Protect trust assets from a child's poor decisions while avoiding the GST tax
February 5, 2007
New Jersey Law Journal
As the number of millionaires rises, the question of how to pass wealth to younger generations continues to increase in importance. While many parents would like to leave a legacy for their children, many also worry that their children do not share their financial morals or are not financially savvy. For these parents, the prospect of leaving money outright to a child is disheartening.
These parents may instead instruct their estate planning professionals to draft the necessary instruments to leave their money to their child in a trust. However, if a parent creates a lifetime trust for the benefit of their child where the ultimate beneficiary of such trust will be such child's children (i.e., the grandchildren), the parent's Generation-Skipping Transfer (GST) tax exemption will need to be allocated to such trust. The GST exemption amount is currently $2 million, but will increase to $3.5 million in 2009, and may be repealed in 2010. However, for individuals who have accumulated substantial wealth over their lifetimes, the current $2 million GST exemption may not sufficiently cover the amount of assets being held in a lifetime trust for the benefit of their child and may be subject to a GST tax if proper planning is not utilized.
The GST tax is a federal tax in addition to any estate taxes which may be imposed on the individual's estate. It is imposed at the highest federal estate tax rate (currently 45 percent) on transfers of property to those individuals who are deemed to be two or more generations below that of the person making the transfer (i.e., transfers from grandparents to grandchildren). In the example discussed in the above paragraph, where assets are transferred to a lifetime trust for the benefit of a child, with the remainder passing to the grandchildren upon the child's death, this constitutes a GST transfer. If the amount of the transfer is in excess of the parents' available GST exemption, such excess will be subject to the GST tax.
To avoid the imposition of a GST tax, the lifetime trust could be drafted to provide the child with a testamentary general power of appointment over that portion of the trust that is not exempt from the GST tax. Pursuant to § 2041 of the Internal Revenue Code of 1986 (IRC), a testamentary general power of appointment is a power given to the child to appoint the assets in the trust to his estate, his creditors, or the creditors of his estate upon his death. By including a general power of appointment in the trust, the assets of the trust will be deemed to be included in the child's estate when he or she subsequently dies and, therefore, will not be subject to the GST tax.
A parent, or a trustee, does not have to affirmatively inform a child that he has a general power of appointment over the assets in a trust for it to cause estate inclusion. The Tax Court in Estate of Freeman v. Commissioner, 67 T.C. 202 (1976), held that a decedent's failure to exercise a general power of appointment over an inter vivos trust of which he had no knowledge did not exclude it from being a general power of appointment under § 2041(a)(2) of the IRC and being includable in his estate. Therefore, a child's lack of knowledge of the existence of the power, provided he has the mental capacity to exercise such power if he had such knowledge, will not be sufficient to exclude it from being a general power of appointment. However, if such a child requests information regarding the trust, such as a copy of the trust agreement, a trustee may not withhold information regarding the existence of the general power of appointment.
Many parents are hesitant to create a trust where the child has the ability to appoint the assets of the trust to his creditors. If the parent chooses to limit the class of individuals to whom the child may appoint, the power of appointment will be deemed to be a 'limited power of appointment.' Since § 2041(a)(2) of the IRC states that a decedent's estate shall include only that property over which the decedent had a general power of appointment at the time of his death, the granting of a limited power of appointment will not bring the assets of the trust into the child's estate upon his death and will be subject to the GST tax.
In an effort to meld the desires of a parent to both protect the assets of the trust from the child's undesirable exercise of the power yet also avoid the GST tax, the child's trust could be drafted so that the general power of appointment may be exercisable only with the consent of a nonadverse party. A power of appointment created after Oct. 21, 1942, may be a general power of appointment even if such power is only exercisable with the consent a nonadverse party. In Estate of Towle v. Commissioner, 54 T.C. 368 (1970), the Tax Court held that a power of appointment that was only exercisable with the consent of a bank, which was also acting as a trustee, was neither substantial nor adverse and was a general power of appointment within the meaning of § 2041 of the IRC. Pursuant to § 2041(b)(1)(C)(ii) of the IRC, a 'non-adverse' party is any person not having a substantial beneficial interest in the property subject to the power. As demonstrated in Estate of Towle v. Commissioner, a person can be a 'non-adverse' party regardless of whether he is serving as a trustee of the trust. For example, if a child's sibling would be the ultimate beneficiary of a trust if a child failed to exercise his power of appointment, such child's sibling would be an 'adverse' party rather than a 'non-adverse' party. If such child could only exercise his power of appointment with the consent of his sibling, the power of appointment would be a limited power of appointment. By including the restriction that the general power of appointment is only exercisable with the consent of a nonadverse party, the parent is able to achieve his dual goals of protecting the assets of the trust and avoiding the GST tax.
A general power of appointment that may only be exercised with the consent of a nonadverse party is a tool that wealthy parents who have already fully utilized their GST exemptions may use to pass wealth to future generations by means of a lifetime trust for a child, with the remainder to the child's descendants. Since the power of appointment will cause the trust property to ultimately be included in the child's estate upon his death, it will not be deemed to be a transfer to a person two or more generations below, thereby avoiding the imposition of a GST tax.
Thus, when considering which estate planning strategy to use, a general power of appointment that may only be exercisable with the consent of a nonadverse party, should be considered, as it will allow a parent to pass wealth to their future generations without the imposition of a GST tax.
Stephen L. Ferszt, a member of Wolff & Samson P.C. of West Orange, practices in the areas of estate planning, estate administration, taxation, ERISA and employee benefits. Roxanna E. Hammett, counsel at the firm, and Shannon L. Keim, an associate, focus on estate planning, estate administration and taxation.
This article is reprinted with permission from the FEBRUARY 5, 2007 Issue of the New Jersey Law Journal © 2007 ALM Properties, Inc. Further duplication without permission is prohibited. All rights reserved.