Generation skipping transfer tax

In short

A friend of mine once told me that the hardest part of giving to grandchildren is not the giving, it is the paperwork nobody warned him about. If you are thinking about leaving money to grandchildren, or to anyone more than one generation below you, the generation skipping transfer tax may apply on top of the estate tax. Each person has a lifetime exemption from this tax, set by law at the current figure, which the official source publishes each year. Gifts and trusts that stay under that amount are not hit by the tax. Anything over it is taxed at a flat percent, the current figure, which the official source publishes each year. The Internal Revenue Service wants the exemption claimed on Form 709 for lifetime gifts and Form 706 for estates. Talk to a trusts and estates attorney before you sign anything.

The whole of it

What it is

I once watched an old farmer walk his property line at sunset, telling his grandson which fields would be his someday. What he did not say was that the government keeps a quiet eye on exactly that kind of handoff. If you are a person with a large estate, you have probably wondered why a gift to a grandchild is treated differently from a gift to a child. The reason is simple. Congress did not want families to avoid a round of estate tax by skipping the middle generation.

Here is the idea in plain terms. When a parent leaves money to a child, the estate tax applies at the parent's death. When that child later dies, the estate tax applies again on whatever is left. A wealthy family could dodge that second round by leaving money straight to grandchildren. So the law adds a separate tax, the generation skipping transfer tax, often shortened to GST tax, to close that gap. It sits beside the gift tax and the estate tax, and it is found in Chapter 13 of the Internal Revenue Code.

It matters most to families with tens of millions of dollars. Smaller estates usually fall under the exemption and never feel it at all. But for larger ones, a mistake can cost dearly, so the rules deserve a patient look.

How it works

A friend of mine who runs a family office likes to say that this tax has three doors, and you should know which one you are standing in. The first door is the direct skip. That is a gift or bequest straight to a skip person, who is someone two or more generations below the giver, like a grandchild. The second is the taxable termination. That happens when a trust interest held by a non skip person ends, and only skip persons remain as beneficiaries. The third is the taxable distribution, which is a payout from a trust to a skip person.

Trusts are where most of the action lives. Many wealthy families set up long term trusts, sometimes called dynasty trusts, meant to hold assets for several generations. The GST tax is the reason these trusts need careful planning. Without the exemption, each time wealth passed to a lower generation inside the trust, the tax could bite.

The tool that protects a trust is the GST exemption. The person who funds the trust, called the transferor, may assign part of the personal exemption to it. A trust that receives enough exemption to cover all of its value is often called fully exempt. The tax is then not charged on later growth or on payouts to grandchildren, even if the trust runs for decades. That growth is the quiet power here. The exemption is applied to the value at the time of the transfer, and growth after that is not counted against it.

Married couples can each use their own exemption. The law also allows a spouse to elect to split a gift, so a gift from one spouse can be treated as made half by each. Both spouses, though, must file the proper forms for the split to count.

One more thing is worth knowing. Some gifts are not taxed even without using the exemption. The annual exclusion for gifts, set at the current figure, which the official source publishes each year, can apply to a direct gift to a grandchild. Tuition and medical bills paid straight to the school or the provider can also be outside the tax. Those are narrow rules, so a lawyer should check the facts.

The numbers, and where to find yours

If you are holding a large estate plan in your hands, the first thing you want is the right number. The lifetime GST exemption per person is the current figure, which the official source publishes each year. The tax rate on amounts above it is the current figure, which the official source publishes each year. The annual gift exclusion is the current figure, which the official source publishes each year. The site fills in the verified figure for each of these, with its source and date.

These figures change, so do not trust an old article, and do not trust memory. The Internal Revenue Service publishes the current numbers each year. Look for its pages on estate and gift taxes, and for the instructions to Form 709 and Form 706. The statute itself is Chapter 13 of the Internal Revenue Code, and the Treasury regulations explain how it works in practice. Those are primary sources, written by the people who set the rules.

Your own number is a little different. What matters is how much of your exemption you have already used. Past gifts that used some of it reduce what is left. So pull your old Form 709 filings and list them. A good attorney will build that running tally for you.

A worked example

Let me tell you about a woman I will call Margaret, because the name suits a careful person. Margaret is a widow with an estate of $60,000,000. She wants to help her three grandchildren, and she wants the help to last. Say her remaining GST exemption equals $12,000,000 for this example. That figure is my own round number, picked only to show the arithmetic.

Margaret sets up a trust for her grandchildren and puts $12,000,000 into it. She files Form 709 and assigns $12,000,000 of her exemption to the trust. Since the gift equals the exemption she assigned, the trust is fully exempt. The inclusion ratio, which is the share of the trust that is taxable, is zero.

Suppose the trust grows to $36,000,000 over the years. Because the exemption was set at the time of the gift, the growth of $24,000,000 is not taxed under the GST. Check it: $36,000,000 minus $12,000,000 is $24,000,000. That is the quiet power of the exemption.

Now compare. Say Margaret had instead put $20,000,000 into the trust and assigned only the $12,000,000 she had left. The inclusion ratio would not be zero. The taxable share is the part not covered. First, $20,000,000 minus $12,000,000 is $8,000,000 left uncovered. Then $8,000,000 divided by $20,000,000 is 0.40. So 40 percent of the trust is taxable under the GST. If the law set the rate at 40 percent for this example, a later payout of $1,000,000 to a grandchild would carry a taxable part of $1,000,000 times 0.40, or $400,000. Tax at 40 percent on $400,000 is $160,000. These are example figures, not the legal rate. Look up the real rate in the IRS materials.

The lesson sits right there in the numbers. Funding a trust bigger than the exemption can leave part of it taxed forever.

Where it goes wrong

I have seen smart people trip on this tax, and it is never because they are foolish. It is because the rules are quiet until they are not. The most common slip is forgetting to file. The statute does set up deemed allocation rules that can assign exemption to certain transfers without a filing, but they cover only some transfers, so a trust may end up with less exemption than the giver meant. For that reason, careful planners file Form 709 on purpose and state the allocation.

Another slip is mixing exempt and non exempt money in one trust. When a trust has an inclusion ratio between zero and one, every payout is partly taxed. Many advisers prefer to keep separate trusts so the exempt one stays clean. That is a planning choice, not a rule.

A third mistake is missing a skip person. A trust that looks harmless may name a grandchild as a future beneficiary. A step grandchild is also treated as a grandchild for this tax, so a gift to one can count as a skip. For a person who is not related to the giver, the statute assigns a generation by the gap in age, so that gap can decide whether the person is a skip person. Read the definitions closely.

Last, the exemption can change. Congress has raised and lowered it before. A plan built on today's number may need a second look if the law moves. Stay in touch with your attorney.

Questions to answer before you leave this page

Do you know how much of your GST exemption you have already used, and do you still have the old Form 709 filings that prove it? Have you listed who counts as a skip person in your family, including step grandchildren and any trust beneficiaries? Is each trust you have built, or plan to build, funded in a way that makes it fully exempt, or does it carry a mixed inclusion ratio? Have you and your spouse talked about whether to split gifts, and will both of you file the forms it takes? Have you checked the current exemption, rate, and annual exclusion on the IRS pages instead of relying on a number you once heard? And have you sat down with a trusts and estates attorney who can look at your own papers and your own family?