Generation Skipping Tax: GST 101

The Generation Skipping Tax (“GST”) is a tax made on gifts to grandchildren, great grandchildren, or beyond. This tax came about to address the problem of dynasty trusts. Essentially, very wealthy families would set up a life estate for their children, which turned into a life estate for their grandchildren, which turned into a life estate for their great-grandchildren, and so on and so forth. During each life estate, the generation would have access to income from the trust. Because a life estate is not subject to a federal estate tax, the plans could shield massive amounts of money from federal taxation.

How does the Generation Skipping Tax apply?

In 1976, the federal government finally got wise to the dynasty trusts. They created the Generation Skipping Tax (or Generation Skipping Transfer Tax) to impose a high tax on the skip generation. This is on top of the federal estate tax, creating a very high tax burden. In its current form, the tax applies to three groups of people. (1) It applies to intentional skips, such as grandparents leaving money to their grandchildren. (2) The tax applies to trusts left to children, where the children die without exhausting the trust. The residue of the trust would go to their children (the grandchildren). (3) It applies to trusts where the only beneficiaries are grandchildren or beyond. (4) The tax applies to non-relatives that are more than 37 ½ years younger than the gift giver. If a gift is made to a grandchild but at the time of the gift the child (parent) has deceased, then no GST is triggered.

The Generation Skipping Tax applies to gifts made during life and at death. The GST rate is equal to the federal estate tax rate. As of 2020, the tax rate is 40% for any taxable estate. Likewise, there is a GST exemption equal to the federal tax exemption. As of 2020, the federal estate tax exemption is $11,580,000. Unlike the federal estate tax exemption, the GST exemption is not portable between spouses.

How do you plan around the GST?

The Generation Skipping Tax exemption is currently quite large. The exemption can be used by making a direct gift to a grandchild. If the gift went to the child first then to the grandchild, the gift would be part of the child's estate. If that estate were large enough, it would be taxed. Also, by giving the gift directly to the grandchild, it guarantees that the grandchild will get the gift. In other words, the child will not have an opportunity to redirect the gift. As previously noted, this skipping transfer can be direct or done with trusts.

Digging a little deeper, the GST exemption can be used to benefit one's children as well. First, you could create a trust with the child as the beneficiary. They could receive, for example, income from the trust. Second, at some specified age, the child could be appointed as the sole trustee over the trust. Two things would need to happen. (1) Discretion to distribute from the trust must be subject to some ascertainable standard. Distributions for Health, Education, Maintenance, or Support (“HEMS”) is a typical standard used. (2) The child cannot be given general testamentary power of appointment. In other words, they cannot change the beneficiaries of the trust. Finally, third, when the child dies, the trust passes to their children and the GST exemption would be triggered. Therefore, the gift ultimately going to the grandchildren was able to benefit the children while they were alive. And it happened by use of the GST exemption.

This is just one example of using the Generation Skipping Tax exemption to shelter an estate from taxes. There are certainly other structures that can be used, some much more complicated than this. For example, the GST exemption could be used with an AB trust to great benefit.

Takeaway

Currently the GST exemption is only exhausted for lifetime gifts of $11.58 million. This is a size far beyond what most estates will attain. However, there are two things to keep in mind. First is that while your estate may not be substantial enough to benefit from the exemption, your children's might. Second, while the GST exemption is currently high, if there is an administration change, the GST exemption may drop dramatically. Combined with that first point, the GST exemption suddenly looks to have some value. If you have questions about how the GST affects your estate plan, contact Signature Law for a free consultation.