When considering giving gifts to family members, you should consider the possible tax consequences of those gifts. Nothing ruins a grand gesture quite like a hefty tax bill. So, when an estate planner looks to minimize the tax burden on certain gifts, your planner should not forget to minimize the impact of the generation-skipping transfer (“GST”) tax.
What is a generation-skipping transfer? Well, the United States began taxing estates in the early 20th Century, and in order to minimize these taxes, some people would transfer their wealth directly to their grandchildren (a transfer that literally “skipped” a generation). However, tax legislators ultimately tried to capture some tax revenue that was lost from that technique by enacting the GST tax in 1976, and it linked the estate, gift, and GST taxes into one, unified estate and gift tax.
In this blog, we will discuss the ins and outs of what the GST tax is. We will also explain how the related exemption works, and the GST tax’s interplay with the estate and gift taxes.
Is There a Tax on a Generation-Skipping Transfer?
Many people realize that when they die and leave their estates to their children, their estates will be taxed on the excess over whatever the federal estate tax exemption amount is at that time. That is how basic estate tax works.
Now, if those children preserve that wealth and then pass it on to their children, then the same wealth will be taxed again. That is because the IRS seeks to collect its share as wealth passes from one generation to the next.
Astute estate planners, however, began to use a strategy to avoid what was effectively a second bite of the apple: they structured it so that their clients’ wealth passed directly to their grandchildren instead of their children. The point was to “skip” a generation, and therefore, in many circumstances, avoid the estate tax at one level. Eventually, tax legislators saw this unintentional loophole being used too often, so they closed it by enacting what is known as the generation-skipping transfer tax.
The GST tax is an additional tax on assets passed down to a person more than one generation younger than the transferor (typically grandchildren) at death, or on assets given as a gift during the transferor’s lifetime. Generally, the tax is incurred when grandparents directly give money or property to their grandchildren, and “skip” giving the assets to their children.
What is a “Skip Person”?
What matters most is that a generation is being skipped when the transfer is being made. That’s why the GST tax applies even to gifts or transfers made to other family members and unrelated people who are at least 37 and one-half years younger than the person transferring the assets.
The beneficiaries of such an asset transfer are called “skip persons.” In fact, the GST tax applies to trusts as well. The beneficiaries of a trust are considered the “skip persons” for GST tax purposes, but the trust is also a “skip person” in most circumstances.
Thus, since 1976, the GST tax has been used to compensate for the gift or estate taxes that might otherwise have been collected if the generation had not been skipped.
Is There a Tax Exemption for a GST?
Generally speaking, the GST exemption is the money or property that can be transferred from a grandparent to a grandchild without incurring the GST tax. The exemption amount has fluctuated significantly over its history (including its temporary repeal for the 2010 tax year).
Under the Tax Cuts and Jobs Act of 2017, the exemption amount doubled and was tied to inflation. As a result, the exemption amount that can be applied to GSTs (including those held in trusts) during 2020 is $11.58 million per person, and double that amount for a married couple. This is a $180,000 increase from 2019. Therefore, a grandparent can directly transfer $11.58 million to a grandchild without having to pay any tax on that money.
What Happens to the Amounts Above the Exemption?
That’s the really bad part: any transfers or gifts over $11.58 million would be taxed at 40 percent. That rate is on top of any gift or estate tax on the same transaction. In the past, this rate has ranged from 35 percent to 55 percent, but the current rate has been in effect since 2014.
It is important to remember that the exemption amount is a cumulative, lifetime cap. That is if you made a gift of $5 million to your granddaughter in 2015, then upon your death, your estate could only make an additional transfer to her (or any other “skip person”) of $6.58 million ($11.58 million 2020 exemption amount, less the $5 million lifetime gift) before the estate would be assessed the GST tax at 40 percent.
This means that applicable GSTs made during your lifetime are flagged and will reduce the exemption that you could use to protect your estate at the time of your passing. However, the federal tax law provides for an “annual exclusion,” similar to gift taxes. That exclusion allows someone to give away up to $15,000 to a “skip person” per year without it being applied toward the exemption.
Contact Doane & Doane for GST Advice
Although the GST tax affects only the largest estates, and many people will never encounter it because of the high threshold, it is a serious concern for those who are impacted by it. In fact, the current exclusion amounts are set to sunset in 2026 and maybe reduced even sooner, which would make GST tax apply to even more people.
If you do not take advantage of your GST tax exemption during your life or at your death, it will be lost. This could result in your grandkids paying unnecessary transfer taxes that could have been avoided.
Whatever your goals in connection with the generation-skipping tax, we can help you achieve them. At Doane & Doane, we have handled a number of generation-skipping transactions. We know when it is most appropriate, and we can guide you accordingly. Again, call Doane & Doane today for more information. You can contact us today at 561-656-0200 or fill out our online contact form.