Let’s take a look at a hypothetical scenario. Your grandparents started from scratch having inherited nothing to speak of, and they worked hard all of their lives. They were fortunate enough to accumulate some wealth, but when they passed it along to your parents, it was reduced by nearly half due to the estate tax. Your parents did well in their own right and never had to touch what they inherited from your grandparents. When they pass on and leave that legacy to you it is subject to the estate tax once again. The same thing will happen when you leave those assets to your children and this goes on and on.
A pragmatic reaction to the harsh realities of the estate tax is the creation of a generation-skipping trust. With this vehicle you name your grandchildren as the beneficiaries of the trust, but your children can still benefit from it. For example they can live in property that is placed in the trust rent free, and they can receive cash distributions from the trust. They can even control the disposition of assets within the trust to parties other than themselves through the utilization of a special power of appointment.
Since your children don’t own the resources that have been placed in the trust, former spouses and other potential claimants can’t go after these assets. And since the assets were not directly bequeathed to any individual no estate tax is applicable. There is a generation-skipping transfer tax, but there is an exemption that is in the range of $1.3 million, so if the contents of the GST are less than that threshold this tax would not be levied either.
To take it a step further, your children can then set up a generation-skipping trust and name their grandchildren as beneficiaries, and so on down the line, creating a dynasty of sorts that keeps the assets in the family and out of the hands of the tax man.