The generation-skipping transfer tax (GST) is perhaps one of the most confusing and least understood topics in estate planning. Many attorneys have only a limited understanding of how GST works beyond the basics. This is problematic because GST tax can have a significant adverse effect on estates that fail to plan for it.
What Is the GST Tax?
The GST tax is a federal tax that results when there is a transfer of property by gift or inheritance to a “skip person”, that is, a beneficiary (other than a spouse) who, if a lineal descendant of the donor, is two or more generations removed by the donor (e.g., a grandchild or great-grandchild), or if a non-lineal descendant, is at least 37½ years younger than the donor. The tax was enacted to close a perceived “loophole” that enabled wealthy individuals to gift money and bequeath property to grandchildren and future generations without paying federal estate tax. The GST tax rate is a flat 40%, which is equal to the federal estate tax rate. Similarly, the federal GST applicable exclusion amount, i.e.,the amount a donor can give to skip people without paying any GST, is $12,920,000 in 2023.
How Does the GST Tax Work?
Think of the GST tax as an overlay that sits on top of the gift tax, but only comes up when the beneficiary is or later becomes a skip person. A gift made directly to a non-skip person, such as a child, implicates the gift tax but does not implicate the GST tax. In contrast, a gift made directly to a skip person implicates both the gift tax and the GST tax.
While the federal gift tax and GST tax systems have the same exemption amount and the same tax rate, they are cumulative of each other, not concurrent. Thus, if a gift is “taxable”, meaning that there is no applicable exclusion or exemption available to shield it from either tax, the combined tax rate would be a whopping 80% – 40% for the gift tax and 40% for the GST. Yes, you read that right – 80% of the gift might be lost to federal taxes.
GST tax issues become much more complicated (and expensive) when gifts are made to trusts instead of individuals. If the trust has multiple beneficiaries, some of which are skip people and others non-skip people, the gift to the trust may not trigger GST initially, but the entire trust may later be subject to GST tax when all of the non-skip people have died – an event referred to as a taxable termination. Even worse, the trust will be taxed again (at the GST tax rate of 40%) when all of the beneficiaries in the original skip people’s generation have died (for example, when the grandchildren have all died and the remaining beneficiaries are great-grandchildren and more remote descendants), and so on with each successive generation.
How Can You Minimize GST Tax?
When a gift is made, the so-called “automatic allocation rules” under the Internal Revenue Code will often work to apply the donor’s available GST exemption to cover the gift. However, sometimes it’s advisable not to use up your exemption and instead to opt out of the automatic allocation, such as when you intend for the trust to be fully distributed to non-skip beneficiaries. Accordingly, you should evaluate whether or not to allocate your GST exemption to every gift. On a timely filed gift tax return, you can affirmatively elect to apply the exemption or opt out. It is recommended that you make a selection on your gift tax return either way, even if you don’t believe you will ever exceed the individual exemption amount. You may need the exemption in the future and you do not want to use it up on transfers that would not be subject to GST tax or fail to use exemption on such transfers.
Importantly, it is possible to make a late allocation of GST. If you fail to opt out in the year you made the gift, you can do it at any time up until your death. After death, your executor can allocate any GST exemption available at your death to your lifetime gifts as needed.
Why Should You Plan for GST Tax?
More and more states are allowing for so-called “Dynasty Trusts” which allow grantors to create trusts which extend for many generations. For example, Connecticut permits trusts lasting 800 years, Florida 360 years, and South Dakota indefinitely.
If properly created, these trusts will continue for generations. The exemption applies to the value of the assets when the trust is created. As a result, the trust can be funded with low-value assets to minimize the amount that may go over the exemption. Subsequent appreciation in the assets is not considered. If the GST exemption is properly allocated to cover the entire gift, the 40% tax will be forever avoided. In contrast, if GST exemption is not allocated to the trust, as each generation passes, the GST tax may be applied to the trust assets, substantially eroding the trust principal over time.
GST tax planning is an important thing to consider, even if you don’t think you will ever have a taxable estate. . As part of our estate planning services, we conduct a comprehensive evaluation of our clients’ needs, goals, and circumstances to identify strategies to maximize their estate and save taxes. Contact us for a consultation.