The generation-skipping transfer tax (the ”GST tax”) is a special 40% federal tax on wealth transfers to family members who are more than one generation below the transferor (i.e., a grandchild) or non-family members who are at least 37.5 years younger than the transferor. Few people have heard of it, even fewer understand how it works. The purpose of this article is to provide a broad introduction to the generation-skipping transfer tax so that readers have a basic understanding of what this tax is and how it applies.
The Generation-Skipping Transfer Tax: The Backstory
There are two other, much older federal taxes on wealth transfers: the estate tax and the gift tax. The estate tax is a 40% tax on a deceased person’s net worth in excess of the estate-tax exemption amount. In 2024, the exemption amount is $13.61 million per person, though it’s scheduled to be cut in half on January 1, 2026. The gift tax is also a 40% tax, but instead of applying to a deceased person’s net worth, it applies to gifts made during the giver’s lifetime. The gift tax and the estate tax share a single exemption amount. So, to the extent that you use gift-tax exemption during your lifetime, you reduce the estate-tax exemption that you have left over when you die.
The generation-skipping transfer tax was created to back stop these two other taxes and prevent people from being able to circumvent one or more layers of estate/gift tax. An example will help illustrate why Congress decided this new tax was needed.
Imagine that Andrew has a daughter named Yvonne and a $20 million estate. Assuming he’s already used up his estate-tax exemption, Andrew will only be able to leave $12 million to Yvonne after estate taxes ($20 million x (1-0.40)). If Yvonne wants to leave that $12 million to her son, Zach (Andrew’s grandson), again assuming she has no estate-tax exemption amount left and doesn’t earn any investment returns, Yvonne will be able to leave Zach only $7.2 million after taxes ($12 million x (1-0.40)). That’s 36% of the original amount Andrew left Yvonne! The other 64% was lost to two generations of estate taxes.
One interesting feature of both the gift tax and the estate tax is that they don’t differentiate based on the donee’s identity. So a gift to a grandchild is treated no differently than a gift to a child — e.g., you would pay a 40% gift/estate tax rate on gifts to either category of donees. Eventually, people realized that someone like Andrew could get around the second layer of estate tax on his daughter’s death by gifting assets directly to his grandchild. That way, while there would still be tax on Andrew’s death, there wouldn’t be any additional tax on Yvonne’s death, since the assets wouldn’t be passing through Yvonne’s estate. And so the “generation-skipping” transfer was born.
For a while, these generation-skipping transfers to grandchildren were a staple of estate-tax planning. But eventually policymakers decided to do something about it. Thanks to the generation-skipping transfer tax, a direct transfer to a grandchild (or another individual who is much younger than the transferor) will be taxed more or less the same as a transfer to a child followed by a subsequent transfer to the grandchild.
The Basic Structure of the Generation-Skipping Transfer Tax
The key thing to understand about the generation-skipping transfer tax is that while it’s a separate tax, it’s designed to mirror the estate tax. That means that the tax rate is the same (40%) and the exemption amount is the same ($13.61 million per individual in 2024, or $27.22 million for married couples). But the generation-skipping transfer tax’s exemption (the ”GST exemption”) is completely separate from the estate and gift tax exemption. So, while using gift-tax exemption reduces your future estate-tax exemption, using gift-tax exemption does not necessarily have any impact on your available GST exemption. As a result, a person’s available gift-tax exemption and his or her available GST exemption can be different amounts. After making a series of gifts, you might have $7 million of remaining gift-tax exemption but only $3 million of remaining GST exemption. Or it could be the other way around!
The effect of the GST tax is to impose roughly the same amount of tax on a transfer to a grandchild as the estate-tax system would have imposed if the transfer had been made first to a child and then later to the grandchild. In other words, assuming no exclusions, a transfer to a grandchild is subject to both gift/estate tax (at 40%) and GST tax (at 40%), while a transfer to a child and then from the child to a grandchild would be subject to 40% gift/estate taxes on each of the two transfers.
The Concept of Skip Persons
Whether the generation-skipping transfer tax comes into play at all depends on who the transferee is. The tax only applies to transfers to “skip persons.” An individual skip person is (a) a family member who is more than one generation below the transferor (i.e., a grandchild, since grandchildren are two generations younger than their grandparent), or (b) a non-family member who is at least 37.5 years younger than the transferor (i.e., if a 60-year-old transferor wants to leave assets to an unrelated 20-year-old, generation-skipping transfer tax will come into play). Trusts can also be skip persons when the only beneficiaries are themselves skip persons.
Anyone who is not a skip person is a “non-skip person.” Transfers to non-skip persons have no generation-skipping transfer tax consequences. If the beneficiaries of a trust include both skip persons and non-skip persons, then the trust itself will be treated as a non-skip person, but distributions from the trust to skip-person beneficiaries will be subject to generation-skipping transfer tax — unless, of course, the trust is exempt from generation-skipping transfer tax.
