Beware of the Generation-Skipping Transfer Tax
Thanks to recent tax law changes, most families can avoid liability for federal estate and gift taxes. However, there’s a lesser-known tax whammy that can hit wealthy individuals without warning: the generation-skipping transfer (GST) tax. As its name implies, the GST tax generally applies to transfers that “skip” a generation.
Nevertheless, with astute estate tax planning, including the use of a generous lifetime gift tax exemption, you may able to sidestep any dire consequences under the GST tax, or at the least minimize its impact.
History of the GST Tax
The genesis of the GST tax goes back to the 20th century. Normally, federal estate tax would be triggered after the owner of sizeable assets passed away. Instead of leaving assets to their children, however, wealthy individuals often bypassed the next generation and bequeathed or gifted the property to their grandchildren, who were expected to end up with the bulk of the wealth anyway. This effectively eliminated one tax bite at the apple for Uncle Sam.
Accordingly, Congress enacted legislation to close this “tax loophole” in the form of the GST tax. Introduced in 1976, the GST tax applies to transfers to related individuals more than one generation away — such as grandchildren or great-grandchildren — and unrelated individuals more than 37½ years younger. All these designated beneficiaries are referred to as “skip persons.”
Furthermore, taxpayers can’t sidestep this potential tax pitfall simply by transferring assets to a trust, with descendants named as ultimate beneficiaries. For these purposes, all of the trust beneficiaries are treated as skip persons and even the trust can be a skip person in certain circumstances.
Similarly, a trust termination generally results in the imposition of the GST tax. This occurs when an interest in a trust terminates unless only nonskip persons are receiving the trust assets and no skip persons have a right to receive the assets after the termination.
Be aware that the tax law provides a special exception concerning grandchildren whose parents have predeceased them. In this event, the grandchildren are effectively moved up the line in the place of their parents, so the transfers no longer are technically skipping a generation. But such transfers are still subject to regular federal estate tax.
Key Components
Many of the rules relating to the GST tax mirror the rules applying to federal estate tax. For example, GST tax rates are currently the same as they are for regular estate tax liability. Under the last tax rate change, which went into effect in 2014, the top tax rate increased from 35% to 40%, where it remains today.
The GST tax exemption amount, indexed for inflation, mirrors the federal gift and estate tax exemption amount. The exemption amount has jumped dramatically since the turn of the century when it was just above $1 million. Under the latest legislation affecting these rules, the Tax Cuts and Jobs Act, the GST tax exemption was doubled along with the regular federal estate tax exemption, from $5 million to $10 million.
As previously mentioned, the GST tax exemption is indexed for inflation. The amount for 2020 is $11.58 million. In other words, a married couple can effectively used a combined exemption of $23.16 million to shield assets from the GST tax.
Also, be mindful that you can benefit from another GST tax exemption for lifetime transfers that is aligned with the annual gift tax exclusion. Just like the annual gift tax exclusion, you can gift up to $15,000 per person, including a grandchild or other descendant, each year without triggering any GST tax liability. This exclusion is also indexed for inflation, but it remains the same in 2020 as it was in 2019.
Be aware that gifts made to skip persons directly or through a trust are referred to as "direct skips.” If any GST tax is paid rather than applying the lifetime exemption, the direct skip is turned into an "indirect skip.” Generally, the tax must be paid on Form 709 in the year the gift is made.
Turn to the Professionals
Clearly, the GST tax rules are complex, and only the highlights have been discussed. In addition, you may face state tax complications, since many jurisdictions have their own version of a GST tax. The bottom line is to seek the assistance of your estate planning advisor.
SIDEBAR: GST Tax Strategies in Action
If you find that you have generation-skipping transfer (GST) tax liability, there are steps you can take to minimize or eliminate the tax bite:
- Maximize the use of the GST tax exemption. Even though lifetime transfers reduce the available tax shelter, the current $11.58 exemption ($23.16 for a married couple) should provide plenty of flexibility.
- Use your annual exclusion. This can shelter from tax gifts of up to $15,000, above and beyond the lifetime exemption. Utilize this before tapping into your lifetime gift tax exemption.
- Take advantage of the ability to use trusts when appropriate. Coordinate these strategies as part of your estate plan.