Why is this Topic Important to Wealth Managers? Provides details about one concept that wealth managers often overlook, the generation skipping transfer tax. Also presents general concept themes and examples to show effective uses of life insurance and trust in consideration of the tax.
In general, the generation-skipping transfer tax is levied on the value of life insurance that is transferred during the grantors lifetime or at death, to a skip person.  The GST is levied in addition to estate and gift taxes. 
The generation-skipping transfer (GST) tax “scheduled to resume in 2011 at a rate of 55%, with a $1 million exemption. The rate was 45% in 2009, with a $3.5 million exemption.”  For more information about the expiring tax cuts and new tax rates, see our blogticle: AdvisorFYI: Estate and Gift Taxes, Tax Cuts and More.
“Certain direct gifts that qualify for the gift tax exclusion may also qualify for an annual exclusion that can be applied against the GST tax.”  Many wealth managers encourage clients to take full advantage of the annual exclusion to avoid GST tax considerations at some later point. However, “the expiration of the GST tax has complicated matters for wealthy individuals hoping to make 2010 gifts in trust that skip generations.”  The use of trusts in consideration of the GST tax is discussed below. For examples of insurance uses with trusts generally, see our previous blogticle: Trusts that Purchase Life Insurance; Known Formally as the “Irrevocable Life Insurance Trust
It is helpful to understand key terms and concepts when discussing the GST tax. A skip person is at least two generations below the transferor’s generation.  Grandchildren are common skip people along with most trust arrangements where trust beneficiaries are skip persons.
On the other hand, the GST tax does not apply to amounts transferred to non-skip people, those who are no more than one generation after the transferor, or who are any generation above the transferor.  Examples of the former are children or siblings. Examples of the latter generally include parents and grandparents.
When does the GST tax apply?
- Direct Skip- transfer subject to gift or estate tax is made to a skip person (or trust). 
- Examples: 
- Client gives life insurance policy to a grandchild.
- Client transfers life insurance policy to an ILIT for grandchildren and great-grandchildren.
- Client dies owning life insurance and proceeds are paid to grandchild
- Taxable Transfer- Occurs the moment when there are no more non-skip persons ahead of the skip person for amounts or property held in trust. 
- Example: 
- Client creates a life insurance trust that provides “Income from this trust is to be paid to my three children for life. At the death of the last survivor, principal is to be distributed to my six grandchildren”.
- When the last non-skip person’s (children’s) interest terminates (in this example, by death), the property in the trust is subject to the GST tax.
- Taxable Distributions- Occurs when income, principal or property is distributed from a trust to a skip person. 
- Such distributions can occur while the non-kip persons are alive. 
Let’s take a look an example  of the use of a trust versus “doing nothing”:
Assume a trust is established and the grantor makes a gift of $1,000,000 (under the GST tax, tax exempt). Assume further, the trust earns 6.5% annually, and all income is reinvested. The calculations are made under a 55% federal estate tax rate (which is to occur in 2011 without further action from Congress).
After the first generation (28 years) the amount held in trust is $5,831,617, assuming this amount is outside the grantor’s estate for estate tax calculation purposes, the estate tax will be zero, and for the third generation, the estate tax too would be zero, if outside the grantor’s estate. The value in trust after the grandchildren’s generation is just over $34,000,000 and when it gets to the end of the great grandchildren’s generation (84 years from first gift) the amount held in trust, and to be distributed to the great-great grandchildren is $198,320,235. If the trust was not used the initial gift from grantor is passed through the generations, the great-great grandchildren will end up with a mere $18,071,934 or less than 10% of the amount when the trust is used. Talk about the time value of money.
Please note the above example is available in printable .pdf format on AdvisorFX, please log-in to view and print. In addition, the GST tax and use of trusts is further examined on FX under AUS: Section 2.1 The Generation Skipping Transfer Tax, “C—The Insurance Funded Family Bank.”
Tomorrow’s blog will discuss key employee life insurance. .
We invite your questions and comments by posting them below, or by calling the Panel of Experts.
Leimberg, Doyle. Tools and Techniques of Life Insurance Planning, 4th
Ed. 375. 2007. The National Underwriter Company. Cincinnati, Ohio.
 26 U.S.C. § 2601.
 Northern Trust. “2010 Tax Legislation Update — Bush Tax Cuts Expiring.” http://www.northerntrust.com/wealth/10-summer/2010-tax-legislation-update-bush-tax-cuts-expiring.html. Last Accessed 10/26/2010.
 Leimberg, Doyle. Tools and Techniques of Life Insurance Planning, 4th Ed. 375; see also, 26 U.S.C. § 2642 (c).
 Northern Trust. “2010 Tax Legislation Update — Bush Tax Cuts Expiring.”
 26 U.S.C. § 2613.
 26 U.S.C. § 2612; 26 U.S.C. § 2613(b).
 2612 (c)
 Tools and Techniques of Life Insurance Planning. “Life Insurance and the Generation Skipping Tax.” PowerPoint Presentation. Slide: 25-4, see also, Leimberg, Doyle. Tools and Techniques of Life Insurance Planning at 377.
 2612 (a).
 Tools and Techniques of Life Insurance Planning. “Life Insurance and the Generation Skipping Tax.” PowerPoint Presentation. Slide: 25-5; see also, Leimberg, Doyle. Tools and Techniques of Life Insurance Planning at 377.
 2612 (b).
 Tools and Techniques of Life Insurance Planning. “Life Insurance and the Generation Skipping Tax.” PowerPoint Presentation. Slide: 25-6; See also, Leimberg, Doyle Tools and Techniques of Life Insurance Planning at 377.
 Example first presented in AUS Main Libraries. Section 2.1 The Generation Skipping Transfer Tax, C—The Insurance Funded Family Bank. http://www.advisorfx.com/articles/f2-1_1_12_1260.aspx?action=13. Last Accessed 10/27/2010.