25 Jan The Ins & Outs of the Generation-Skipping Transfer Tax
by Jay Bowen
When it comes to creating a plan that will transform your personal wealth into generational wealth, understanding the intricacies of inheritance taxes is crucial to ensuring you are able to pass on as much wealth as possible to your loved ones. Because without this knowledge, your estate plan may not end up leaving behind the legacy you ultimately intended it to.
One of the most important taxes to understand when building your generational wealth plan is the generation-skipping transfer tax (GSTT). Here’s what you need to know.
What is The Generation-Skipping Transfer Tax?
The GSTT is a federal tax on the transfer of property by gift or inheritance to a beneficiary who is at least 37½ years younger than the donor.
The GSTT was introduced in 1976 (and then repealed and replaced with the version still upheld today in 1986) as a way to ensure that federal estate taxes would be paid when a wealthy individual would bequeath money and other assets to a grandchild. Before 1976, wealthy individuals could avoid paying estate taxes by simply gifting their grandchildren instead of their children.
Though many individuals designate a grandchild as a skip person, a skip person does not have to be a family member or related to the grantor or transferor in any way. Any individual is eligible to receive a generation-skipping transfer as long as he or she is at least 37½ years younger than the transferor.
Also, it’s important to note that the beneficiary usually does not pay the GSTT: The transferor or the transferor’s estate is responsible for paying the tax.
Limitations on Generation-Skipping Taxes
The GSTT is a flat rate of 40%, which is the same as the estate tax rate and the gift tax rate. (Remember, rates are subject to fluctuations based on new laws that might be enacted moving forward.) However, this 40% kicks in only when the transferred amount exceeds $11.58 million per individual for 2020. (This exemption amount is adjusted annually for inflation; in 2019, it was $11.40 million, and in 2018, it was $11.18 million).
As such, the GSTT is due only when a beneficiary receives amounts in excess of the GST estate tax credit, or $11.58 million.
An additional amount each year is also disregarded for both gift and estate tax purposes. This annual exclusion, $15,000 in 2020, is granted separately for each recipient. For example, a married couple with four children could give their children a total of $120,000 each year ($15,000 from each parent to each child) without owing tax or counting toward the lifetime exemption (again, $11.58 million in 2020).
All direct skips in excess of the $15,000 annual exclusion need to be reported on IRS Form 709, the U.S. Gift (and Generation-Skipping Transfer) Tax Return.
Generation-Skipping Tax Trusts
A generation-skipping trust (GST) is a type of legally binding trust agreement that directs assets be passed to the grantor’s grandchildren, thereby “skipping” the grantor’s own children.
GSTs are useful for individuals with significant assets. The main reason why they are created is to avoid having to pay estate or inheritance taxes twice: once for the passing of assets to the grantor’s children and then again to the grantor’s grandchildren.
Recipients of a generation-skipping tax trust don’t necessarily have to be a blood relative. The beneficiary can be anybody who is at least 37½ years younger than the grantor and not a spouse or ex-spouse.
GSTs are liable for taxation — the 40% GSTT — if the amount transferred exceeds a certain annually adjusted threshold, which is, again, $11.58 million for 2020.
Direct and Indirect Skips With GSTT
There are two types of skips — direct and indirect — and as such, the taxation of a generation-skipping transfer depends on which type it is.
As explained previously, a direct skip, such as a grandparent to grandchild, is an asset or property transfer that is subject to an estate or gift tax.
An indirect skip has a few intermediate steps before it reaches the final skip person. There are two types of indirect skips: the taxable termination and the taxable distribution.
A taxable termination involves a skip person and a non-skip person. A non-skip person is the primary beneficiary who will receive property before it is transferred to the skip person. The transfer to the skip person occurs upon the death of a non-skip person — typically the child of the transferor. As an example of a taxable termination, a transferor establishes an income-producing trust for his son. Upon the son’s death, the remaining property would be passed on to the transferor’s grandchild — the skip person — at which time those assets would be subject to the GSTT.
A taxable distribution refers to any distribution of income or property from a trust to a skip person that is not otherwise subject to estate or gift tax. If a grandmother established a trust that made payments to her grandson, those payments would be subject to GSTT taxes, which the recipient is responsible for paying.
Navigating Generation-Skipping Taxes and Trusts
Individuals should not make decisions that carry potential tax consequences alone. Instead, they need to rely on a trusted partner with years of experience working with families with sizable assets and complex needs related to generational wealth transfer.
For those needing a comprehensive approach to wealth management and personalized service, Gratus Capital prides itself on being a hands-on, proactive firm that serves as its clients’ Personal Wealth Advocate. It coordinates advice provided by CPAs, estate attorneys, brokers and others, integrating tax strategies, investment due diligence, estate planning techniques and reporting that brings it all together.