Plan carefully to avoid surprises

Posted On: APRIL 2022

If you wish to share some of your wealth with your grandchildren or great grandchildren — or if your estate plan is likely to benefit these generations — it’s critical to consider and plan for the generation-skipping transfer (GST) tax. Designed to ensure that wealth is taxed at each generational level, the GST tax is among the harshest and most complex in the tax code.

It’s also among the most misunderstood. Even though the GST tax enjoys an annual inflation-adjusted lifetime exemption in the same amount as the lifetime gift and estate tax exemption (currently, $12.06 million), it works a bit differently. For example, while the gift and estate tax exemption automatically protects eligible transfers of wealth, the GST tax exemption must be allocated to a transfer to shelter it from tax.

The tax code contains automatic allocation rules designed to prevent you from inadvertently losing the exemption, but it’s dangerous to rely on these rules. In some cases, the exemption isn’t automatically allocated to transfers that may trigger costly GST taxes. And in others, the exemption is automatically allocated to transfers that are unlikely to need its protection, wasting those exemption amounts.

How the GST tax works

To ensure that wealth is taxed at each generational level, the GST tax applies at a flat, 40% rate — in addition to otherwise applicable gift and estate taxes — to transfers that skip a generation. The tax applies to transfers to “skip persons,” including your grandchildren, other relatives who are more than one generation below you and unrelated people who are more than 37½ years younger than you.

There’s an exception, however, for a grandchild whose parent (your child) predeceases you. In that case, the grandchild moves up a generation and is no longer considered a skip person.

Three types of transfers may trigger GST taxes:

1. “Direct skips” — transfers directly to a skip person that are subject to federal gift and estate tax,

2. Taxable distributions — distributions from a trust to a skip person, or

3. Taxable terminations — for example, if you establish a trust for your children, a taxable termination occurs when the last child beneficiary dies and the trust assets pass to your grandchildren.

As noted above, the GST tax doesn’t apply to transfers to which you allocate your GST tax exemption. In addition, the GST tax annual exclusion — which is similar to the gift tax annual exclusion — allows you to transfer up to $16,000 per year to any number of skip persons without triggering GST tax or using up any of your GST tax exemption. Note, however, that transfers in trust qualify for the exclusion only if certain requirements are met. (See “Handle the annual GST tax exclusion with care” below.)

Beware of automatic allocation tax traps

Ordinarily, to allocate GST tax exemptions, you must affirmatively elect to do so on a timely filed gift tax return. If you neglect to do so, however, you may be saved by the automatic allocation rules.

These rules, which are intended to protect you against inadvertently losing exemptions, automatically allocate the exemptions to direct skips as well as to transfers to “GST trusts.” The definition of a GST trust is complicated, but essentially, it’s one that meets certain criteria that create a strong possibility that the trust will benefit your grandchildren or other skip persons down the road.

Often, the automatic allocation rules ensure that GST tax exemptions go where they’ll do the most good. But in some cases, they may work against you.

For example, let’s say Anita has $4 million in unused GST tax exemptions. She plans to make $2 million in outright gifts to her grandchildren and to set up a $4 million trust for their benefit. If she makes the gifts first, $2 million in GST tax exemptions will automatically be allocated to them. When she sets up the trust, she’ll have only $2 million in exemptions left, so only 50% of her $4 million contribution will be sheltered from GST tax. If her initial contribution grows to $16 million and then is distributed to her grandchildren, half of that amount, $8 million, will be subject to GST tax.

Anita would have been better off opting out of the automatic allocation rules and allocating her remaining $4 million in exemptions to the trust. She’d owe GST tax on the $2 million in gifts, but the entire $16 million in trust distributions would be exempt from GST tax.

Have a plan

If you wish to make substantial gifts, either outright or in trust, to your grandchildren or other skip persons, be sure to allocate your GST tax exemption carefully. We can help you devise a strategy that leverages the exemption and minimizes your GST tax liability.

Sidebar: Handle the annual GST tax exclusion with care

The annual gift tax exclusion allows you to transfer up to $16,000 to any number of recipients each year free of federal gift taxes, including properly structured gifts in trust. Annual exclusion gifts are also exempt from generation-skipping transfer (GST) taxes, but special rules apply to gifts in trust.

Transfers to a trust qualify for the annual GST tax exclusion only if 1) the trust is established for a single beneficiary who’s a grandchild or other skip person, 2) the trust provides that no portion of its income or principal may be distributed to (or for the benefit of) anyone other than that beneficiary, and 3) if the trust doesn’t terminate before the beneficiary dies, any remaining assets will be included in the beneficiary’s gross estate.

If transfers to a trust don’t qualify for the annual GST tax exclusion (because, for example, they have multiple beneficiaries), consider allocating enough of your GST tax exemption to shelter those transfers from tax.

© 2022