the Federal tax, the Illinois tax does not apply to lifetime gifts.
The property subject to the tax is the taxable estate. This is not necessarily the same as the probate estate or the estate your will gives away. For instance, property you put in a trust which says you get the income for your life and after your death, the principal goes to your kids is not in your probate estate. Your will does not control who gets it. Yet, it is in your taxable estate because you get the income from it, and you created the trust. Generally, any property you once owned and now get the income from or any property for which you control or retain the right to say who gets it is in your taxable estate. For instance – your life insurance is usually in your taxable estate because you retain the right to name and chose beneficiaries, even though you may never see a dime of the insurance money.
Estate planning often involves lifetime gifts to children. This gets appreciation on the assets out of the parents’ estates. This was also done in the past to shift income to children who were usually in a lower tax bracket. Now a child under 18 pays tax at the parents’ highest marginal tax rate on the child’s unearned income over $1900 if that would be higher than the child’s tax. The tax also applies if the child’s earned income does not exceed one-half of the child’s support and the child is 18 or is a full-time student aged 19-23.
There is a federal tax on estates and gifts. Some states also have taxes. For example, Illinois now imposes an estate tax in the amount the federal credit for state taxes used to be.
The federal tax is a single tax on all transfers, either during the grantor’s life (gifts) or at death. It is progressive and goes up to 40%. It is cumulative, so each gift or transfer adds to the amount to be taxed. There is a credit against the tax, which allows $5,340,000 in 2014 to pass tax-free. This makes the effective estate tax rate 40% for all transfers.
Taxable estates must file estate tax returns. In addition, even if the estate of the first spouse to die is not taxable, an estate tax return must be filed if it is desired to elect portability of that spouse’s unused tax-free amount (i.e., to add it to the tax-free amount of the surviving spouse when he or she dies) or if the marital deduction is claimed.
Sometimes it is possible to shift income within a family from someone in a higher tax bracket to someone in a lower bracket. This is difficult with children under 14 since their unearned income (except for the first $1600) is taxed at their parent’s tax rates. However, not all children are under 14. Basically, income is split by giving property to children. After that, the income from it belongs to the children. Interests in family businesses or farms are ideal. Gifts of cash work, too, if available. Employing your children also is a good way to shift income to them. However, they must actually work, and the pay cannot exceed a reasonable amount for what they do.
One of the major reasons for the gifts made during someone’s life is tax avoidance. In 2014 gifts of $14,000 per donee per year ($28,000 if a spouse joins) are exempt from tax. The key to an effective gift is to relinquish all control over the money or property. The person giving the property away must not be able to get it back. Also, you cannot make an effective gift for tax purposes by giving money to a trust for someone else if you are the trustee. The IRS says this is retaining rights in the property. You can make an effective gift in trust if someone else is the trustee. However, it is hard to get any gift tax exemption for gifts over $5000 per year per beneficiary to a trust. This is because IRS says that the exemption applies only to present gifts. IRS says a gift in trust is not a present gift because the beneficiaries don’t get the principal until later. Gifts to charities are also deductible for the purposes of the income, estate and gift taxes. They must be gifts to qualifying charities. Just because an organization is not-for-profit does not mean a gift to it qualifies for this tax deduction.
Gift Tax Exclusion
The estate and gift tax is a tax applying to all lifetime and death transfers. There is an exclusion for gifts not exceeding $14,000 each year in 2014. The exclusion applies to all gifts to a particular donee in a year. In other words, a donor’s gifts up to $14,000 to each donee each year are exempt. The exclusion is doubled if a spouse joins. Therefore parents can give $28,000 per year to each child without incurring gift tax or having to file a return.
The amount of the exclusion is indexed for inflation, so it may rise in the future.
Payment of tuition or medical expenses directly to a qualified school or medical provider is exempt also, even if over $14,000.
Part of estate tax planning can include giving away assets to children during life. Not only the assets, but the appreciation on them, are out of the donor’s estate. The gifts can also sometimes be made at discounted values. The annual exclusion is used to shelter these gifts from gift tax. People with very large estates often make additional gifts for which a gift tax return must be filed and use part or all of their unified credit against tax or even pay some gift tax. (The exclusion also applies to the Generation-Skipping Transfer Tax.)
Illinois has no gift tax.
Credit Against Tax/Unified Credit
There is a credit against the estate and gift tax. This is called the applicable exclusion amount. The effect was to exempt $5,340,000 from the tax in 2014. This credit applies to the generation-skipping tax also.
- The credit can be used for lifetime gifts or gifts at death. Use is optional. You must claim it.
- Any used during life cannot be used at death.
- In larger estates, the available gift tax credit is often used up for lifetime gifts to children of property that will appreciate. This way, all the appreciation is removed from the parents’ estates, i.e., stock in a growing family business.
- The credit can be used by married persons at death to give $10,680,000 tax-free to the kids. What one spouse does not use is “portable” and can be used by the other spouse.
These $5,340,000 gifts to children can be outright, but they seldom are since people don’t want kids to get money outright and because the use of a trust allows the surviving spouse to have the income from the $5,340,000 provided certain limits are obeyed. The spouse doesn’t have to get the income, though. The children can get it, or the spouse and children can share it. The rest of the first to die estate will be completely free of tax, no matter how high its value, if it is all given to the surviving spouse. The unlimited marital deduction applies. Keep in mind that the Illinois tax-free amount is only $4,000,000. Usually, the amount between that and $5,340,000 is put into a vehicle that qualifies for a marital deduction in Illinois but not under the Federal tax.
These trusts are usually called family trusts because they are usually for the spouse and children. Sometimes they are called credit shelter trusts because the amount in them is sheltered from tax by the credit. So if a trust is used and you give $5,340,000 to your kids to save taxes, your spouse can get the income from it just as if you have it to him or her.
Disclaimer: The site is for educational purposes only, as well as to give general information. This blog is not intended to provide specific legal advice. The site should not be used as a substitute for legal advice from a licensed professional attorney in your state.