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.
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.
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.
The indirect skip is the most common GST used. It is indirect in that there are intermediate steps, either:
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
Taxable Distribution Indirect Skip Trust
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).
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:
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.