The generation-skipping transfer (GST) tax, first enacted in 1976 and simplified in 1986, came about as an effort by Congress to close what was perceived as a loophole in the federal estate tax and gift tax system. A popular estate planning technique, prior to the GST tax, would be for a wealthy grantor to create a trust where the grantor's child receives a life estate in the trust assets and the grantor's grandchild receive the remainder interest. Even after the settlor dies, the child continues to exercise his life interest in the trust assets until his or her own death. Once the child passes, his life interest is extinguished, and the grandchild receives the trust assets outright. Since the child's interest in the property is terminable upon death, the federal estate tax is not imposed on this transfer. The GST tax was created for the purpose of collecting the equivalent of the federal estate tax against the generation that gets passed over from the transfer.
26 U.S.C. §2641(a) sets the GST tax at a flat rate for the highest federal estate tax level, currently at 40%. The GST tax is imposed on the following transfers:
- Direct Skip: A transfer to a "skip person", defined as a person that is two or more generations below the transferor. A direct skip also occurs when there is a transfer to a trust where all of the interests in the trust are held by skip persons. The GST tax is paid by the TRANSFEROR.
- Taxable Termination: A termination by death, lapse of time, release or otherwise of an interest in property held in a trust whereas a skip person has an interest in the trust property immediately afterwards. A taxable termination does not occur if, immediately after the termination, a non-skip person has an interest in the trust property. The GST tax is paid by the TRUSTEE.
- Taxable Distribution: A distribution from the settlor's trust to a skip person. The GST tax is paid by the TRANSFEREE.
Determining if someone is a "skip person" means assigning that person to a generation level relative to the transferor. 26 U.S.C. §2651 explains assigning generation levels depending on whether there is a familial relationship or not:
- Transfer To A Relative: Generation levels are assigned along family lines. The transferor's spouse and siblings are considered to be in the same generation. The transferor's (or his spouse's) children are one generation away and the transferor's (or his spouse's) grandchildren are two generations away. Lineal descendants of the transferor's grandparents are assigned generation levels relative to the transferor, with first cousins sharing the same generation as the transferor, and aunts and uncles being one generation behind. Anyone married to a lineal descendant of the transferor's grandparent is considered to share generation level as the lineal descendant. EXCEPTION: A grandchild of the transferor whose parents are deceased at the time of the transfer is NOT considered a skip person.
- Transfer To A Non-Relative: Generation levels are assigned based on the difference between the transferor's date of birth and the transferee's date of birth. Persons not more than 12.5 years younger than the transferor are considered part of the same generation. After the 12.5 year mark, every 25-year period thereafter is treated as a new generation. Therefore, a transferee who is over 37.5 years younger than the transferor is considered a skip person.
Like the federal estate tax and the federal gift tax, there is an exemption available to shield a certain value of assets from the generation skipping transfer tax. According to 26 U.S.C. 2631(a), the GST exemption is the same as the estate tax basic exclusion amount. For 2018, since the passage of the Tax Cuts and Jobs Act of 2017, the GST exemption amount is $11.18 million. However, this amount will return to a level nearly half of its value after 2025 unless Congress lifts the sunset provision.
Although the estate tax basic exclusion amount and the GST exemption are identical, the GST exemption does not use the unified credit. It is not portable, meaning that the unused amount of the exemption cannot be transferred to the surviving spouse. The $11.18 million exemption may be allocated by the transferor or the executor to ANY generation-skipping transfer during life or after death provided it is done so before the due date of the Form 706 Estate Tax Return (within 9 months of death) to the Internal Revenue Service, whether one is required to be filed or not. The allocation is irrevocable once made.
The GST exemption makes only the wealthiest taxpayers subject to the generation-skipping tax. However, it can really be punishing in situations where it applies. For example, a transfer that is subject both to the 40% GST tax AND the 40% maximum federal estate tax is virtually decimated. This does not even include if the taxpayer's state has its own estate tax or generation-skipping tax (Michigan has neither of these). Fortunately, there are some potential strategies available to both make transfers to a more remote generation and possibly minimize or eliminate GST liability.
- Lifetime Gifts - The $15,000.00 per donee/per year exclusion for the federal gift tax also applies against GST taxation of transfers to direct skips. Additionally, exclusions for unlimited amounts of tuition (made to qualifying educational institutions) and medical expense payments (made to qualifying medical providers) allowed under the federal gift tax are also applicable to the GST tax.
- Dynasty or Generation-Skipping Trusts - A taxpayer can create a long-term irrevocable trust, funded either during life or at death, designed to hold assets at the grantor's direction and never directly distributed to beneficiaries except for specific purposes. Known as a "dynasty trust", this legal entity can theoretically last into perpetuity and benefit the descendants of the taxpayer for generations to come. Since the assets never transfer to any successive generation, then the GST tax can be avoided. The dynasty trust was impossible only decades ago because nearly all jurisdictions had a statute called "the rule against perpetuities" (RAP) that limited how long a trust could last. Due to the notorious complexity and difficulty in applying the RAP correctly, many states have either amended or outright appealed the statute. Prior to June 3rd, 2008, a private trust could not last longer than 90 years in Michigan. However, Michigan's own RAP was amended to allow a trust, under certain conditions, to last into perpetuity.
If you have questions about the generation skipping transfer tax or any other aspect of federal tax law, do not hesitate to contact the estate planning and tax attorneys at Kershaw, Vititoe & Jedinak PLC.