For years wealthy, individuals gave or bequeathed money and property to their grandchildren without paying federal estate taxes. Unfortunately for those individuals, the generation-skipping transfer tax put a stop to that; it was created to make sure that no one could skip over a generation in order to skip out on taxes.
What is the GST?
A generation skipping transfer (GST) refers to the shift of property by gift or at death to a person who is two or more generations below that of the person granting the gift. The person giving the gift is referred to as the transferor and the recipient is known as the skip person. (To learn more, read Tax-Efficient Wealth Transfer.)
Many people use a grandchild as a skip person, but a skip person does not have to be a family member. Any individual other than a spouse or ex-spouse is eligible to receive a generation skipping transfer as long as they are at least 37.5 years younger than the transferor.
What Is the GST Tax?
The GST tax is a federal tax imposed on gifts given to skip-persons to make certain that taxes are paid at each generational level and cannot be escaped through the use of a trust.
The tax is only due when a skip person receives amounts in excess of the GST estate tax credit. Fortunately, most people will never encounter the GST tax because the tax credit levels are relatively high. Since 2006, the GST estate tax credit has been $2 million per person, meaning that every taxpayer is entitled to a $2 million exemption. (For a complete guide, check out our Estate Planning Tutorial.)
Once a transferor has exceeded the exemption, the GST tax is assessed at a flat rate. The chart below shows GST tax rates since 2001.
|Year||GST Tax Rate|
|2007 – 2009||45%|
|Source (up to 2011): "Estate Planning For Dummies" by Jordan Simon and Brian Caverly|
The GST tax is assessed when the property transfer is made. GSTs can occur before or after the death of the transferor. The transferor can give the gift directly to the skip person while still living or transfer the gift to a generation skipping trust to be transferred to the skip person upon the transferor's death. After the transferor dies, his or her will may bequeath property to a skip person or establish a trust from which the distributions may be made to a skip person. The form required for a GST is the same form as the federal gift tax return form, Form 709.
Direct vs. Indirect Skips
The taxation of a GST depends on whether the transfer is a direct or an indirect skip. A direct skip is a property transfer made to a skip person that is subject to an estate or gift tax. An example of a direct skip would be a grandmother gifting property to a grandchild. The transferor, or his or her estate, is responsible for paying the GST tax for direct skips. (Many people try to avoid this process altogether, making things difficult for heirs. See Top 7 Estate Planning Mistakes for more insight.)
Indirect skips involve transfers that have intermediate steps before reaching a 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 takes place upon the death of the non-skip person. Typically, a non-skip person is the child of the transferor. An example of a taxable termination would be a transferor establishing a trust that provides income for his son. Upon the son's death, the remaining property would be passed on to the transferor's granddaughter. The GST tax would be paid out of the property when it was passed down to the granddaughter.
A taxable distribution is 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 GST taxes. The recipient is responsible for paying any applicable GST tax for a taxable distribution. (This arrangement allows you to have more control over your estate - both before and after your death. See Establishing A Revocable Living Trust.)
Reducing the Tax Burden for an Heir
- Know your exemptions.
Most beneficiaries will avoid the GST tax because their estates will be worth less than the estate tax credit provided by the government. Since 2006, each taxpayer has been entitled to a $2 million exemption. The exemption was increased to $3.5 million in 2009 and $5 million for 2010 and 2011, $5.12 million for 2012, and $5.25 million for 2013. Married couples can double these amounts to determine the exempt portion of their GST.
- Create a generation-skipping transfer trust.
To lower the effects of the GST tax, transferors can create a dynasty trust. A dynasty trust allows property to be passed through multiple generations without being subjected to the generation-skipping transfer tax at every level. Each person is entitled to a $1 million gift tax exemption, which can be used to fund a dynasty trust. Creating a dynasty trust will not result in tax savings for the transferor, but will save their descendants from being taxed at every level. Upon the death of transferor's descendants any distributions from the trust will not be subject to estate or gift taxes.
The average person will never have to worry about the generation-skipping transfer tax. For those who may encounter the tax, it can be extremely costly and very difficult to navigate. There are strict rules and deadlines regarding issues such as lineage, the eligibility of skip persons, gift reporting and payment of taxes. It is imperative to seek professional advice from an accountant and/or an attorney so that plans can be made for efficient, cost-friendly transfers from one generation to another. (Find out why you shouldn't put off putting your affairs in order; read Six Ways To Lose Your Estate.)