Generation-Skipping Transfer Tax—GSTT

What Is the Generation-Skipping Transfer Tax (GSTT)?

The generation-skipping transfer tax is a federal tax that results when there is a transfer of property by gift or inheritance to a beneficiary who is at least 37½ years younger than the donor. Generation-skipping transfer taxes serve the purpose of ensuring that taxes are paid when assets are placed in a trust, and the beneficiary receives amounts in excess of the generation-skipping estate tax credit.

Before the generation-skipping transfer tax was introduced in 1976, wealthy individuals were legally able to gift money and bequeath property to their grandchildren, without paying federal estate taxes. The legislation effectively closed the loophole where inheritances could skip a generation to avoid double estate taxation.

Understanding the Generation-Skipping Transfer Tax

The generation-skipping transfer tax (GSTT) is an additional tax on a transfer of property that skips a generation, known as a generation-skipping transfer (GST) for short. The GSTT was implemented to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren. The parent's generation is skipped to avoid an inheritance being subject to estate taxes twice. The GSTT ensures that grandchildren end up with the same value of assets that they would have had if the inheritance was transferred to them directly from their parents, rather than their grandparents.

The person giving the gift is referred to as the transferor and the recipient is known as the skip person. Many people use a grandchild as a skip person, but a skip person does not have to be a family member. Any individual is eligible to receive a generation-skipping transfer as long as they are at least 37½ years younger than the transferor.

The generation-skipping transfer tax is imposed only if the transfer avoids incurring a gift or estate tax at each generation level. To make up for the taxes that may be avoided by skipping one generation, the Internal Revenue Service (IRS) imposes a second layer of tax on gifts and bequests above the estate and lifetime gift exclusion. It means that the GSTT is only due when a beneficiary receives amounts in excess of the GST estate tax credit.

Direct vs. Indirect Skips With the GSTT

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's 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.

An indirect skip involves a transfer that has 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 occurs upon the death of a non-skip person — typically the child of the transferor. As an example of a taxable termination, consider a transferor who establishes an income-producing trust for his son. Upon the son's death, the remaining property would be passed on to the transferor's grandchild, at which time those assets would be subject to the GST tax.

A taxable distribution refers to 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, which the recipient is responsible for paying.

How Much Is the Generation-Skipping Transfer Tax?

In the past, the GSTT has been hefty, ranging from 35% to 55%. The current rate, which has been in effect since 2014, is 40%. However, the Tax Cuts and Jobs Act dramatically lessened the estates that might be affected by it. Effective January 1, 2018, the federal estate, gift, and GSTT exemption was set at $11.18 million for each individual and $22.36 million for married couples, doubling the $5.45 million limit (for individuals) of the previous years.

The exemption amount is adjusted annually for inflation. In 2019, the exemption amount is $11.4 million for individuals, $22.8 million for couples.

Some states also collect generation-skipping transfer taxes, generally the ones that impose their own estate taxes.

Only the value of a person’s estate that is in excess of the applicable exemption is subject to an estate tax at death or the GSTT, at that flat rate of 40%. So, only aggregate gifts and bequests to a skip person in excess of $11.2 million would be subject to the 40% flat generation-skipping transfer tax.

The GSTT is assessed when the gift or property transfer is made; GSTs can occur before or after the death of the transferor. While still alive, the transferor can give the gift directly to the skip person. But upon death, the transferor's will may either stipulate that property is bequeathed to a skip person, or it may call for the establishment 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.

GSTT Strategies

Most beneficiaries will avoid the GST tax because the estates they inherit will be worth less than the government-provided estate tax credit. The GSTT exemption is very high (as noted above).

Although the GSTT commonly occurs with a transfer to grandchildren, most people will not incur it, since the GSTT exemption is very high. However, in cases where the tax could apply, transferors can create dynasty trusts, which are designed to avoid or minimize estate taxes with each generational transfer. By parking assets in the trust and making specified distributions to each generation, the corpus of the trust isn’t subject to estate taxes with the transfer.