How Does a Generation-Skipping Trust Work?

Generation-skipping trusts allow assets to grow or be transferred tax-free

Generation-skipping trusts aren't just for the very wealthy -- they're a way to save any family's assets from excessive taxation, ex-spouses looking for money, and creditors. Plus, they protect assets such as stocks that are likely to grow in value over time.

What's the benefit to a generation-skipping trust?

Generation-skipping trusts are a good way for wealthy families to transfer assets from the senior generation to their grandchildren and great-grandchildren without exposing those assets to several levels of estate taxes. Typically, if the second generation in a family is already comfortable financially, the grandparents set up a generation-skipping trust providing for all of their descendants as possible beneficiaries. Ultimately, any remaining assets will be distributed to grandchildren or great-grandchildren many decades in the future. This way, all of the descendants (children, grandchildren, and great-grandchildren) can benefit from the trust assets, but the grandchildren or great-grandchildren eventually receive the remaining funds without the imposition of estate taxes when the children die, and again when the grandchildren die.

Not just for the wealthy

Let's say a child in the second generation goes through a nasty divorce. The divorcing spouse can't lay claim to a share of the assets in the trust, because they legally don't belong to the ex-spouse. They're for the benefit of the entire group of descendants of the grandparents. Likewise, if a child funds a start-up company and provides personal guaranties and the company drowns in debt, the trust assets can't be directly tapped to pay the debts, because the child doesn't own those assets.

The assets would also be protected in the event of other financial catastrophes, such as large gambling debts or an uninsured car accident. "A creditor could get a judgment against the child, but they can't go directly after the assets in the trust, because they wouldn't be his or her assets," attorney Philip Feldman says.

Likewise, if the grandparents fear that one of their children is a spendthrift and would waste his inheritance quickly, a generation-skipping trust allows the child to have access to the trust assets but not necessarily direct control over the amount or timing of distributions.

Asset Protection and Limits of Generation-Skipping Trusts

Use a generation-skipping trust to protect assets from creditors or spouses

Generation-skipping trusts can also be used to protect assets from creditors or a divorcing spouse, or to guard assets a trustee believes will grow substantially in value over time. That's why most families should at least consider this type of trust.

For example, a moderately wealthy older couple could put money in a generation-skipping trust, reserving the ultimate distribution for their grandchildren. But they could make the trust assets available to their children for their needs. If the couple transferred those assets outrigh t to the children, and then from them they went to the grandchildren, the assets could be taxed twice at a rate of 45 percent; once when the assets pass from the grandparents to their children, and then again when they pass from their children to their grandchildren. By establishing a generation-skipping trust, the couple makes sure the assets are taxed only once, at the time of the initial transfer to the trust.

Because the second generation never technically owns the assets (they only have a right to distributions for reasonable needs), the trust assets have some protection from the claims of creditors or divorcing spouses in the second generation. "This is not just a strategy for the wealthy. This is usable by anyone. In my practice, even clients with modest net worth might benefit from such a trust," says Philip Feldman, a trusts and estates partner with Coblentz Patch Duffy & Bass in San Francisco.

Limits to a generation-skipping trust

There's a limit on the amount that can be transferred into such a generation-skipping trust. Currently, there's a $2 million exemption; that is, each person may leave up to $2 million in a generation-skipping trust free of the generation-skipping transfer tax.

Coincidentally, you can also leave up to $2 million to your family free of estate tax, so if you plan carefully, you can leave up to $2 million in a generation-skipping trust without any transfer tax. Any transfers in excess of this limit will be subject to gift or estate tax when the senior generation passes along the assets, and an additional generation-skipping tax is imposed when the middle generation of beneficiaries die and the property is transferred to the third-generation beneficiaries. Every dollar over the $2 million exemption is subject to the highest existing estate tax rate, currently 45 percent. But with proper planning this exempt $2 million may grow to a sizable amount that gets transferred free of tax when the middle generations die.

A Trust for Appreciating Assets

You don't have to be in your twilight years to take advantage of a generation-skipping trust. You can create such a trust any time during your life, and make lifetime transfers to that trust (you can use up to $1 million of the $2 million exemption during your lifetime). Any asset that might grow appreciably is a candidate for such a trust. "For families that are establishing a wealth transfer plan, my advice is to place appreciating assets in a generation-skipping trust and let these assets grow outside your taxable estate," attorney Philip Feldman says.

It works this way. Any appreciable asset -- a piece of real estate, stock in a private company that may go public, hedge fund assets -- is a candidate for a generation-skipping trust. Say an engineer who joins a start-up receives stock valued at a dime a share. If she's given 1 million shares, they're worth $100,000. If she places that stock in a generation-skipping tr ust, when the company goes public at $20 a share, the trust suddenly owns an asset worth not $100,000 but $20 million.

Because it's in a trust, that appreciation is not taxable, even when the engineer and her spouse die. "You can keep the money available to the family and use it when they need it," Feldman says. And none of this $20 million will be subject to gift or estate tax as the assets pass to the children and grandchildren. Had the engineer held the stock personally, the $20 million (and all of the investment growth on that $20 million) would have been taxed at $9 million or more as it passed to the kids, and another 45 percent tax would have been assessed at the death of the children.

Feldman also points out that life insurance policies are often excellent candidates for a generation-skipping trust, but it's critical to get expert professional advice to navigate some of the technical requirements.

Planning for an Inheritance

A generation-skipping trust can also be used when a client "looks upstream" at what he may inherit from his parents. For example, a surgeon who has a lot of liability risk may want the parents to put the funds he'll inherit into a generation-skipping trust. That way the inher ited assets are available to him, but the inheritance itself is protected from creditors and can be passed down to the grandchildren without gift or estate tax. "This is like putting the assets in a tax-free insurance wrapper," says Feldman. "Any clients who have even moderate wealth might consider having their parents transfer their inheritance into a generation-skipping trust."

So even a family with $1 million in home equity and a retirement plan might consider a generation-skipping trust. "This is very straightforward, vanilla-type estate planning," says attorney Philip Feldman. Consult your trusts and estates attorney on the details, as some drafting nuances must be addressed, and state laws vary on specific aspects of these trusts.