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Tax-smart strategies for leaving generation-ranging wealth

Estate, Gift, & Trust Planning

People who hope to leave wealth to grandchildren, and even great-grandchildren, may need to worry about the generation-skipping transfer (GST) tax. This article explains how the tax works by applying a flat, 40% rate at each generational level. The article also covers GST tax exemptions, gift tax returns and automatic allocation rules.

Skip persons and other rules

To ensure that wealth is taxed at each generational level, the GST tax applies at a flat, 40% rate — in addition to otherwise applicable gift and estate taxes — to transfers that skip a generation. The tax applies to transfers to “skip persons,” including your grandchildren, other relatives who are more than one generation below you and unrelated people who are more than 37½ years younger than you. But there’s an exception for a grandchild whose parent (your child) predeceases you. In that case, the grandchild moves up a generation and is no longer considered a skip person.

Three types of transfers may trigger GST tax:

  • “Direct skips,” which are transfers directly to a skip person that are subject to federal gift and estate tax,
  • Taxable distributions, or distributions from a trust to a skip person, and
  • Taxable terminations.

In this last case, if you establish a trust for your children, a taxable termination occurs when the last child beneficiary dies and the trust assets pass to your grandchildren.

Exemptions and allocations

The GST tax doesn’t apply to transfers to which you allocate your GST tax exemption (up to $13.61 million for 2024). In addition, the GST tax annual exclusion allows you to transfer up to $18,000 in 2024 to any number of skip persons without triggering GST tax or using up any of your GST tax exemption. However, the GST tax exemption must be allocated to a transfer to shelter it from tax.

Ordinarily, to allocate GST tax exemptions, you must affirmatively elect to do so on a timely filed gift tax return. Transfers to a trust qualify for the annual GST tax exclusion only if the trust:

1. Is established for a single beneficiary who’s a grandchild or other skip person,

2. Provides that no portion of its income or principal may be distributed to (or for the benefit of) anyone other than that beneficiary, and

3. Doesn’t terminate before the beneficiary dies.

However, if you neglect to file gift tax returns, you may be saved by the automatic allocation rules, which are designed to prevent you from inadvertently losing the exemption. These rules automatically allocate the exemptions to direct skips as well as to transfers to “GST trusts.” The definition of a GST trust is complicated, but essentially, it’s one that meets certain criteria that create a strong possibility that the trust will benefit your grandchildren or other skip persons down the road.

Often, automatic allocation rules ensure that GST tax exemptions go where they’ll be beneficial.

But in some cases, they may work against you. For example, the exemption isn’t automatically allocated to transfers that may trigger costly GST tax. Or an exemption may be automatically allocated to transfers that are unlikely to need its protection, thus wasting those exemption amounts.

Review your options

To help ensure you use your GST tax exemption to the greatest advantage, examine all options closely. This is particularly critical if you want to make substantial gifts to skip persons or if transfers to a trust don’t qualify for the annual exclusion (because, for example, they have multiple beneficiaries). Estate planning advisors can introduce you to tax-minimization strategies based on your unique needs and concerns.