How Does a Trust Become Exempt from Generation-Skipping Transfer Tax?
As mentioned above, each individual has a certain amount of lifetime GST exemption. In 2024, the exemption amount is $13.61 million. That exemption can be allocated to transfers in one of two ways. First, a transferor can file a gift tax return allocating exemption to a particular transfer. Second, a transferor can do nothing and just rely on the tax code’s default rules, which allocate GST exemption to certain transfers automatically. In general, if you make a gift to a grandchild or some other skip person, a proportionate amount of your GST exemption will be automatically allocated to that transfer. Likewise, if you make a gift to a trust and grandchildren or other skip persons among the beneficiaries, in most cases GST exemption will be automatically allocated to that trust.
There are complicated rules for determining when a transferor’s GST exemption is automatically allocated to a trust. Most of those rules are beyond the scope of this article. But it’s worth mentioning one particularly important rule: GST exemption cannot be allocated to trusts that are currently inside the grantor’s estate. That means that a grantor or transferor cannot allocate her GST exemption to Grantor Retained Annuity Trusts (”GRATs”), Qualified Personal Residence Trusts (”QPRTs”), or Charitable Lead Annuity Trusts (”CLATs”) until after the end of the initial trust term. So if a GRAT has a two-year term, the transferor can’t allocated GST exemption to it until it terminates at the end of Year 2. At that point, the transferor may allocate GST exemption to the remainder interest in the trust (though doing so is likely not the most efficient was to use your GST exemption). This is why people generally name their children, not their grandchildren, as beneficiaries of GRATs, QPRTs, and CLATs.
The Power of the GST Exempt Trust
When a trust becomes GST exempt, it leaves the reach of the generation-skipping transfer tax completely and forever. So a trust that was GST exempt 30 years ago is still GST exempt today, and under current law it will still be GST exempt in 100 years. That means that all future distributions from the trust, whether to your grandchild or great-great-great grandchild, will be exempt from GST tax, no matter how large the trust grows.
For example, imagine that you fund a trust with $5 million of company stock and allocate $5 million of GST exemption to the trust. In 20 years, that trust may have $25 million of assets. All of those assets will be GST exempt, because the entire trust is covered in a GST-exempt wrapper. If, in the future, the trustee makes distributions, those distributions will not be subject to any generation-skipping transfer tax. The trust will also be outside of anyone’s taxable estate for estate-tax purposes (gift tax or estate tax exemption would likely have been allocated to it when it was funded), which means the beneficiaries will never have to worry about any of the three federal transfer taxes (estate tax, gift tax, and generation-skipping transfer tax). Income taxes will still apply to the trust.
The only real limitation on how long a trust can remain GST exempt is the Rule Against Perpetuities, a law in some states that requires trusts to terminate after a certain amount of time, usually around 100 years. In recent decades, most states have either abolished the Rule Against Perpetuities or extended the maximum trust term to several hundred years. South Dakota was one of the first states to abolish the Rule Against Perpetuities. As a result, South Dakota trusts can last forever, and the distributions from a South Dakota trust will avoid transfer taxes whether your descendants receive distributions in 2060 or 2600. (Valur offers South Dakota trusts.)
Examples of How the Generation-Skipping Transfer Tax Applies
Let’s say that our transferor, Andrew, would like to gift $10 million to an Intentionally Defective Grantor Trust (”IDGT”) for the benefit of his daughter and and his daughter’s descendants. If Andrew has $10 million or more of unused gift-tax exemption and $10 million or more of unused GST exemption, the gift would use up $10 million of each exemption amount. As a result, Andrew’s unused gift-tax exemption amount and his unused GST exemption amount would fall by $10 million, and the trust would be fully GST exempt.
On the other hand, if Andrew had $10 million of unused GST exemption but zero unused gift-tax exemption, he’d have to pay $4 million of gift tax in order to make that $10 million gift to the IDGT ($10,000,000 x 0.40).
If Andrew had $10 million of unused gift-tax exemption but zero unused GST exemption, he wouldn’t be able to set up a new GST-exempt trust. But he would be able to set up a trust that is not GST exempt. He can also shift assets to existing GST-exempt trusts by making loans or selling assets to them.
Yes, Your Child can be the Beneficiary of a GST-Exempt Trust
A common misconception is that in order for a trust to be GST exempt, it must be for the sole benefit of the grantor’s grandchildren or other much younger beneficiaries. In fact, that’s not the case. A trust for the benefit of the grantor’s child can be GST exempt even if the grantor’s grandchildren aren’t current beneficiaries. For example, many trusts are drafted so that they’re for the primary benefit of the grantor’s child or children, with the remainder going to the grandchildren after the child or children die. This type of trust can be GST exempt. Likewise, a trust for the benefit of the grantor’s spouse (such as a “SLAT”) can also be GST exempt, provided that the ultimate beneficiaries (for example, after your spouse’s death) include people in later generations.
