An Overview of Generation Skipping Transfer Tax
Families make gifts every day. A parent may give money to their child, a grandparent may give money to a grandchild. Both are given out of love and affection for the recipient, either to help with expenses, add to the individual’s savings, or even just to allow them to buy something special. While the motivation for these gifts is the same, they are not the same for estate and gift tax purposes. For estate and gift tax purposes, the second, a gift from a grandparent to a grandchild, is subject to a special tax known as GST tax, at a rate of 40%. For this reason, it is important to understand that all gifts are not the same and spoiling a grandchild with too many gifts can be a problem from a tax perspective.
Definition of GST
GST is an abbreviation for generation-skipping transfer. A generation-skipping transfer is a gift that is made to someone who is two generations below you, such as the gift from a grandparent to a grandchild mentioned above. These gifts are subject to an additional wealth transfer tax known as generation-skipping transfer tax (or GST tax) in the US. Taking effect in 1986, GST tax was enacted with a goal of addressing class inequities between the wealthy and disadvantaged classes by enforcing a 40% tax on transfers made to individuals referred to as skip persons (or persons two generations below the donor).
How Do You Determine Who is a Skip Person?
From a familial perspective, a skip person is just that: someone who “skips” a generation is someone two or more generations below you. The generational distance between two people is less simple with unrelated persons. For the purpose of defining who is a skip person, an unrelated person who is 37 ½ years (or more) younger than the donor is considered to be two generations below that donor.
While it would seem that two definitions are all that would be needed, because of the diverse nature of relationships, there indeed are additional facts to be considered. For instance, what about your spouse, an adopted person, or even a trust which has many beneficiaries? The chart below addresses some of these circumstances. The short version is that you will be assigned to the same generation as your spouse, regardless of his/her age. An adopted child is treated the same as a natural born child. And finally, if your parent passes away before the time of the gift, you move up a generation.
| Circumstance | Who is a skip person? | |
|---|---|---|
| Lineal descendants | A person 2 generations below the transferor will be a skip person | |
| Spouse’s lineal descendants | A person 2 generations below the transferor’s spouse will be a skip person | |
| Legal adoptions | A relationship by legal adoption shall be treated the same as by blood. | |
| Marriage | An individual who has been married at any time to the transferor shall be assigned to the transferor’s generation. | |
| An individual married to a lineal descendant shall be assigned to the same generation as their spouse. | ||
| Unrelated persons | Born 0 – 12 ½ years | After the transferor = same generation |
| Born 12 ½ – 37 ½ years | After the transferor = 1 generation below | |
| Born >37 ½ years | After the transferor = skip person (or 2 generations below) |
|
| Similar rules apply every 25 years | ||
| Trust | Dependent upon the relationship of the beneficiaries to the donor. | |
| Predeceased parent rule | Generally, if an individual’s parent, who is a lineal descendant of the transferor, is deceased at the time of the transfer, their child is deemed to be of the parent’s generation and any more remote descendants will likewise move up a generational level. | |
When is a Gift Not a Taxable Gift?
Once you have determined whether the gift is indeed generation skipping transfer, you will need to determine whether or not it is a taxable gift. For instance, some gifts made to skip persons are not taxable gifts, such as amounts given equal to or below an individual’s annual exclusion amount, currently $18,000 per person for 2024. Another form of non-taxable gift is one made on behalf of an individual and directly paid to either an educational or medical institution. This type of gift is known as a qualified transfer and is also exempt from GST taxation. Some specific examples of qualified transfers include payment of a grandchild’s tuition, medical bills, or other health related treatments.
How to Avoid Causing GST Tax
Every individual is given a lifetime exemption to GST taxation for a set amount, currently $13,610,000 in 2024. This means that an individual can gift up to this amount to skip persons, or trusts for the benefit of skip persons, throughout their lifetime without incurring GST tax. This is why so many individuals create GST exempt trusts for their descendants, to create a vehicle to hold assets that can pass to their descendants free of GST tax for generations. This exemption amount is currently at an all-time high and scheduled to sunset in December of 2025. At that time, the lifetime exemption amount may be significantly reduced. While it will not affect amounts already allocated, it will limit future allocations to whatever amount is set by the new legislation.
How Do I Use my GST Tax Exemption When I Need To?
The IRS created a deemed allocation regiment to avoid accidental missed allocation of GST tax exemption in situations where most individuals would intend to have allocated their exemption. The deemed or automatic allocation rules provide that GST tax exemption automatically applies to gifts made directly to a skip person and gifts made to a trust which has only skip persons as beneficiaries. This automatic allocation occurs until the individual has utilized their entire GST tax exemption.
If the gift does not fall under the automatic allocation rules or if you do not want to allocate your GST tax exemption in a manner consistent with the rules, you will need to affirmatively allocate your GST tax exemption by filing a gift tax return (Form 709) for the year of the gift. Similarly, you will need to opt-out of the automatic allocation of GST tax on this same form if you do not want your exemption used in the manner or order which occurs automatically under the rules. If allocating your exemption to a trust, it must be allocated to the entire trust, not a specific asset. If you have not allocated all of your exemption at the time of your death, your executor can allocate the remaining balance via your estate tax return.
Conclusion
Careful gift planning is essential to any estate plan, but also to your regular gifting plan. Everyone enjoys seeing the smile on their grandchild’s face when they receive a gift, but being sure to consider the tax consequences is essential with a 40% tax rate. The best gifting plan includes giving gifts equal to or under the annual exclusion amount and qualified gifts paid to medical or educational facilities on behalf of a skip person. If large gifts are desired, take the time to consult with your attorney and create a structure that utilizes your GST tax exemption wisely. Keep the December 31, 2025 date in mind, as the amount of your lifetime exemption may change significantly, making gifts made between now and then more desirable. Spoil those grandchildren but do it with intention.
Commonwealth Trust Company is pleased to provide this article as a guide. Commonwealth Trust Company is not engaged in the practice of law and is not providing legal advice by the provision of these materials. Commonwealth Trust Company recommends that clients seek the opinion of their attorney regarding the specific legal and tax issues addressed in this article.