How powerful are generation-skipping transfers in building family wealth?

Grandparents typically provide for their property to go to their children first, then to their grandchildren. However, this will cause two levels of transfer tax: first at the grandparent level, then at the parent level. Even in modest estates, this may cause 80% of the available assets to be consumed by taxes. An individual who wishes to transfer $1 million net to a grandchild would require assets of $4,938,272 in order to do so:

Amount available in
  grandparent's estate            $4,938,272
Less: Federal estate tax at 55%   (2,716,050)
Amount received by child,
  preserved and bequeathed to
  grandchild                       2,222,222
Less: Federal estate tax in
  child's estate at 55%           (1,222,222)
Balance to grandchild from
  parent's estate                 $1,000,000

Grandparents, therefore, often wish to bypass their financially well-off children and transfer assets directly to grandchildren. Transfers to grandchildren, however, are subject to the generation-skipping transfer tax (GSTT); the Federal tax is imposed at a 55% rate on taxable transfers to, or for the benefit of, grandchildren or other persons two or more generations below the transferor. This results in Federal transfer taxes on a direct bequest to a grandchild being the same ($3,938,272) as the total estate taxes on assets passing through two generations.

In contrast, a lifetime gift directly to a grandchild produces gift tax substantially larger than 55% of the gift, because the gift tax is computed on the sum of the taxable gift and GSTT thereon:

Assets available
  to grandparent                $2,402,500
Less: Generation-skipping
  tax at 55% on $1,000,000
  given directly to grandchild    (550,000)
Less: Gift tax at 55%
  imposed on $1,550,000           (852,500)
Amount given
  to grandchild                  1,000,000

Note, however, that the total transfer taxes on a $1 million lifetime gift to a grandchild ($1,402,500) are substantially less than the taxes on a $1 million. (net) bequest to a grandchild (assuming the grandparent lives for three years from the date of the gift).

Use of the $1 million GSTT exemption substantially reduces the impact of transfer taxes on a family. The table (top right) summarizes the total Federal transfer taxes imposed on transferring $1 million (net) to a grandchild under two alternatives.

                            Without      With
                          $1,000,000   $1,000,000
                            GSTT         GSTT
                           exemption   exemption
Bequest to child
  followed by child's
  bequest to grandchild   $3,938,272    $3,938,272
Bequest directly to
  grandchild               3,938,272     1,222,222
Lifetime gift directly
  to grandchild            1,402,500      550,000

Although a lifetime gift results in the lowest overall tax, it requires current payment of gift/GSTT tax (to the extent the transfer is not protected by a married couple's $1.2 million gift/estate tax exemption equivalent and/or their $2 million GSTT exemption). One should compare the amount of the overall transfer tax savings, as well as the advantage of having future income and appreciation on on the transferred property escape both generation-skipping and estate taxes, with any current tax payments (and the loss of income on those payments).