This article addresses one of these “mysterious” areas of estate planning that is often referred to as GST (Generation Skipping Transfer). Actually, this area involves the concept of planning over several generations, and is based on the reality that estate planning cannot focus on a single client or a single generation. Estate planners always need to be aware of how actions of prior generations will affect the current generation, and how the actions of the current generation will affect future generations. The proper term for this kind of planning is probably something like “multiple generation planning”. However, the terms generation skipping and GST are used quite often because of the specific tax rules that operate to control multiple generation plans (and because planners are always looking for shorter ways to refer to ideas).
The Federal Generation Skipping Tax
The current federal Generation Skipping Transfer Tax (GST Tax) came into existence with the Tax Reform Act of 1986 (the original 1976 version was repealed retroactively. Thank goodness it was an unbelievable mess.). Basically, the federal “death” tax imposes a tax on the transfer of assets during life and at death in excess of the “basic exclusion amount” (“BEA”), which refers to all taxable gifts a person makes during life and death. The credit is now “unified”, meaning it applies to all life and death gifts. When a person’s combined taxable gifts exceed the BEA, noncharitable gifts are subject to a “gift and estate tax” (currently 40%). The credit was raised to $5 million in 2012 and now increases each year in the inflation amount (about $100,000 each year). In 2018, the BEA was “doubled” under the TCJA, but this “bonus exemption” expires at the end of 2025. Therefore, taxpayers will lose this opportunity if not used before then.
Similarly, the GST Tax applies above an exemption amount (currently same as BEA, and doubled till 2026), and is designed to ensure that taxpayers cannot avoid gift and estate tax by giving their property to grandchildren, and to ensure that large family fortunes are taxed at each generation, unless an exemption applies.
The primary target of the GST Tax is the typical “generation skipping trust” (sometimes called a GST Trust or Dynasty Trust), which provides distributions for the benefit of a child for life with the remainder continuing on for the grandchildren (or more remote descendants). Under the current estate tax rules, GST exempt trust assets are not taxed at a child’s death where the child lacks such control that the IRS would fairly consider the assets to be “in” or included in the child’s estate. In this context, the reference to generation skipping does not mean that the economic benefits of the trust “skip” the children, but simply that the estate transfer tax is “skipped” at the death of the children. The GST Tax was established to prevent this type of tax “skipping” (at least above certain limits, as described below).
In the case of the typical GST Trust, the GST Tax is to be imposed at the death of the child, when the assets continue for the grandchildren, BUT ONLY (1) for gifted amounts in excess of the GST exemption and (2) for assets in the trust not otherwise subject to the other tax, the gift and estate tax, at the child’s death. The GST Tax also applies to direct transfers to grandchildren that would otherwise avoid the GST Tax because no trust is involved.
Rate and Specific Application
When the GST Tax applies, the rate is currently 40%. The GST Tax apples to each gift that is a Direct Skip, Taxable Termination, or Taxable Distribution.
A direct skip occurs whenever a transfer is made to a “skip person” with no intermediate benefit to a non-skip person (i.e., a gift to a grandchild but not that child’s parent). A skip person is anyone assigned to a generation that is two or more generations below the transferor’s assigned generation (the most common example of a skip person is a grandchild). A trust can also be a skip person if all the beneficiaries are skip persons.
A taxable termination occurs in a trust when the interest of a non-skip person terminates and there are no more non-skip persons still holding an interest. For example, a taxable termination often occurs upon the death of a child beneficiary and the only remaining beneficiaries are grandchildren.
A taxable distribution occurs whenever a distribution is made from a trust to a skip person. However, a taxable distribution does not occur if the event is otherwise classified as a direct skip or a taxable termination.
To determine if a person is or is not a skip person for GST Tax purposes, everyone is assigned to a specific generation on the basis of: 1) lineal descent (if applicable); or 2) an implied generation assignment based on each 25-year age group (for example, a person born more than 12 _ years but less than 37 _ years after the transferor will be deemed to be in the generation immediately below the transferor). [IRC § 2651] In the case of lineal descendants, the spouse of a descendant is deemed to be in the same generation as such descendant. [IRC § 2651(c)]
There is also the “move up rule,” which provides that at the time of any transfer to a skip person, if the parent of the skip person (who is a descendant of the donor) is not living, then the transfer will not be deemed a direct skip because the skip person is “moved up” to the generation of his or her deceased parent. [IRC § 2612(c)(2)] The move-up rule does not apply if the non-skip person is only deemed to have predeceased the transferor as a result of a qualified disclaimer.
Exclusions from the GST Tax
The GST Tax does not apply to transfers made prior to September 25, 1985, the date Congress got wise to avoidance planning, so that an irrevocable trust created before then is considered “grandfathered” for GST Tax purposes (distributions from the trust are generally not subject to the GST Tax). In addition, the GST Tax does not apply to any transfer under a will or revocable trust if the will or trust was executed before October 22, 1986, and the decedent died before January 1, 1987. However, if additions are made to a grandfathered trust, the trust becomes partially taxable in the future, except to the extent a GST Exemption (described below) is allocated to the additional transfer.
