Your Guide to Understanding the Generation-Skipping Transfer Tax 

I.  Generation-Skipping Transfer Tax 101

Many people are familiar with the existence and some aspects of estate and gift taxes. If you are part of an ultra-high-net-worth family, it is important to also understand the generation-skipping transfer (GST) tax and how it may affect your particular situation. During the planning process, it is vital to consider unique family dynamics, financial goals, and values when deciding the best tax strategies to distribute your generational wealth. 

What Is the Generation-Skipping Transfer Tax? 

The government collects federal estate taxes to generate revenue when wealth is passed down to subsequent generations. When people die, they usually leave their money first to their spouses, then to their children, then to their grandchildren, and then to more distant relatives. At each passing of generational wealth, the government collects an estate tax.   

Wealthy families found a way to avoid estate tax by skipping a generation and transferring wealth directly to grandchildren and great-grandchildren, allowing them to pass down more wealth to future generations. Estate taxes were avoided when the skipped generation (in our example, the children) died because the children never owned the money or property.   

The government responded with legislation in 1976^[1] and again in 1986,^[2] attempting to eliminate the transfer tax advantage of skipping a generation by imposing a GST tax when a skip occurs. This ensured that large estates still paid estate tax at each generation.

 The GST tax rate is currently 40 percent (the same as the highest federal estate and gift tax rate) so the tax burden on high-net-worth individuals can be substantial. Luckily, there is a GST exemption amount of $13.61 million for individuals in 2024 (the same lifetime exemption as the federal estate and gift tax exemption) that can be used when someone wants to make gifts or leave an inheritance that would otherwise be subject to the GST tax.^[3] If you have a significant estate, your family may need to use their GST tax exemption in addition to the estate and gift tax exemptions.  

Who Are the Parties Involved in a Generation-Skipping Wealth Transfer? 

There are typically three parties involved in a generation-skipping wealth transfer: 

●      The transferor: the person making the wealth transfer to an individual or a trust

●      The skip person: the person receiving the money or property, who must be two or more generations removed from the individual making the transfer or is at least 37 ½ years younger than the transferor; a skip person may also be a trust in some instances  

●      The non-skip person or skipped person: the generation between the individual transferring wealth and the one receiving it^[4] 

II. Let's Do the Math: How Does the Generation-Skipping Transfer Tax Work?

You may have considered creating a trust to transfer wealth to your grandchildren and great-grandchildren. But you may not have considered how the generation-skipping transfer (GST) tax could affect this inheritance. To better explain how the tax would impact a gift in trust, we are going to take a look at some math.

Generation-Skipping Transfer Tax Rate  

The federal GST tax rate matches the highest federal estate tax rate, currently set at 40 percent.^[5] For high-net-worth individuals, effective GST tax planning is crucial in managing combined estate, gift, and GST tax burdens. 

Generation-Skipping Transfer Tax Exemption   

You can transfer a specific value of money and property to skip persons (grandchildren, great-grandchildren, other distant relatives, someone at least 37 ½ years younger, or a trust for a skip person), either during your lifetime or after death, before triggering the GST tax. This exemption equals the federal estate and gift tax exemption amount ($13.61 million in 2024). Be aware that there is no portability for the GST tax exemption. Meaning, you will need to use it or lose it.    

Exceptions to the Generation-Skipping Transfer Tax  

You and your family members may have already established a trust. If so, certain irrevocable trusts established before September 25, 1985, are grandfathered and exempt from the GST tax provisions in Section 26.2601-1(b)(1) of the Treasury Regulations. Modifications or additions to these trusts can jeopardize the exception. Additionally, gifts for educational or medical expenses to skip persons, such as Health and Education Exclusion Trusts (HEET), are excluded from the GST tax application.^[6] 

Calculating Generation-Skipping Transfer Tax 

To understand how the GST tax will affect the inheritance you leave behind, you need to do some math. The GST tax calculation relies on an inclusion ratio, indicating the extent to which a transfer is subject to GST tax. This ratio is determined by the applicable fraction, based on the amount of your GST tax exemption. An inclusion ratio of one means the direct skip or trust is fully taxable. Any number between zero and one indicates the transfer is partially subject to GST tax.^[7]  

The amount of the GST tax exemption allocated to the transfer is divided by the value of the property involved in the transfer. The fraction is rounded to the nearest one-thousandth (.001) and looks like this:  

 GST tax exemption allocated / Value of property transferred  

The next step is determining the inclusion ratio by subtracting the fraction from the number one. Depending on the ratio, the trust is either fully exempt, fully taxable, or partially taxable.  

Fully Exempt Trust  

Let's say you create an irrevocable trust for the benefit of a grandchild and their descendants in 2024 when your entire GST tax exemption of $13,610,000 is available and you can allocate it to the trust.  

If you transfer $13,610,000 (or less) worth of accounts or property to the trust and allocate your entire GST exemption, the inclusion ratio would be zero: 

1 – (13,610,000 / 13,610,000) = 1 – 1.000 = 0 

The trust would be fully exempt from GST tax. 

Fully Taxable Trust  

Now, let's assume that you have previously used your GST tax exemption and there was none available to allocate to your grandchild's irrevocable trust, the inclusion ratio would be one: 

1 – (0 / 13,600,000) = 1 – 0 = 1 

The trust would be fully subject to GST tax.

Partially Exempt Trust 

Partially exempt trusts have a portion of money or property subject to the GST tax, while another portion may qualify for an exemption.    

If you put $15,500,000 in the irrevocable trust, and your entire exemption was available, the inclusion ratio would be: 

1 – (13,610,000 / 15,500,000) = 1 – .877 = .122

The applicable fraction is .878, and the inclusion ratio is .122. The trust would be partially subject to GST tax. When distributions are made to the grandchild, there will be a tax due. To calculate how much will be owed, we first must know what the tax rate is at the time of the distribution. For example, if the rate is 40 percent,

40 percent x .122 = 4.88 percent

If your grandchild receives a taxable distribution from the trust of $125,000, the GST tax would be $6,100.

For gifts or an inheritance left directly to the skip person, the formula works similarly, the inclusion ratio is multiplied by the GST tax in effect at the time of the transfer.

III. Why Should You Be Mindful of This Tax?

If you have a substantial estate and are considering making sizable gifts or bequests to skip persons, you need to work with experienced professionals to ensure that the right strategy is used to maximize your gift and minimize the tax consequences.  

The earlier you can get started, the better your results will be. It will take time and collaboration with trusted advisors to ensure the best possible outcome. After your estate plan is created, you will need regular reviews for updates due to changing circumstances. 

Professionals to Align Legal and Tax Planning Strategies  

You and your loved ones will need comprehensive advice when creating your estate plan to ensure that legal, financial, and tax implications are all considered in your estate planning strategy. Ibis Legacy Law, LLCs welcomes the opportunity to collaborate with your existing advisors. When strategizing the best outcome for you, your loved ones, and your hard-earned money, it takes expertise from multiple areas to create the best plan possible. Please call us at 216-991-6200 for more information.