This is Part 2 in a two-part series about Transfer Taxes. In Part 1, I discuss what is the gift tax and estate tax.
The GST Tax
The generation skipping transfer (GST) tax is often overlooked and misunderstood even by practitioners. It is complex to say the least.
In this article, I discuss what the GST tax is, why it exists, how it works, and how to plan around it.
Why is there a GST Tax?
The GST tax is a type of federal transfer tax, the others being the gift tax and estate tax, which I have previously discussed in an earlier article.
To understand what a GST tax is and the need for one, we must first understand the estate tax. An estate tax is a tax paid on the transfer of wealth from generation 1 to generation 2. Again, when generation 2 dies, there is another estate tax when wealth transfers to generation 3. This continues at the passing of each and every generation. The government must be paid, after all.
To reduce the amount of estate tax paid overall, a savvy individual from generation 1 may decide to transfer wealth to generation 3 directly. By skipping generation 2, some estate taxes are reduced because, while there may still be an estate tax for the transfer from generation 1 to generation 3, there will not be an unneeded estate tax from the transfer of wealth from generation 2 to generation 3, for example.
In fact, prior to the GST tax, an individual could avoid estate taxes over several generations by placing the property into an irrevocable trust for the benefit of current and future generations of descendants. This way, using a trust, the “skipped generation” could still use the assets through trust distributions to them!
Congress thought prudent to respond to this abuse and so it instituted a tax anytime wealth skips at least one generation. This tax, called the generation skipping transfer tax (GSTT), can be easy to understand in theory but harder to identify in practice, especially in situations where it does not seem to indicate that a GSTT is involved, but where in fact, it is.
The history of the GST tax has been riddled with various starts and stops. In 1976, Congress enacted the first GST tax, which was replaced about a decade later with another version. In 2010, after a temporary repeal of the tax, it came back with the passage of the Tax Relief Act of 2010, and through various tax bills even subsequent, we have the GST tax we know today, whereby each US domiciliary is afforded a lifetime GST tax exemption. Like the estate tax “coupon,” this GSTT coupon can be allocated to any transfers up to the lifetime exclusion amount. Any transfers that eclipse the coupon value will trigger a GST tax.
Understanding the Rules of GST
In discussing the GSTT, there are certain definitions that are essential to know:
- Skip persons: A person who is assigned to a generation at least two generations below that of the transferor.
- Non-skip persons: A person or trust that is not a skip person.
Gifts to a “skip person” triggers a GST tax. Therefore, it is critical to understand exactly who is a “skip person,” since every other person or entity is characterized automatically as a non-skip person and, thus, no GST tax applies to those transfers.
Basic Rules
Let’s set out some basic rules.
First, let’s refer to Generation 1 as an individual’s grandparents. Thus, Generation 1’s siblings and spouses all belong to the same generation. The individual’s parents, and their siblings and spouses, all belong to Generation 2. The individual, his spouse and siblings and their spouses, all belong to Generation 3, and so forth. If an individual is not related to the transferor but is related to the transferor’s spouse, then that person’s generation is the same based on reference to the spouse.
Second, what if an individual though is unrelated to the transferor or the transferor’s spouse? In such a case, they are considered to be part of Generation 1 if they are not more than 12.5 years older or younger than the transferor. If they are more than 12.5 years younger, but not more than 37.5 years younger, than the transferor, then they are part of Generation 2. If they are more than 37.5 years younger than the transferor, then they are part of Generation 3. This continues down into further generations based on 25-year increments.
Third, a trust for a skip person is itself treated as a skip person when: (1) all the beneficiaries currently eligible or entitled to receive trust income or principal are skip persons; or (2) no person is currently eligible to receive trust income or principal and at no time may distributions be made to non-skip beneficiaries. For these purposes, any distribution that has less than a 5% chance of being made (based on actuarial standards) is ignored.
When is GST Tax Imposed?
There are 3 instances where GST tax is imposed.
1. DIRECT SKIPS
Direct skips are usually easy to recognize.
If I gift to someone related to me, two generations down or more, my gift is subject to GST tax if I have no more of my coupon remaining to allocate. Another example: if I gift to someone unrelated to me, who is more than 37.5 years younger than me, she is a skip person, and again, I would need to apply my GSTT coupon to that gift, otherwise it’s subject to GSTT. Or, a final example: if I gift to a trust where all the beneficiaries are skip persons, then I will need to allocate my remaining GSTT coupon to that gift in order to avoid GST tax, since my transfer to the trust is considered a gift to a “skip person.”
If I gifted money to my niece or nephew, however, this is a transfer to a “non-skip person” since the recipient is only one generation below me.
If a transferor has no more lifetime “coupon” left to allocate, then any amounts gifted to skip persons will be taxed at 40%! The GST tax is in addition to the estate tax! Thus, a transfer can be taxed twice.
