For years, wealthy people gifted money and bequeathed property to their grandchildren without paying federal estate taxes. That is, until the generation-skipping transfer tax was introduced in 1976. It was created to close the loophole whereby inheritances could skip a generation to avoid double estate taxation.
What Is the GST?
A generation-skipping transfer (GST) refers to the transfer of money or property, as a gift or inheritance, to a person who is two or more generations below that of the grantor. The giving party is referred to as the transferor and the recipient is 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 of the high threshold. (For a complete guide, check out our Estate Planning Tutorial.)
Once a transferor exceeds 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%|
|2013 or later||40%|
GSTs can occur before or after the death of the transferor, and the GST tax is assessed when the gift or property transfer is made. While living, the transferor can give the gift directly to the skip person. Upon death, the transferor's will may bequeath property to a skip person or establish a trust from which distributions will be made. Form 709 is used to report both GST taxes and transfers whereby federal gift taxes are due.
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 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 their estate is responsible for paying the GST tax for direct skips. (Many people try to avoid this process, which can cause difficulty 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 grandchild. The GST tax would be paid out of the property when it was passed down to the grandchild.
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. From 2006 through 2008, each taxpayer was entitled to a $2 million exemption; however, each year, the exemption has progressively increased. As of 2018, the individual exemption is $11,180,000, which is more than double the amount for the previous tax year. 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. Creating a dynasty trust will not result in tax savings for the transferor, but it 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 encounter the generation-skipping transfer tax. For those who will, 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.)