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Generation-Skipping Transfers: What You Need to Consider

This article will give you a basic understanding of the GST tax and what you need to consider for successful wealth management.

November 20, 2008
Sponsored by BNA Software

by Nancy Faussett, CPA

A generation-skipping transfer (GST) is the transfer of an asset to a beneficiary who is at least two generations below the transferor’s generation (a.k.a., a “skip person,” such as a grandchild). The transfer may be an outright transfer or it may be a transfer to a trust for the skip person’s benefit. There is a GST tax imposed on some of these transfers. It is a separate tax, apart from the estate or gift tax. The type of transfer determines who is liable for the GST tax.

This article will give you a basic understanding of the GST tax and what you need to consider for successful wealth management. Considering the recent downturn in the economy, this may actually be a good time to transfer wealth to younger generations. Transferring depressed investments reduces the size of one’s estate and, when the investments rebound, the gain accrues to the heirs.

GST Tax Calculation

The GST tax is assessed at a flat rate, which is the same as the highest marginal estate tax rate at the time of the transfer, multiplied by an inclusion ratio.

The “inclusion ratio” is defined as one minus an applicable fraction. For the “applicable fraction,” the numerator is the allocated amount of the GST exemption (currently $2 million, but scheduled to increase to $3.5 million in 2009) and the denominator is generally the value of the property transferred. Therefore, when no GST exemption amount is allocated to the transfer, the inclusion ratio is always one.

Just as the estate tax is repealed for 2010, so is the GST tax. In 2011, however, unless legislation changes this, it will revert back to the 2001 rate. The maximum GST tax rate is 45 percent for 2007 to 2009. (It is, of course, possible that the scheduled GST and estate tax changes will be rescinded by Congress before 2010. In fact, we may find the 2009 estate, gift and GST tax laws applicable to 2010 and future years.)

Taxable Events for the GST Tax

The GST tax may be imposed due to one of the following types of transfers:

  • Taxable distribution: This is a distribution from a trust to a skip person, but is neither a taxable termination nor a direct skip. The recipient is liable for the GST tax.

    Example: A trust is established for a child and a grandchild. The trustee makes a distribution to the grandchild. This is a taxable distribution.
  • Taxable termination: A taxable termination occurs when a beneficiary’s present interest in property held in a trust is terminated (for example, due to death). The termination cannot cause either a “nonskip person” to have an interest in the property or a distribution to be made from the trust to a skip person any time thereafter. A taxable termination does not occur if the termination is a transfer subject to estate or gift tax. The trustee is liable for the GST tax.

    Example: A trust is established for a child and a grandchild. When the child dies, as long as the grandchild is alive and there are no other beneficiaries of the trust, a taxable termination occurs.
  • Direct skip: A direct skip occurs when an interest in property is transferred to a skip person and the transfer is subject to federal estate or gift tax. Therefore, if the transfer qualifies for the gift tax exclusion it is not subject to the GST tax. Generally, the transferor is liable for the GST tax, but if it is from a trust, the trustee is liable. If the direct skip is made at death, but not from a trust, the executor is liable.

    Example: When a grandparent either transfers property directly to a grandchild or establishes an irrevocable trust for the grandchild, it is a direct skip (as long as all beneficiaries are skip persons).

Generation Assignment

Generally, assignment to a generation is based on lineal descent, that is, along family lines. However, there are a multitude of special rules. For example, the current or former spouse of the transferor is always assigned to the same generation as the transferor. This is also true of spouses of relatives who are considered the same generation as the relative to whom they are married. Legally adopted children are considered blood relatives of the adopting parent.

All other beneficiaries are assigned to a generation based on their age. A generation is assumed to be 25 years in length with the transferor being in the middle of his or her generation. Therefore, a person (other than a lineal descendant) who is more than 37½ years younger than the transferor is a skip person.

There is a special “move-up” rule for a transfer to a skip person who is a lineal descendant of the transferor. If the parent of a skip person is deceased at the time the transfer is subject to estate or gift taxes, then that person’s child is deemed to be one generation below the lower of:

  • The transferor’s generation, or
  • The generation assigned to the youngest living ancestor of the person, who is also a descendant of the parent of the transferor (or the transferor's spouse or former spouse).

This rule does not apply to someone who is not a lineal descendant of the transferor if, at the time the transfer is made, the transferor has any living lineal descendants.

Example: Assume a trust is created when Child 1 is alive but Child 2 is deceased and leaves surviving children. The trust income is paid to Child 1 for life, and the remainder passes to the children of Child 2. Even though the children of Child 2 are grandchildren, they are not considered "skip persons" as a result of the "move-up" exception.

If someone can be assigned to more than one generation, then such person is assigned to the youngest generation.

Most charitable organizations are deemed to belong to the transferor’s generation.

Miscellaneous, But Important

There are several additional points about generation-skipping transfers:

  • If the strategy of gift-splitting is used, each spouse may allocate their GST exemption to their half of the gift.

  • A transfer between spouses allows more flexibility. When transferring property to someone other than a lineal descendant, spouses may decide who should be considered the transferor and thus affect the assignment of generation, based on the recipient’s relative age.

  • There is no GST tax when making direct payments for certain medical and educational expenses on behalf of a skip person.

Estate Tax Planning Software

Estate tax planning software can be an excellent tool for wealth management. Such software can compute the GST tax on all three types of GST transfers (direct skip transfers, taxable terminations and taxable distributions) and may also handle some advanced GST strategies as:

  • GST Dynasty Trusts,
  • Net Gift GSTs (GST tax paid from the gift),
  • Reverse QTIP Elections,
  • Charitable Lead Annuity GST Trusts,
  • Subsequent Transfers to GST Trusts and
  • Impact of GST on Gift Tax (IRC Sec. 2515).

Estate tax planning software can even show you side-by-side comparisons to clearly demonstrate the differences in tax due to potential transfers either in the current year or in future years.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.