The Three Scenarios Where Generation-Skipping Transfer Tax Applies
When GST exemption is allocated to a transfer, GST tax doesn’t apply. But when GST exemption isn’t allocated to a transfer, there will eventually be GST tax (though not necessarily right away). The tax is applied in three different scenarios:
- Outright transfers to a skip person (”direct skips”). For example, if a grandmother gifts $1 million to her grandson personally, that’s a direct skip that will use some of the grandmother’s GST exemption. Of course, if the grandmother has more than $1 million of GST exemption, there won’t be any actual tax levied on the transfer. But if the grandmother has already used up her GST exemption by making prior gifts, she will owe a 40% generation-skipping transfer tax ($400,000) on her gift.
- Distributions from a GST-non-exempt trust (a trust that has not had any GST exemption allocated to it) to a skip person (”taxable distributions”). Any tax will be paid by the beneficiary. On the other hand, if the trust were GST exempt, there wouldn’t be any tax on the distribution.
- The termination of the beneficial interests of a GST-non-exempt trust’s non-skip-person beneficiaries (”taxable terminations”). For example, imagine that a trust is created for the benefit of the transferor’s son and granddaughter. The initial transfer to the trust is not a direct skip since the trust has a mix of skip-person beneficiaries (the son) and non-skip-person beneficiaries (the granddaughter). But when the son dies, leaving a skip person (the granddaughter) as the trust’s sole beneficiary, the trust becomes a skip person, triggering GST tax at that point. The trust itself is liable for any tax. On the other hand, if the initial gift to the trust used the grantor’s GST exemption, then there would be no taxable termination on the son’s death, and all the distributions to the granddaughter would be GST exempt.
The Generation-Skipping Transfer Tax’s Exclusions
Any transfer to a spouse or charity is exempt from the GST tax. Certain payments on behalf of another person for educational or medical purposes are also exempt from the tax.
In addition, like the gift tax, the generation-skipping transfer tax has its own “annual exclusion” — that is, a certain amount that an individual can gift to another person each year without using up any lifetime GST exemption. In 2024, the GST annual exclusion is $18,000, which means you can gift $18,000 to each of your grandchildren (or any other skip person) without any tax consequences. The rules for when the GST annual exclusion applies are similar to the rules for when the gift tax’s annual exclusion applies: it always applies to outright gifts, and it applies to gifts to trusts when the trusts are structured a certain way. But the GST annual exclusion rules for trusts are stricter than the gift tax’s annual exclusion rules.
In order for a trust to qualify for the GST annual exclusion, it must:
- Be a “Crummey trust” with Crummey withdrawal rights;
- Have only one beneficiary; and
- Be included in that beneficiary’s estate for estate-tax purposes.
As an aside, Valur’s Crummey trusts are designed to qualify for both the gift-tax annual exclusion and the GST annual exclusion.
Understanding GST Inclusion Ratios
A trust’s GST “inclusion ratio” is a metric the IRS uses to measure how much of the trust’s assets are included in the generation-skipping transfer tax system. It’s always a number between 0 and 1. A trust with an inclusion ratio of 0 is fully GST exempt. A trust with an inclusion ratio of 1 is fully GST non-exempt. A trust that is partially GST exempt is said to have a “mixed inclusion ratio.”
Trusts with mixed inclusion ratios are relatively rare. Most trusts are either entirely exempt from generation-skipping transfer tax or entirely non-exempt. But some trusts end up partially exempt because the transferor, for whatever reason, didn’t allocate enough GST exemption to shield the entire trust from the tax.
For instance, if someone funds a trust with $4 million, but only allocates $3 million of GST exemption to it, that trust will be 75% GST exempt and 25% GST non-exempt. In other words, it will have an inclusion ratio of 0.25. Any distribution to a skip person will then be subject to a 10% effective tax rate rather than a 40% rate (0.40 x 1/4).
Minimizing Generation-Skipping Transfer Tax
Because of how onerous the generation-skipping transfer tax is, it’s important to minimize it. Here are the key strategies for doing that:
- You want to make gifts to irrevocable trusts that are outside of your estate, and then allocate GST exemption to those trusts. That will ensure that the trust principal, including the future appreciation that occurs inside the trust, will be GST exempt.
- You want to set up Crummey trusts for your grandchildren that qualify for the GST annual exclusion. It’s an easy way to get $18,000 to each of your grandchildren each year without running into GST tax issues.
- Once you’ve run out of GST exemption, you want to use more advanced techniques to get assets into existing GST-exempt trusts. The most common strategies for doing so are (a) selling assets to GST-exempt trusts and (b) loaning assets to GST-exempt trusts.
Bottom Line
The generation-skipping transfer tax is a major obstacle to intergenerational wealth transfer. It is important for individual taxpayers and advisors to have at least a basic understanding of what it is and how it works. Irrevocable trusts play an important role in planning around this levy, potentially saving taxpayers’ heirs millions of dollars that would otherwise have been lost to the generation-skipping transfer tax.
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