At the federal level, wealth transfers are subject to three separate, but overlapping, taxes: (1) the federal gift tax; (2) the federal estate tax; and (3) the federal generation-skipping transfer tax. Each of these wealth transfer taxes must be considered whenever one person transfers cash or other property to another person, during lifetime or at death, without receiving full and adequate consideration (i.e., a gift or inheritance). This article provides a brief overview of the generation-skipping transfer (GST) tax and a discussion of planning that may be used to avoid or lessen its impact.
Note that some states also impose state-level wealth transfer taxes, in addition to any federal wealth transfer taxes that may apply to a transfer. Nebraska, for example, levies an inheritance tax at death which is calculated according to the amount received by a beneficiary and the beneficiary’s relationship to the decedent. For additional information about Nebraska’s inheritance tax, please refer to the Tax Planning Newsletter article titled “The Nuts and Bolts of Nebraska’s Inheritance Tax,” which is available on McGrath North’s website.
Broadly speaking, the federal gift tax applies to property transferred during lifetime and the federal estate tax applies to property transferred at death. The GST tax is a separate federal tax that is imposed on certain transfers of property to a “skip person” who is two or more generations below the transferor. For example, if a grandfather dies and leaves assets to his grandchildren, thus skipping over his children, the property distributed to the grandchildren will be subject to the GST tax. The GST tax is in addition to any other federal wealth transfer taxes that may apply, meaning that a single transfer of property can be subject to both estate/gift tax and GST tax.
The GST tax is imposed at a flat rate equal to the maximum estate tax rate in effect at the time of the transfer. In determining the amount of GST tax, however, the available GST exemption and any applicable exclusions must be taken into account. In 2017, the statutory federal GST tax exemption amount is $5,490,000 per individual. This exemption amount is adjusted annually for inflation. Any generation-skipping transfers (as defined below) that exceed the transferor’s federal GST tax exemption are subject to GST tax at a rate of 40% under current law.
In order to understand how the GST tax functions and when it applies, it is necessary to define several operative terms. Some of the most commonly used GST terms are described below.
- Generation-skipping transfer: The GST tax only applies to a “generation-skipping transfer,” defined as one of the following: (1) a direct skip; (2) a taxable termination; or (3) a taxable distribution. Whether a particular transfer or event is a direct skip, taxable termination or taxable distribution depends on whether the transferee is considered a “skip person” or “non-skip person” for GST tax purposes. Certain payments made directly to a qualified educational institution or medical provider are excluded from the definition of a “generation-skipping transfer.”
- Skip Person: Very generally, a “skip person” is an individual who is at least two generations younger than the transferor. For example, the transferor’s children (non-skip persons) are one generation below the transferor and the transferor’s grandchildren (skip persons) are two generations below. Adopted children are treated the same as biological children, and half-blood relatives are treated the same as whole-blood relatives. In addition, the transferor’s spouse or former spouse is assigned to the same generation as the transferor. Individuals who are not related to the transferor by blood or marriage are assigned to a generation based on age. For these purposes, an unrelated individual will be considered a “skip person” if he or she is more than 37.5 years younger than the transferor. Also note that, under certain circumstances, a person whose parent is deceased may be moved up by one generation for purposes of determining whether a generation-skipping transfer has occurred. A trust may also be considered a “skip person” if all of the interests in the trust property are held by skip persons.
- Direct Skip: A “direct skip” is generally defined as a transfer of property to a skip person that would be subject to estate or gift tax. For example, an outright lifetime gift to the transferor’s grandchild is a direct skip because a grandchild, being two generations below the transferor, is a skip person and the gift tax applies to the transfer. Similarly, a gift to a trust for the exclusive benefit of the transferor’s grandchildren is a direct skip since all of the trust beneficiaries are skip persons (and, thus, the trust itself is considered a skip person). In contrast, a transfer in trust for the benefit of both the transferor’s children and grandchildren is not a direct skip because the trust beneficiaries include non-skip persons (the children). Instead, a generation-skipping transfer will occur when all of the children die or distributions are made to grandchildren. An outright gift or bequest to or for the benefit of a person three or more generations below the transferor (e.g., a great-grandchild) is treated as a single direct skip, and triggers only one GST tax, even though more than one generation is skipped.
- Taxable Termination: At a basic level, a “taxable termination” includes any termination of an interest in a trust unless: (1) the trust property is subject to the estate or gift tax at the time of the termination; (2) a non-skip person has an interest in the trust property immediately after the termination; or (3) it is not possible for a distribution to be made from the trust to a skip person at any time after the termination. A taxable termination can occur on the death of a beneficiary or other person, by lapse of time, by the release of a power or otherwise.
- Taxable Distribution: A “taxable distribution” is defined generally as a trust distribution made to a skip person that is not either a taxable termination or a direct skip. For example, assume that property is transferred in trust to pay the income to the transferor’s child and to distribute the principal to the transferor’s grandchild, one-half when the grandchild reaches the age of 35 and the remainder on the child’s death. If the child survives beyond the grandchild’s 35th birthday, the first principal distribution is a “taxable distribution” because it is made to a skip person (the grandchild) and is neither a taxable termination nor a direct skip. The beneficiary is liable for the GST tax on a taxable distribution. If the trust pays the tax (or any penalties or interest thereon), such payment is treated as an additional taxable distribution and is likewise subject to the GST tax.
Maximizing Use of GST Exemption through Dynasty Trust Planning
One common planning technique used to avoid the application of the GST tax is the creation of an irrevocable Dynasty Trust. A Dynasty Trust created during lifetime or upon death allows the person creating the trust (commonly known as the “grantor” or “settlor”) to utilize his or her GST exemption ($5,490,000 in 2017) so that the trust assets will be excluded from the taxable estates of the settlor’s children and more remote descendants for federal estate tax purposes, and should not be subject to federal GST tax, regardless of the future value and earnings of the trust assets.
It should be noted that the ability to pass significant wealth to future generations was historically limited by a legal concept known as the “Rule Against Perpetuities.” This rule was designed to prevent property from being held in trust indefinitely. Under the common law rule, a future interest in a trust was invalid unless it was required to vest within 21 years after the death of the last identifiable individual living at the time the interest was created. However, the Rule Against Perpetuities has been abolished in several states, including Alaska, Rhode Island and South Dakota. Other states, such as Nebraska, allow the settlor of a trust to “opt out” of the Rule Against Perpetuities if specific language is included in the trust agreement. The result is that a Dynasty Trust created in Nebraska, if properly structured, may continue indefinitely for the benefit of successive generations, without the imposition of onerous federal wealth transfer taxes.
If you would like to learn more about how the GST tax may impact you or your family, or if you want to explore planning ideas to help avoid the GST tax, please contact a member of the McGrath North Tax Group.