The Generation-Skipping Tax (sometimes abbreviated as “GST”) can have a huge impact on the assets you plan on leaving to your heirs if not properly planned for. GST can apply when a grandparent leaves assets to a grandchild – skipping over their parents in the line of inheritance. If you are thinking about passing assets on to future generations, it is important to know how GST may affect your estate plan.
- What is Generation Skipping Tax?
The “Generation Skipping Tax”, as the name implies, is a mechanism for taxing certain transfers that span multiple generations. The purpose of GST is to tax transfers which would otherwise escape estate or gift taxation. The spirit of the rule is that federal transfer tax of some kind should be imposed on transfers of wealth at each generational level. Congress became increasingly worried about breaking up dynastic generational wealth when it was clear that clever estate planners could avoid the estate and gift tax in one generation if they helped taxpayers bypass that generation (e.g., children), and pass wealth to the second generation instead (e.g., grandchildren). This avoided estate and gift tax at the children’s level, allowing for greater transfers of wealth to future generations.
- The History of GST
GST has had somewhat of a tumultuous history. It was originally put into place by the 1986 Tax Reform Act, but then was repealed in the 2001 Economic Growth and Tax Relief Conciliation Act for transfers after 2009. But in late 2010, the Tax Relief, Unemployment, Insurance Reauthorization, and Job Creation Act of 2010 reinstated GST for generation-skipping transfers made after 2009. This version is what we have today.
- When GST Applies
GST is imposed on transfers that skip two or more generations (e.g. grandparent to grandchild) when the transfer is a taxable gift (thus it would trigger gift tax) or the transfer would be included in the estate of the person making the transfer (thus it would be subject to estate tax). Beneficiaries who will receive a transfer subject to GST are often referred to as “skip persons”. Transfers to a trust that benefit skip persons are also subject to GST. For beneficiaries who are not part of the transferor’s family, the tax is imposed when the donor is at least 37.5 years older than the recipient.
In summary, there are three situations where a transfer is subject to GST:
- A direct generation skipping transfer that is non-exempt; or
- A non-exempt trust with skip persons as potential beneficiaries that must make distributions to skip persons or all interests in the trust are held by skip persons; or
- A non-exempt trust terminates and interests in the property held in trust or distributions from the trust are made to skip persons.
- GST Rates
The applicable GST tax rate is determined using the highest federal estate tax rate at the time of the generation-skipping transfer,1 which is 40% for decedents dying and generation-skipping transfers made after 2012.2 The actual tax on a GST transfer is based on the “inclusion ratio”, which is how much of the transfer is subject to GST. This is determined by subtracting the applicable fraction of the property transferred and subject to GST from the number one. This is a subject which could warrant its own article, but for now, it is sufficient to say that if the applicable ratio is 1.0 (i.e. the entire amount of the transfer is subject to GST), then the entire amount is subject to the 40% GST tax rate.
- Exemptions to GST
Much like the “unified credit” or “lifetime exemption” for estate and gift taxes, there is also a GST exemption. This means that each individual is able to make transfers subject to GST up to a certain amount before tax must actually be paid due to GST. The GST exemption is cumulative for transfers during lifetime and at death, and is allocated automatically to transfers made during lifetime that are direct skips. The amount of GST exemption per taxpayer is $12,060,000 in 2022 for transfers made after 2017 and before 2026. Unless congress changes the current rules, the GST exemption amount will revert to a $5,000,000 baseline indexed for inflation in 2026.
There is also an exemption rule for transfers made to skip persons who have predeceased parents. If a skip person has a deceased parent when the transfer is made, then the skip person moves up one generation and the transfer is not subject to GST (it is instead subject to gift or estate tax). For example, if grandpa gifts $300,000 to his grandson but grandson’s father is deceased at the time of the gift, grandson is treated as stepping up to his father’s generational level, and thus the transfer is not subject to GST. It is instead subject to gift tax.
- GST Planning
The potential pitfalls with GST discussed above, especially in the trust context, make it very important for taxpayers to consult with an experienced estate planner to ensure that the GST exemption is utilized properly and GST is minimized or eliminated entirely in a comprehensive estate plan.
See IRC §2641.