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Generation-Skipping Trust

A generation-skipping trust (GST) is a type of irrevocable bypass trust for assets to be subsequently passed on to your grandchildren while avoiding estate taxes during your children’s generation. They can be a living or testamentary trust. GSTs are much more complicated than they seem and you likely need a professional to create one.

A GST lets you transfer assets over the federal and/or state limits to beneficiaries at least two generations removed from you (skip person), and avoid estate taxes during the middle generation. This is called a generation-skipping tax or generation-skipping transfer tax.

  • It does this by either deferring ownership of the trust from your spouse and your children to your grandchildren or transferring assets from the trust to them in the form of gifts before they inherit it.
  • It could be used for other family members or unrelated people who are at least 37 ½ years younger than you, although not a spouse or ex-spouse.

Like any trust, you will name a trustee and can determine how, when, and why the funds are given to your children and/or grandchildren. Your child could be the trustee.

Because of the time frame involved, there is a much higher chance of things changing or going wrong. A GST will require more thought and outside assistance than single generation trusts.

  • You will need to try and anticipate future changes in the estate tax limits for decades rather than years. Currently the federal estate tax limit is $11,700,000 and will increase for inflation until 2025 after which it is due to be lowered by 50%. State estate taxes, inheritance tax, and other taxes on the transfer of estates will probably change as well. It is also likely that other inheritance laws will change.
  • Named beneficiaries may change, so contingent beneficiaries are essential. New beneficiaries through birth or adoption will usually be added automatically but it is best to assure this will happen.
  • It is even more important to include replacement trustees or have a professional firm manage the trust, and to include power of appointment that will allow trustees to adapt to any of these circumstances.
  • If you don’t include contingencies or successors, the court will make the decisions.

The generation-skipping tax differs from other estate taxes when over the limit. Rather than a variable taxation rate from 18% to 40% for the first $1,000,000, the entire amount is taxed at 40%. However, since the GST avoided estate tax during your children’s generation, the overall result is less taxes.

There are two ways to transfer assets from your estate to your grandchildren or other “skip persons,” the indirect and direct skip.

Indirect Skip

The indirect skip is the most common GST used. It is indirect in that there are intermediate steps, either:

  • Transfers do not go directly to your grandchildren or skip person, but provide income for and/or is used for gifts to your children before your grandchildren inherit them; or
  • The skip person pays a generation-skipping transfer tax at the time of the gift rather than having the gift reduce the lifetime estate tax exemption when the final transfer takes place.

These disbursements can be either to your children or grandchildren, depending on the trust. Whether it is a living or testamentary trust determines if it is a taxable termination trust or taxable distribution trust.

Taxable Termination Indirect Skip Trust

 

  • The taxable termination indirect skip trust is the most common indirect GST and involves both skip and non-skip persons.
  • It is a testamentary trust created at your death that is first used to provide income and/or gifts to your children, the primary beneficiaries, before ownership is transferred to the skip person.
  • Although your children benefit from the GST assets, they do not own them and are not part of their taxable estate.
    • Even if the estate value in the GST is over the federal estate tax limit, $11,700,000 in 2021, when your child dies it will not be subject to federal estate tax. This would also apply if your state has its own estate tax.
    • If the estate value in the GST is over the federal estate tax limit when your grandchildren or other skip person dies, any amount over this amount is taxed at 40%.
  • If your child has died before you, your grandchild will take their parent’s place and would not have ownership but be able to pass on the trust to their children (your great-grandchildren) tax-free. For other provisions see the Predeceased Ancestor Rule.
  • If you have a spouse, double these amounts can be given.
  • If your children receive any gifts from the trust property, they are  subject to the same restrictions as outlined in the Gift Tax section. 
    • The skip person can receive gifts from this trust before they inherit the assets.
    • These gifts can be used to decrease the value of the assets in the GST before your grandchildren inherit them to reduce estate taxes.
  • The skip person only inherits the assets after the death of the primary beneficiaries.

Taxable Distribution Indirect Skip Trust

 

  • This is a living GST trust created while you are alive from which you can distribute gifts in the form of income or property to your grandchildren or other skip persons.
  • Any gifts from the trust property will be subject to the 40% generation-skipping transfer tax at the time of the gift to be paid by the skip person. Although the gift does not impact the estate tax lifetime exemption, it could reduce estate taxes by decreasing the value of the assets when the final transfer takes place.
  • After your death, the assets in the trust may either go to your grandchildren as you designate or be used to form a new trust for them where you can specify how the assets are used.

Direct Skip

With the direct skip method the assets go directly to your grandchild. The GST could be a living trust from which gifts can be given before your death or as inheritance after your death. Alternately, a testamentary trust can be created for them where you can specify how and when they will receive the assets. Your children will not be beneficiaries and will not get any benefits from the trust.

The federal generation-skipping transfer tax applies when the assets are inherited by the skip person. Because this is the first time the assets are transferred, the skip is direct. The taxable amount is any inheritance over your unused federal estate tax exemption limit ($11,700,000 in 2021). 

  • For example, if you have already transferred $10,000,000 of your estate, the remaining federal generation-skipping transfer tax credit would be $1,700,000. 
  • If you left your grandchild $2,800,000, the estate would pay $680,000 in estate tax ($1,700,000 times 0.4) for transfer of this trust.

The lifetime gift exemption is automatically applied and you do not have to file an IRS Form 709, the U.S. Gift (and Generation-Skipping Transfer) Tax Return. 

 

Assets from this trust can be given directly to your grandchild as gifts before your death. The gifts:

  • Can be used to decrease the value of the assets in the GST before your grandchildren inherit them to reduce estate taxes; and/or
  • Are subject to the same restrictions as outlined in the Gift Tax section. 
    • Any gifts less than the gift tax exclusion for that year ($15,000 per person per year for 2021)  do not impact the estate tax lifetime exemption.

All gifts in excess of the $15,000 annual exclusion are to be reported on an IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return and are deducted from the estate tax lifetime exemption.

A private annuity can also be used as a type of generation-skipping trust.

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