Generation-Skipping Transfer Tax Basics

If you have ever sought the advice of an estate planning professional, you’ve probably heard of the generation-skipping transfer tax (GSTT). It is likely that you and your descendants will not be subjected to this tax — either due to the $11.7 million per person gift tax, federal estate tax and GSTT lifetime exemption or because of planning that subjects trust property to estate tax inclusion in the lower generations to avoid the GSTT. But I am getting ahead of myself.

What is the Generation-Skipping Transfer Tax?

The generation-skipping transfer tax is another transfer tax akin to the gift tax and the estate tax. The GSTT applies to all transfers made by gift or inheritance to any person considered a “skip person” under the law and to distributions from all trusts to a skip person if the trust was established on or after Sept. 25, 1985 (with the exception of a trust established by a non-U.S. grantor funded with only non-U.S. situs property, meaning property that is not subject to U.S. taxation due to treaty or another sovereign’s exclusive power). 

For this discussion, a taxable transfer is any property you give to a person or an irrevocable trust for less than its fair market value. A skip person is a person who is assigned to a generation at least two generations below you. So, who are these skip persons?

• First generation: You and your spouse, your siblings and their spouses.
• Second generation: Your children and their spouses.
• Third generation (skip persons): Your grandchildren and their spouses (and all descendants following). Also included as skip persons: unrelated persons who are more than 37½ years younger than you.

The purpose of the GSTT is to capture and tax all taxable transfers that may avoid the application of the gift and estate tax by skipping a generation or more. One example would be writing a $30,000 check to a grandson for a down payment on a house. This gift would skip your own child, thus avoiding the possible gift tax that would apply if the gift had passed from you to your child and then from your child to your grandchild. Therefore, it is subject to the GSTT.

Another example would be establishing an irrevocable trust for the benefit of your eight grandchildren with instructions for the trustee to pay all their college expenses until the youngest grandchild is 25 years old. At that point, the trust would divide into eight shares, with each grandchild getting their share outright and free of trust. Every distribution from this trust would be subject to the GSTT, including the final division when the trust terminates.

The social science argument behind the GSTT is that if property could be transferred for successive generations without paying a transfer tax at each successive transfer, then wealthy families would eventually accumulate so great a percentage of the nation’s total wealth that upward mobility for the lower economic classes would be unfairly restricted, and future generations of middle-class workers would be driven into poverty.

How the GSTT works

Because Congress intends that transfer taxes only apply to wealthy families, the law provides a lifetime exemption threshold from all such taxes and an annual exclusion for lifetime gifts. The GSTT exemption and applicable exclusion are determined every year and are indexed for inflation.

The current federal estate tax, gift tax and GSTT exemption is $11.7 million per person, with a top tax rate of 40%, which is set to “sunset” at the end of 2025 to pre-2018 levels (adjusted for inflation). Legislation has been introduced this year proposing to lower the GSTT exemption and cap the duration of trusts that are exempt from GSTT to 50 years — presumably assessing GSTT at the end of the period at the same rate as the estate tax.

The GSTT must be paid either at the time the estate tax return is due (in the case of a transfer at death), when the gift tax return is due (in the case of a lifetime transfer) or when a trust solely for the benefit of skip persons makes a distribution or terminates in favor of a skip person — as in the example above of the trust paying for grandchildren’s college education. The tax is either paid by the trustee, the executor or the skip person who receives the transfer, depending on the circumstances.

Exemptions and exclusions

However, a proper application of the gift tax, estate tax and GSTT lifetime exemption relieves most trusts and estates from paying any transfer taxes at all. Your estate planning professional will also have you include a provision in your estate plan that:

• Isolates any GSTT non-exempt property to a separate trust that can either control the distributions to properly pay the tax, or
• Exposes the trust property to the estate tax so it may be subject to a trust beneficiary’s own gift tax, estate tax and GSTT lifetime exemption.

Besides the exemptions, there is another exception for a taxable transfer to a grandchild whose parents are deceased. This applies if the parent died before the taxable transfer or was deceased at the time the irrevocable trust is executed.

To benefit from these exemptions and exclusions, you must file a gift tax return for any lifetime taxable transfers you make to allocate the gift, estate and GSTT lifetime exemption in that year. However, if the total taxable transfer to one person in a single year is below the annual exclusion gift limit, currently $15,000 ($30,000 if your spouse joins your gift), then no reporting is required. So that $30,000 check for the down payment on your grandchild’s new house could actually avoid the GSTT if your spouse agrees to the gift and you both make no further taxable transfers to that grandchild in the same year.

Finally, if you file a gift tax return to allocate part of your gift tax, estate tax and GSTT lifetime exemption to that irrevocable trust for your grandchildren’s college education, then that trust is an estate tax and GSTT-exempt trust. It will never pay any transfer taxes even when it terminates (although any proceeds that your grandchildren receive outright could be taxed if they then make taxable transfers to someone else).

This tax-exempt status applies for as long as the trust lasts, unless it violates state law limiting the duration of trusts or a prohibition of a restraint on the alienation of real property. So, you could draft the aforementioned college education trust so that rather than terminating when the youngest beneficiary reaches age 25, it could instead divide into eight separate share trusts for the benefit of each grandchild and their descendants for as long as state law allows (which is 360 years to forever, depending on the state) and avoid transfer taxes the entire time.

The value of expert planning advice

If your current estate is likely to be subject to the federal estate tax at death, meaning it is or may be greater than the applicable lifetime transfer tax exemption, and/or you plan to make gifts greater than the annual exclusion limits, then you should seek out advanced estate planning advice today to appropriately apply your tax exclusions and exemptions for all the times you or your trusts will make a taxable transfer.

An estate planning professional will advise you on how best to structure your gifts and trusts so that you avoid paying any more transfer taxes than legally required, which for a vast majority of taxpayers is none at all.