Prior to the enactment of the Generation-Skipping Transfer (GST) tax, an older generation individual (for example, a grandparent) could transfer property to an individual who was more than one generation younger (a grandchild). The transfer would escape one layer of transfer tax that would have applied if the property was transferred first to an individual in the next generation (a parent) and then to the ultimate transferee. The GST tax is designed to ensure that transfer tax is paid when generations are skipped.
The GST tax is broad-based and applies to most transfers from grandparents to their grandchildren or others, including non-family members, below their children’s generation. This tax only applies to situations in which a gift tax was imposed on the transfer or the transferred property was included in the transferor’s gross estate. This article provides an overview of the generation-skipping transfer tax and does not cover all gifts that can trigger this tax.
The Direct Skip Transfer
A direct skip is a transfer of property to a skip person that is subject to either the estate tax or gift tax. Generally, skip persons are individuals who are two or more generations younger than the transferor. A trust is a skip person if all the interests in the trust are held by skip persons. A trust will also be a skip person if no person has an interest in the trust and future distributions or terminations from the trust can be made only to skip persons. A person will have an interest in a trust if he or she has a right to receive income or principal.
There are three types of direct skips – inter vivos direct skips, direct skips at death, and direct skips at death from a trust. It is important to distinguish between the three definitions because the tax calculation and the person liable for the tax differ for each.
The GST tax exemption amount for 2021 is $11,700,000 and the GST tax rate is 40%.
1. Inter Vivos Direct Skips
Inter vivos direct skips are direct skip transfers made during the transferor’s life. Inter vivos direct skips include direct transfers from the transferor to a skip person as well as transfers to a trust that qualifies as a skip person. An inter vivos direct skip is a transfer subject to the gift tax.
Direct skips during a lifetime can be expensive if your GST tax exemption has already been used.
2. Direct Skips at Death and From a Trust
Transfers to a trust that qualifies for the gift tax annual exclusion do not automatically qualify for the GST tax annual exclusion. Direct skip transfers to a trust that qualifies as present interests eligible for the gift tax annual exclusion will not qualify for the tax annual exclusion unless –
- The trust is solely for the benefit of a skip person, and
- The trust assets will be included in the skip person’s gross estate if he or she dies before the trust terminates.
Transfers to certain minor’s trusts will qualify for the annual exclusion for GST tax purposes as the trust is considered a skip person. However, most other transfers to trusts will not be eligible for the annual tax exclusion.
Automatic allocation of the lifetime GST tax exemption applies for indirect skips to GST trusts.
GST Tax Requirements
The difference in the requirements for claiming the gift tax annual exclusion and those for claiming the GST tax annual exclusion creates problems and is quite complex. For transfers after the year 2000, an automatic allocation of the GST tax lifetime exemption for indirect skips to GST trusts can be made.
Each transferor is allowed a lifetime GST tax exemption. Each individual may transfer a cumulative $11,700,000 (for 2021) of property without the transfers being subject to the GST tax. Only the transferor or the transferor’s executor may allocate the GST tax exemption to the transferred property. Once made, the allocation is irrevocable. The law provides a set of rules governing the allocation of the GST tax exemption if the transferor or executor fails to allocate the exemption to a particular transfer.
The GST tax exemption may be allocated to lifetime direct skips or to transfers in trust that may result in future taxable distributions or terminations. Assuming a timely allocation, the exemption is allocated based on the transferred property’s value on the date of the gift. The allocation of the exemption will be timely if the allocation is made on a timely filed gift tax return including extensions.
If the allocation of the GST tax exemption is made on a gift tax return that is not timely filed, the value of the property is the value on the date the gift tax return is filed. The gift tax return is deemed filed on the date it is postmarked to the IRS. For gift tax returns that are not timely filed, the transferor can elect to value the property on the first day of the month the gift tax return is filed.
A portion of the transferor’s unused GST tax exemption will automatically be allocated to lifetime direct skips. The allocation of the exemption to lifetime direct skips can be made on the gift tax return.
If the transferor does not want to allocate a portion of his lifetime exemption to a lifetime direct skip, he can elect out of the automatic allocation rules on a timely filed gift tax return. A taxable distribution from a trust to a skip person is subject to the generation-skipping transfer (GST) tax at 40%.
Generation-skipping transfer tax is a very complex issue and this article is a basic summary of some of the complex rules that need to be applied. Reach out to an AZ professional for more detailed guidance.