WATCH OUT FOR THAT TAX, GRANDMA!

Grandparents are blessed individuals. They get to have little children scamper at their feet twice in their lives. They get to see their children – whom they lovingly raised to mature adults – have children of their own. They get to play with their grandchildren and share in the wonder of discovery all over again. And, then, as the saying goes, they get to see their grandchildren leave at the end of the day, so they can have a peaceful night of sleep.

But the federal government doesn’t seem to think as highly of the love that flows between grandparent and grandchild. The federal government, through a little know tax – little known to anyone who isn’t an estate planning attorney or accountant – taxes bequests and gifts from grandparent to grandchild at a flat tax of 48% (year 2004 figure).

I’m not joking. This is a real tax. It’s called the Generation Skipping Transfer Tax (“GST”), and it really does exist.

Now, it may not apply to many people, because the tax will only be paid if the amount of the bequest or gift exceeds the exemption equivalent against the tax. In 2004, which is just around the corner now, the exemption equivalent will be $1,500,000, which is the same exemption equivalent that we will all receive against federal estate tax.

In other words, if grandfather dies in the year 2004, leaving his entire estate of $1,000,000 to his grandson, the grandfather’s estate will not pay GST Tax or federal estate tax; however, if grandfather dies leaving his $1,600,000 estate to his grandson, his estate will pay GST Tax and federal estate tax on the amount over $1.5 million, or, in this hypothetical, $100,000.

The combined tax on that $100,000 would be $93,000. The federal estate tax would impose a tax of 45%. The federal estate tax is progressive. In 2004, the tax starts out at 45% and increases to 48%. The GST tax is a flat tax, pegged to the highest marginal federal estate tax bracket, or 48% in the year 2004. The combined effect of these taxes is to essentially swallow-up any amount in excess of the exemption equivalent as and for tax.

In this area of the country, having $1,500,000 doesn’t make you rich. A person could have a house that easily puts him half way to owning $1.5 million dollars of assets. Don’t get me wrong, having $1.5 million isn’t bad, not bad at all, but it doesn’t make you rich.

Furthermore, it is not inconceivable that a person might want to leave their entire estate to their grandchildren. Their child may have died. They might feel that their child was well taken care of when he was growing up and that their grandchild needs the money more. Whatever the reason, the fact that a grandparent might want to leave his entire estate to his grandchild is certainly not beyond the pale.

And, for those grandparents that have accumulated assets with significant value and who want to leave their estates, or even a portion of their estates, to their grandchildren, beware. The GST Tax could easily turn your hard-earned money into a tax liability.

In fact, the GST Tax can actually be so onerous that a gift could end up costing the gift-giver more money than the gift he gave. Assume that a grandmother has used up all of her available credits and is in the 50% tax bracket for gift and estate tax purposes. The grandmother than makes a $100,000 gift to her granddaughter. As a result of this gift, the grandmother must pay a gift tax of $50,000 (50% of $100,000), a GST tax of $50,000 (50% of $100,000), and an additional GST tax on the gift tax that the grandmother paid of $25,000 (50% of $50,000). The grandmother actually paid $125,000 in tax to make a $100,000 gift.

Now, as mentioned, the tax is greatly alleviated by the $1,500,000 credit equivalent that will exist in 2004 (the credit equivalent is $1,120,000 in 2003). In addition, for lifetime gifts, the same exclusions from the gift tax apply, that is, the $11,000 annual exclusion, the unlimited tuition payment exclusion, and the unlimited medical expense exclusion. The latter two exclusions allow an individual to pay another individuals tuition or medical expense without paying gift or GST tax.

The GST tax is definitely something to bear in mind and to plan around. Planned carefully, you can avoid the tax. Ignored, you could end up paying more tax than the amount of money you transferred.