But what if someone dies out of order? Under the “predeceased child rule” (IRC Section 2651(e)), a grandchild or more remote descendant of the transferor is moved up a generation if, at the time of the transfer, the descendant’s parent, who also is a descendant of the transferor, is deceased. For example, if Andy’s only son predeceases him and Andy wishes to gift to his grandchildren, this would not trigger a GST tax because there is no intervening generation. Because the purpose of the GST tax is to prevent wealth from skipping a generation, moving a grandchild up a generation seems fair and consistent with what Congress was seeking to prevent.
- Yet leave it to lawyers to muddle a simple rule. Let’s say Andy and Aaron are brothers (Generation 1). Andy has two kids and Aaron has two kids. Aaron dies and Andy wants to give gifts to Aaron’s two kids. In this case, do Aaron’s two kids move up a generation under the predeceased child rule? The answer is “no,” because the rule only applies to lineal descendants. In this case, Andy still has two children. However, if Andy does not have any children, then and only then will Aaron’s children move up a generation, thus making the transfer from Andy to them immune from GST taxes.
- Moreover, survival by less than 90 days is treated as predeceasing. What does this mean? Let’s say Andy gifts to his grandson while his son is still alive. This is a direct skip and subject to GSTT. But let’s say that after making the (GSTT taxable) gift, Aaron’s son then passes away two weeks later. In that case, the predeceased child rule’s 90-day safe harbor provision immunizes Andy’s gift to the grandson, because his son’s death is now viewed as having occurred before the gift, in which case the predeceased child rule will still apply. An exception to the exception…
2. TAXABLE DISTRIBUTIONS
What if a transfer is made to trust and the trust beneficiaries are as follows: one beneficiary is the child of the transferor (considered a Generation 2 beneficiary) and four beneficiaries are the grandchildren of the transferor (Generation 3 beneficiaries? In this example, the trust is not considered a “skip person” just yet, because not all the beneficiaries are skip persons (we have a Generation 2 beneficiary). Thus, the initial transfer to trust does not trigger GSTT. However, if money is then transferred to someone in Generation 3, this is known as a taxable distribution and now GSTT would be imposed on the beneficiary. Again, if the transferor allocated GSTT exemption to the initial transfer, then no GSTT would be due even if money was distributed to a Generation 3 beneficiary or beyond.
3. TAXABLE TERMINATION
Let’s take the same example as above, with one Generation 2 beneficiary and four Generation 3 beneficiaries. Let’s imagine that before any money gets distributed to any Generation 3 beneficiaries, the sole Generation 2 (non-skip) beneficiary dies. Now, the trust can only benefit skip persons since all the available trust beneficiaries are Generation 3 (skip persons). At this time, regardless of whether distributions are even made, the assets in the trust at the death of the Generation 2 beneficiary are taxed at GSTT rates. This is called a taxable termination. However, once distributions are made, this would normally constitute a taxable distribution (and GSTT would be due), but this would result in a patently unfair system whereby the generation 3 beneficiaries are being taxed twice (first at the taxable termination, and then again for taxable distributions). Thus, the “generational step up rule” states that at time of the taxable termination of the trust (the death of generation 2 beneficiaries), the transferor (Generation 1) is then treated as being only one generation above the oldest generation with an interest in the trust immediately after the taxable termination; in other words, the transferor is moved to Generation 2, so that any assets transferred will not trigger a GST tax since Generation 3 are no longer skip persons.
Who Pays the GST Tax?
If it is a direct skip, the GST tax is paid by the transferor.
If it is a taxable distribution, the GST tax is paid by the recipient.
If it is a taxable termination, the GST tax is paid by the trust.
Taxable distributions and taxable terminations are more costly than direct skips, because the payor is paying tax on the tax. For example, if Andy makes a $2 million gift to his grandson, he will pay $2,800,000 including the tax. But if the grandson or trust is paying the tax, then they will need to pull out more from the trust to still end up with $2 million (e.g., $3.33 million).
GSTT in Practice
With these rules in place, it’s now easier to flush out the GST tax by going through some common scenarios.
SCENARIO 1: What if I gift $16,000 directly to my grandson? Does this trigger a GST tax? The answer is “no” as long as the transferor still has his annual gift tax exclusion, which in 2022, is $16,000 a year. If he gifts the grandchild $20,000, then $4,000 will be subject to a GST tax, unless the transferor applies his GSTT coupon to the $4,000, which will reduce his lifetime GSTT coupon at death by that same amount. Thus, if he dies in a year where his GSTT coupon is only $1 million, he would have used up $4,000 of that coupon and would be permitted to leave at death an extra $999,996 to skip persons without paying the GST tax.
SCENARIO 2: What if an individual gifted $100,000 to pay their granddaughter’s tuition payment? In this case, the transferor can rely on Section 2503(e) gifts, whereby he can pay directly to any health or educational institutions (e.g., tuition, 529 plans, medical bills, even healthcare premiums), on behalf of his grandchildren, since those amounts are unlimited and do not count against the GST tax limits nor any (annual) gift tax limits!
A word of caution here:
- If he pays his son the money, who then uses it to pay the institution, it is considered a gift.
- Had the gift been made into a trust for the benefit of the grandson, then it is only excluded from GST tax if (1) the trust only benefits one individual (the grandson); and (2) the trust assets will be subject to estate tax on that individual’s death. Otherwise, GST exemption must be used for this transfer to trust.
