Imagine you have a $10 million portfolio you want to leave to your heirs. Ordinarily, you would pass the cash onto your children, at which point the government would assess an estate tax. Years later, when your children died, they would pass the assets onto their children (your grandchildren), incurring an additional estate tax. However, prior to 1986, people chose to leave their assets to their grandchildren to eliminate one of the Estate Tax bites.
Thus the Generation Skipping Tax (GST) was born. It is a tax levied on assets that are given to individuals who are more than one generation away from the donor. The GST may be in addition to the Estate Tax. Property that you give directly to a grandchild is subject to an immediate GST tax in addition to any gift tax or estate tax. This GST tax is intended to duplicate the consequences if you gave the property to a child (rather than a grandchild) and your child in turn gave the property to your grandchild. In that two-transfer situation, two taxes would be imposed; consequently, the GST tax adds a second tax to gifts you make directly to your grandchildren.
For 2017, the GST exemption amount is $5.49 million and any remaining assets that fall under the GST will be taxed at 40 percent.
Why Is There a Generation Skipping Tax?
The GST tax was enacted so that all family property would be subject to a tax, whether gift tax, estate tax, or GST tax, at least once in each generation. Before the GST tax, it was possible to avoid a tax on each generation in one of two ways:
- Property could be transferred in Trust to a child for life, after which the property would pass to the next generation (i.e., grandchildren) without additional gift or estate tax.
- Property could be transferred directly from a grandparent to a grandchild (outright or in Trust) subject only to a single estate or gift tax (a “direct skip”), avoiding taxation on the children’s or “middle” generation.
In general, the GST tax now applies to these two types of transfers. It is designed to impose tax on those the Government believes are trying to circumvent the Estate tax by passing over their children and passing the assets directly to the following generation – hence “the skip.”
A simple example is that of a grandparent leaving money to a grandchild where the grandchild’s parent is still alive, leaving out the middle generation. But GST can also apply in non-family situations. The Generation Skipping Tax may be due if a beneficiary of a gift or estate is 37.5 years younger than the donor or deceased.
How the GST Works in a Trust
If you create a Trust for your child’s lifetime, you pay a gift or estate tax at the time of creating the Trust (subject to your available exemptions and credits). At your child’s death, the Trust property incurs either estate tax (because the child has sufficient control over the Trust to be considered its owner) or GST tax (whenever the estate tax does not apply) before the Trust property passes to the next generation.
The GST tax does not apply, however, if the property passes to someone in the child’s generation, e.g., a sibling. In that case, the GST tax is deferred until the property passes to someone in a lower generation.
Exceptions to the GST Tax
The exceptions to the GST tax include the following:
- Trusts created before 1985, including those Trusts as extended by exercising powers of appointment.
- Many gifts that are exempt from the gift tax. These gifts include payments for tuition or medical care paid directly to the school, doctor, hospital, etc.
- Transfers, up to a per-person lifetime total of $5.49 million (in 2017) designated by the transferor as exempt from the GST tax by use of your “GST tax exemption.” For example, at your death you may leave up to $5.49 million in lifetime Trusts for your children. At your children’s deaths, the Trusts’ $5.49 million (plus any appreciation) may pass to your grandchildren without incurring a GST tax (and without estate tax). Thus, the $5.49 million exemption provides an estate planning opportunity because you might deliberately leave property in a lifetime Trust for a child for tax reasons even if there are no non-tax reasons. In contrast, if you leave this $5.49 million outright to your children, the $5.49 million (plus any appreciation) would be included in the children’s gross estates and would be reduced by estate taxes as it passes to grandchildren.
- Transferring property to a grandchild after the death of your child who is the parent of that grandchild.
Generation Skipping Tax Planning
Planning for the Generation Skipping Tax can allow you to pass assets to your second generation (i.e. grandchildren) without the assets being subject to transfer taxes upon the death of your children. The good news is that each individual is allowed a $5.49 million GST exemption, which can be used with a properly drafted Will or Revocable Living Trust to allow a husband and wife to take full advantage of their combined $10.98 million GST exemption while reducing or eliminating GST with the Trust.