In writing the Tax Reform Act of 1986, Congress devoted a lot of time to closing loopholes for the rich.
One that was given particularly harsh treatment was the "generation-skipping transfer," a once-common device by which wealthy people shifted assets to their grandchildren, thereby cutting out one level of estate tax.
But nobody loves a loophole as much as Congress. In a provision that was particularly beneficial to the wealthy winemaking Gallo family of California, Congress wrote in a temporary exemption for generation-skipping transfers of up to $2 million per grandchild.
Under the "Gallo exemption," as it is known, a grandparent can give during life or bequeath at death $2 million to each grandchild and pay no more than the standard gift-estate taxes. Those taxes are not insignificant, especially on large amounts, but they are still a lot less than the double whammy that will be accorded such transfers after the exemption expires.
That expiration date is coming up in just a little less than two months. Assets transferred across generations after Dec. 31 will bear the full brunt of the 1986 law.
There will remain an exemption of $1 million per grandparent for transfer after Jan. 1, which applies to other descendants, while Gallo is restricted to grandchildren.
For very large transfers, the generation-skipping tax can be staggering. On an estate of $20 million left entirely to a grandchild, taxes could reach almost $16 million, said Jack Porter of the accounting firm BDO Seidman in Washington.
The $20 million would be subject to a 55% ordinary estate tax--the impact of graduated rates applicable to lesser amounts can essentially be ignored when the estate is this big, he said--cutting it to $9 million.
Then a 55% generation-skipping tax would be applied to the $9 million, reducing it to $4.05 million, Porter said.
"The moral is, if you have a generation-skipping will or estate plan, it would be advisable to die before Jan. 1," he said with a laugh.
The impact at lesser sums is not as spectacular but still worth avoiding when intergenerational transfers are contemplated. For most people, other planning avenues will be sufficient.
"It takes great wealth even to consider" using the Gallo provision, said William G. Brennan of Ernst & Young. The $1-million-per-grandparent, generation-skipping transfer tax exclusion, an exclusion from the tax for payments of tuition and medical expenses--along with the exclusion of $10,000 per recipient per year from all taxes--will cover as much asset shifting as all but the very wealthy are likely to make.
"The real point about Gallo," said Sam Radin, president of National Madison Group, an estate planning firm in New York, "is if it may apply, consider it. Make an informed decision to take advantage of it or ignore it, but don't lose the opportunity through the passage of time."
Experts agree that the Gallo provision also has serious disadvantages, said Greg A. Nelson of Arthur Andersen & Co., and so "a lot of people don't seem to be rushing out and using" it.
The first problem is that the grandparent would have to pay gift tax on amounts of more than $600,000 (or $1.2 million in the case of two grandparents). These rates are stiff, Nelson said, and "nobody tends to be interested in writing large checks to the IRS unless they have to."
He added, though, that with assets likely to appreciate substantially, the value of escaping estate taxes on the later appreciation may well exceed the present value of the current gift taxes.
Giving away a large insurance policy--which will appreciate at the death of the insured--can be a useful strategy, he said.
Another problem is that outright gifts create wealthy grandchildren--something that may not be desirable if they are very young or no good at handling money.
It is possible to leave assets in trust and still qualify, but the rules are very strict, and the trust must begin paying income when the beneficiary turns 21.
The rules under Gallo prohibit providing the intermediate generation with an income interest, so the grandparent cannot leave the assets in trust for the grandchild with the income to go to the grandparent's children.