Avoiding Imposition of the GST Tax
Much like I discussed in my article on the estate and gift tax exemptions, each person is allotted a GSTT exemption. This can be allocated for transfers made during life or at death in order to prevent the imposition of GST tax where it would otherwise occur. The current GST Exemption in 2022 is $12.06 million per US domiciliary, and is indexed for inflation. If GST exemption is allocated to a trust at the time of the initial transfer, then any future distributions to any skip persons will not incur a GST tax. Just as with gift and estate tax exemptions, GST exemptions used during life will reduce the amount available at death.
- To fully maximize one’s GST exemption, there is an advanced technique here that can be used called a Reverse QTIP election. Generally in a QTIP election, the surviving spouse is treated as the decedent for estate tax purposes since the assets in a QTIP are included in the gross estate of the surviving spouse. But when this happens, the deceased spouse’s GSTT exemption is wasted because any GST allocated to the QTIP by the decedent vanishes at the death of the surviving spouse, who is then deemed to be the new transferor. Even if the surviving spouse allocates her GSTT exemption to the QTIP trust, the deceased spouse’s GSTT allocations go unused. Therefore, a reverse QTIP is an election made to treat the trust as though a QTIP had not been made for GST purposes, thus treating the first spouse as the transferor for GST purposes. If this is done, the election must be made as to 100% of a QTIP but different elections can be made on different QTIPs.
Another way to avoid the imposition of a GST tax is to confer something called a general power of appointment to a child. A general power of appointment is defined as the power to appoint to yourself, your estate, your creditors, or the creditors of your estate the right to have the beneficial use and enjoyment of certain property covered by the power of appointment. For example, imagine you created a trust that is for the benefit of your child and then your grandchildren. Upon your child’s death, it becomes a taxable termination. However, if you granted your child a general power of appointment, then this means at the death of your child, there is no taxable termination and, rather, the child himself is treated as the new transferor. Thus, there is a one generation transfer and the grandchildren are not skip persons. By including a general power of appointment however, the assets will become part of the child’s taxable estate for estate tax purposes. One efficient planning tool is to grant a formula general power of appointment, wherein the child does not have a general power of appointment (in order to prevent future estate tax impositions upon successive generations) but if there is a GST tax due, then the general power of appointment will be applied to prevent GST. This takes careful drafting however and caution must be taken to ensure that the child himself does not already have a taxable estate for estate tax purposes. The use of a Trust Protector can be helpful here.
Applicable Fractions and Inclusion Ratios
If an individual has not allocated enough GST exemption to a transfer, then a GST tax will be due upon the direct skip or the taxable distribution or taxable termination. To determine whether or how much GST tax applies to a particular taxable distribution or termination, the trust’s “inclusion ratio” must first be determined. The inclusion ratio determines what portion of a trust or of property transferred in a direct skip is subject to the GST tax. The inclusion ratio is defined as 1 minus the applicable fraction.
What is an applicable fraction? The applicable fraction defines what portion of a trust or of property transferred in a direct skip is actually exempt from GST tax.
- If an applicable fraction is zero, the inclusion ratio is 1, which means none of the property is exempt from GSTT and the entire transfer or distribution is subject to GST tax.
- If an applicable fraction is 1, then the inclusion ratio is 0, which means all of the property is exempt from GSTT and the entire transfer is exempt from GST tax.
- If an applicable fraction is between 0 and 1, then this defines the portion of the property that is exempt from GST.
The applicable fraction has two parts. The numerator is the amount of the GST exemption that has been allocated to the property transferred to the trust or in the direct skip. The denominator is the fair market value of the transferred property at the time of the transfer — or, if later, at the time a non contemporaneous allocation of the GST exemption is made.
For example, assume Andy makes a taxable gift of $1 million to a trust and allocates $750,000 of GST exemption to the trust at the time of the transfer. The applicable fraction of the trust will be 3/4. If the beneficiaries of his trust is his child, with the remainder passing to his grandchildren, the initial transfer does not trigger GSTT because the trust is a non-skip person. However, when Andy’s son passes away, there is a taxable termination of the trust and one-fourth (1 minus 3/4) of the amount in the trust at the time will be subject to GSTT.
It is ideal that a trust creates two classes of shares, GST exempt (inclusion ratio of 0) and GST non-exempt (inclusion ratio of 1) trusts. It is not ideal to have partially exempt trusts, where the inclusion ratio is between 0 and 1 because such trusts are wholly inefficient. How? Because in the above example involving Andy, if the trustee distributes $100,000 to Andy’s son, $75,000 of GST exempt property is being paid to a non-skip person. On the other hand, if the trustee distributes $75,000 to Andy’s granddaughter, 25% of the distribution is subject to GSTT.
Instead, by using two classes of trusts, exempt and non-exempt, we can be more efficient and reserve distributions to skip persons using the exempt trusts and distribute to non-skip persons using the non-exempt trusts.
Conclusion
The rules here are subject to change with changes in the law, and it is incumbent to work with a professional who can plan for your specific situation.