In addition, if a transfer is not subject to gift tax when it is within the $15,000 annual exclusion amount. Further, transfers to trusts that qualify for the gift tax annual exclusion as a result of withdrawal rights (sometimes known as Crummey Powers) will not qualify for the GST annual exclusion unless the trust also meets the requirements detailed above.
Finally, transfers made directly to education institutions (for tuition) or healthcare providers on behalf of a donee, which are therefore exempt from gift tax under IRC § 2503(e), are excluded from the GST Tax. [IRC § 2611(b)(2)]
Under the 2018 TCJA, there is an exemption amount for gifts subject to the GST Tax, in the amount equal to the BEA, $5 million which is also “doubled” until 2026. Thus, the GST Tax does not “kick in” to gifts under the exemption amount. However, all gifts in excess of the annual exclusion ($15,000) have to be reported on a IRC Form 709 gift tax return.
The GST Exemption can be “allocated” to gifts in any manner chosen by the transferor (or the decedent’s personal representative). [IRC § 2632(a)] Normally, the GST Exemption cannot be allocated without affirmative action of the transferor. However, the GST Exemption IS automatically applied to direct skips unless the transferor elects NOT to allocate GST credit. [IRC § 2632(b)]
Any part of GST Exemption unused at death and not allocated by the decedent’s personal representative/executor will be automatically allocated to direct skips occurring at death. Any remaining GST Exemption is allocated to trusts with respect to which the decedent is the transferor (including taxable distributions and taxable terminations).
Reverse QTIP Election. Married couples can make use of a special IRC § 2652(a)(3) election (“the reverse QTIP election”) that allows the full use of the GST Exemption for both spouses, even when the unlimited marital deduction has already been used by the deceased spouse. Normally, assets in a Qualified Terminable Interest Property (QTIP) Marital Trust are deemed to pass from the surviving spouse (and can only use the GST Exemption of the surviving spouse). The election under the Code “reverses” this so that, for GST Tax purposes only, the assets in the QTIP Trust are “deemed” to pass from the first spouse (and therefore will utilize the first spouse’s GST Exemption).
ETIP Rules. No GST Exemption can be allocated to a transfer to which the transferor has retained certain rights or interests that would cause the assets to be included in the transferor’s estate for estate tax purposes under IRC §§ 2036, 2037, 2038, 2041, and 2042 (but not IRC § 2035). This is known as the “Estate Tax Inclusion Period” or “ETIP”, which continues until the assets of the trust would no longer be included in the transferor’s estate under the above Code sections.
Allocation to Lifetime Gifts . If an allocation of GST Exemption is made on a timely filed gift tax return (including extensions), the allocation is effective from the date of the gift (even if the value has since changed). An allocation of GST Exemption made after the due date for the gift tax return must be based on the current value of the asset (although the value at the beginning of the month may be used instead, unless the grantor has died). If an allocation of GST Exemption is made for an irrevocable life insurance trust (an “ILIT”), the GST Tax status of the ILIT continues after the grantor’s death, even if the grantor dies within three years and the trust assets (the insurance policy) are included in the Grantor’s estate for federal estate tax purposes.
Every trust has an inclusion ratio that determines the portion of each future distribution or termination that will be subjected to the GST Tax. [IRC § 2642] For example, an inclusion ratio of “zero” means that the trust is totally exempt from the GST Tax; an inclusion ratio of “one” means that all taxable distributions and taxable terminations will be fully subject to the GST Tax.
The inclusion ratio for a trust is initially determined by calculating the portion of the transfer that is not covered by the GST Exemption, or an exclusion, and dividing this amount by the value of the entire transfer. For example, if a person transfers $1,500,000 into a trust for her grandchildren only and allocates $1,000,000 of GST Exemption, the inclusion ratio of that trust would be:
$500,000 / $1,500,000 = 1/3
In practical terms, this means that 1/3 of the trust’s assets is NOT EXEMPT and will be subject to GST Tax.
General Planning Strategies
If the total value of the combined estates of a husband and wife is not expected to exceed their combined BEA exemptions ($10,000,000 inflation adjustered $1,000,000, then the GST Tax will not be a direct concern. However, if children have sizeable estates, it may be beneficial to have some or all of the parents’ estate put into GST Trusts, or be given to grandchildren outright, to avoid unnecessarily increasing the children’s taxable estates. To the extent possible, an estate plan for the parents should consider the planning opportunities for children that may be lost once assets are distributed outright to the children.
If the total value of the combined estates of a husband and wife is is less than the combined BEA exemptions ($5 million each inflation adjusted, doubled until 2026), then special planning to use the GST exemption may not be needed. persons out of exempt trusts.
This article summarizes basic concepts and considerations relating to the GST Tax. This is a complex area of the law, requiring an attorney with knowledge and experience in this area. At DRC, we have significant experience in this area and are able to help high net worth/ultra high net worth clients with effective strategies to reduce gift and estate tax and GST Tax.