Among confusing legal concepts, the generation-skipping transfer (GST) tax is at the top of the list. Because of its complexity, many attorneys lump it in with concepts such as the rule against perpetuities—topics taught in law school that they never quite fully understood and wish to forget. However, for estate-planning attorneys, understanding the GST tax is vital to helping their clients effectively plan to avoid it if possible. As with any concept that causes confusion, breaking it down is the key to better understanding.
What is the GST tax?
The GST tax applies when someone transfers wealth to a person more than one generation below the transferor’s generation. The person who is more than one generation removed from the transferor is called a “skip” person. In addition to individuals, trusts can be treated as skip persons in certain situations, as discussed below. The purpose of the GST tax is to generate revenue from federal estate taxes; if a generation (child) is skipped by the transfer of wealth to a much younger person (the gift skips the child and goes directly to the grandchild), there will be no estate tax when the child dies because they did not own the transferred asset.
A classic example of a GST involves a grandparent who transfers assets directly to a grandchild or to a trust established for a grandchild’s benefit. Grandma creates and funds a trust that benefits her child, but her child does not own the transferred assets. When Grandma’s child dies, the trust’s assets are transferred to her grandchild free from any federal estate tax. Without the GST tax, the U.S. Treasury loses the opportunity to tax the child’s estate. Consequently, the GST tax is intended to replace federal estate tax revenues that would have been collected had the transfer been made directly from the mother to her child.
What is a skip person?
A skip person is an individual whose generation is at least two generations below the transferor. A trust can also be treated as a skip person if
- only skip persons, such as grandchildren, hold an interest in the trust, or
- no person holds an interest in the trust and at no time after the transfer to that trust will a distribution be made to anyone other than a skip person.
An individual or trust beneficiary that does not fall within the definition of a skip person is labeled a “nonskip” person. If a nonskip person, such as the child of the transferor, holds a present interest in the trust as a beneficiary, the trust itself will not be treated as a skip person because a distribution, either mandatory or discretionary, could be made to the nonskip person. For example, if a mother creates and funds a trust for the benefit of her son and his children, her son is considered a nonskip person and her grandchildren are considered skip persons. Because the trust was established for the benefit of a nonskip person, the mother’s transfer of her assets to the trust does not, at the time of transfer, generate a GST taxable event, even though skip persons could also receive distributions from the trust.
What is considered a transfer to a skip person?
Interestingly, according to Treas. Reg. section 26.2652-1(a)(1), an actual transfer of property under local law is not necessary to trigger the imposition of the GST tax. If the transfer is subject to either federal estate or gift taxes, the GST tax applies even if no property has passed between the transferor and the transferee.
What is the GST tax rate?
Currently, the GST tax is a flat 40 percent imposed on the transfer of wealth either by a lifetime gift or by will, trust, or the expiration of a life estate at death. The GST tax is in addition to the federal gift or estate tax. It is not an alternate tax; it is a double transfer tax that depends on the age of the recipient.
Is there a GST tax exemption, and if so, does it work similarly to the federal estate tax exemption?
Yes. For 2021, the GST tax exemption is $11.7 million per individual. That exemption is scheduled to become $5 million (adjusted for inflation) after 2025. As a result, most large gifts made now can be sheltered from the GST tax by virtue of the very large GST tax exemption amount. Although the GST tax exemption amount is the same as the federal estate tax exemption amount, there is one major difference between the two. A surviving spouse can apply a deceased spouse’s unused federal estate tax exemption to their own estate through a concept known as portability. However, portability is not available for the GST tax exemption, and a deceased spouse’s unused GST tax exemption cannot be ported to the surviving spouse.
With a new administration and possible tax law changes, what should we keep an eye on regarding planning and the GST tax?
Because the GST tax exemption amount is so high, the GST tax is not applicable to many clients. Currently, parents can transfer up to $23.4 million to a GST-exempt trust to shelter transferred assets from the GST tax and provide lifetime benefits from the trust to their children and grandchildren with no tax implications. In addition, the use of dynasty trusts provides lifetime benefits to multiple generations of a family with none of the trust assets being taxed as part of the child’s estate, the grandchild’s estate, or the great-grandchild’s estate. However, this situation could change if dynasty trusts can exempt GSTs for only a certain amount of time. Specific legislation, such as the For the 99.5% Act sponsored by Senator Bernie Sanders, proposes to reduce the GST exemption and impose a fifty-year cap on the duration of trusts that are exempt from GST tax.