If you're a part of a family trust, the generation-skipping tax may be a financial option to consider.
Estate taxes can take a big bite out of your family's wealth. In the past, one strategy to reduce estate taxes was to "skip" a generation of heirs to avoid the double estate tax liability that would have occurred if there were two transfers (one from parent to child and another from child to grandchild).
While this strategy can be useful, it's not necessarily tax-free due to the generation-skipping transfer tax.
What is the generation-skipping transfer tax?
The generation-skipping transfer tax, or GSTT tax, taxes people when then make generation skipping transfers in their estate plan in favor of younger generations.
Taxing this type of transfer started in 1976, when Congress discovered that some people were avoiding federal estate taxes using complicated trust structures. For example, a wealthy family could set up a life estate for their children, a life estate for their grandchildren, and a life estate for their great-grandchildren. Since life estates aren't subject to the federal estate tax, this strategy effectively moved wealth from generation to generation, bypassing the estate tax.
Meanwhile, less wealthy families who didn't have access to sophisticated estate planning strategies were paying more tax than the wealthiest families. The federal estate tax would take a chunk of their estate each time it passed from generation to generation.
Now, the GSTT imposes a tax equal to the highest federal estate tax rate on transfers that skip a generation. The top federal estate tax rate is currently 40%.
The tax only applies to transfers over an exemption amount, which started at $1 million and was later indexed for inflation. Since 2001, the exemption has matched the federal estate tax exemption, meaning for 2020, it’s $11,580,000 per person, or $23,160,000 for a married couple. For 2021, it's $11,700,000 per person or $23,400,000 for a married couple. The exemption will grow each year, based on inflation, through 2025. Unless Congress intervenes, the exemption amount is scheduled to revert to its $5 million baseline, indexed for inflation, in 2026.
When does the generation-skipping tax come into play?
The generation-skipping tax kicks in when someone gifts assets to a "skip person," either during their lifetime or after death. A skip person is someone two or more generations younger than the transferor.
- Grandchildren and great-grandchildren are the most common skip persons.
- However, other close relatives, such as great-nieces and nephews, can also qualify.
- A beneficiary who isn't related by blood, marriage, or adoption is also considered a skip person if they're more than 37½ years younger than the person making the gift.
In some circumstances, a grandchild may not be a skip person. For example, a grandchild "moves up" to their parent's level when the parent dies before the gift is made. This is known as the deceased parent rule.
There are two types of skips:
- Direct skip. A direct skip happens when the transferor gifts assets directly to a skip person, and they have immediate ownership rights.
- Indirect skip. In an indirect skip, someone transfers money to an entity (such as a trust) that may eventually distribute assets to a skip person. Sometimes, a gift or bequest goes to a trust, and a skip person may receive assets from the trust, but they're not guaranteed. In this case, the transferor (or executor) can choose to allocate some of their exemption to the transfer. If they don't allocate part of their exemption to the transfer and money is later paid out to the skip person, that money may be taxed.
When someone makes a generating-skipping gift or bequest, the IRS adds the GSTT to the regular estate or gift tax, ensuring the federal government gets its double taxation.
There's an annual exclusion for calculating the GSTT, similar to the gift tax's annual exclusion. That annual exclusion amount is $15,000 for 2020 and 2021.
Other gifts and transfers to skip persons qualify for an exclusion, including educational and medical expenses and health insurance. As long as the payments are made directly to the educational institution, medical facility, or insurer, these transfers avoid the gift and generation-skipping taxes. They also don't count toward the lifetime estate tax exemption or the annual gift tax exclusion.
To be sure, the generation-skipping tax affects only the very wealthy since the federal estate tax exemption is $11.7 million per person in 2021. Still, the exemption is scheduled to significantly drop in 2026. If you have a large estate and plan to leave at least a part of it to grandchildren, great-grandchildren, and other younger generation members, it pays to understand how this tax works.
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