By Dr. Jim Dahle, WCI Founder
There are few areas of the tax code as difficult to understand as those surrounding the Generation-Skipping Transfer Tax (GSTT). Even tax preparers often send this work to specialists and with good reason. However, it is not that difficult to understand the basics of this tax.
What Is the Purpose of the Generation-Skipping Transfer Tax?
Prior to 1976 when this tax was put in place, people would leave money to their grandkids and other very young heirs to avoid paying estate tax at every generation. For example, if you left money to your kids who then left it to your grandkids, estate taxes could be paid on that money twice—both when you die and then again when the kids die. But if you just left it directly to your grandkids, the estate taxes would only be paid once. This was felt to be a loophole that needed to be closed, so it was—at least to a certain extent—using the GSTT.
Does It Really Apply to Every Generation?
Yes, it really does apply to every generation. The IRS carefully defines what constitutes a generation:
Generation Assignment
A generation is determined along family lines as follows.
- Where the beneficiary is a lineal descendant of a grandparent of the -2- transferor (for example, the donor's cousin, niece, nephew, etc.), the number of generations between the transferor and the descendant is determined by subtracting the number of generations between the grandparent and the transferor from the number of generations between the grandparent and the descendant.
- Where the beneficiary is the lineal descendant of a grandparent of a spouse (or former spouse) of the transferor, the number of generations between the transferor and the descendant is determined by subtracting the number of generations between the grandparent and the spouse (or former spouse) from the number of generations between the grandparent and the descendant.
- For this purpose, a relationship by adoption is considered a blood relationship. A relationship by half-blood is considered a relationship by whole blood.
- The spouse or former spouse of a transferor or lineal descendant is considered to belong to the same generation as the transferor or line
However, if someone is NOT a lineal descendant, generation is defined by a difference in ages. When you leave money to someone who is 37 1/2 years or more younger than you, the GSST applies.Anyone (or a trust with a beneficiary) more than 37 1/2 years younger than the decedent is referred to as a “skip person.”
More information here:
Building Family Wealth Across the Generations
You Can’t Make Your Great Grandchildren Rich
What Is the Tax Rate on the Generation-Skipping Transfer Tax?
Any amount above the exemption amount is subject to a flat 40% tax, meaning 60% goes to the heir and 40% to the federal government. A few states (Illinois, Nebraska, and Vermont) charge additional state GSTT, but for most people, this is only a federal tax.
Who Pays Generation-Skipping Transfer Tax?
The good news is that, like the estate tax, very few estates pay GSTT due to the high exemption amounts. As of 2024, the exemption amount for the GSTT is precisely equal (although separate) to the estate tax exemption of $13.61 million. While this is scheduled to be cut in half after 2025, it is indexed to inflation and, if you are married, is fully transferable between spouses. A married couple dying in 2024 could pass $27.22 million to anyone they want without paying a cent of federal estate tax or GSTT. The same annual gift tax amount ($18,000) applies to both taxes. That means you and your spouse can each give $18,000 to anyone you want without having to file the infamous IRS Form 709 (Gift and Generation-Skipping Transfer Tax Return). You may not actually have to pay taxes when you file this form, but having had it filed once in my life, I assure you that it doesn't look very fun (my tax preparer was more than happy to let my estate planning law firm file it on my behalf).
Since most people are worth less than $13 million ($27 million if married) at death, their estate doesn't have to pay federal estate taxes or federal GSTT. However, if you are one of those fortunate few whose estate will be worth more than that (or even half that given that the current limits are scheduled to be slashed by 2026), you should pay attention to this issue.
How Do the Estate Tax Exemption and the GSTT Exemption Work Together?
Remember these two exemptions are separate but equal. If you die in 2024 and leave $13 million to your kid who is 30 years younger than you, you would use up $13 million of your estate tax exemption. If you left $13 million to your kid who is 40 years younger than you, you would use up $13 million of your estate tax exemption AND $13 million of your GSTT exemption. If we increase that inheritance to $20 million, the tax due becomes substantial. The child 30 years younger than you would owe estate tax on approximately $7 million (a tax of close to $2.8 million). However, the child 40 years younger would not only owe close to $2.8 million in estate tax BUT ALSO $2.8 million in GSTT. That would be a total of $5.6 million, almost 80% of the amount above the exemption.
The GSTT does not take the place of the estate tax; it is applied IN ADDITION TO the estate tax. Since lots of doctors acquire a lot of wealth and have kids relatively late in life, this is an important estate planning issue for wealthy WCIers.
More information here:
My Children’s Inheritance
What Can Be Done to Reduce GSTT?
Tax planning related to the GSTT is very similar to that related to the estate tax. The best way to reduce it is to maximize the use of the lifetime exemption and the annual gift tax exemption. One easy way to avoid both estate taxes and GSTT is to simply limit your heirs' inheritance to an amount under the exemptions and leave the rest to charity. No estate, gift, or GSTT will be owed.
However if, like many people, you want to leave as much as you can to your heirs, you will want to give them the annual gift tax exclusion amount every year ($18,000 from each spouse in 2024), either directly or via a trust. You also want to give them assets likely to appreciate (again, either directly or via a trust) as soon as possible, i.e. before they appreciate much. Any appreciation after the assets are given away doesn't count toward the exemption or the tax. So, if you give them a farm currently worth $5 million, you'll only use up $5 million of your exemption, even if that farm is worth $20 million when you eventually die.
Be aware of two caveats when using this technique. The first is the step up in basis at death. If you die and leave property to your heirs, they receive a step up in basis to the value at the time of your death. If they sell it immediately, they won't owe any capital gains taxes. If you give it to them when it is worth $5 million but you are still alive, they inherit your basis. If that basis is very low, they may owe plenty in capital gains taxes when they sell it later. Using that $5 million/$20 million farm example from above, if you left it to them at death, the heirs could sell it immediately and pay $0 in capital gains taxes (although they would likely owe some estate/GSTT taxes). If you gave it to them when it was worth $5 million and had a basis of $1 million and they sold it when you died, they would owe capital gains taxes on $19 million, perhaps as much as $4.52 million in federal income tax alone.
You'll need to weigh income tax savings against transfer tax savings. This can be difficult to do when future tax rates and rules are unknown on both types of taxes and especially when you're not sure if an inheritance will go up or down in value relative to the exemption amount.
The second caveat is that the rules change when Form 709 is filed late. If tax is due, the penalties (5% of the tax due per month to a total of 25%) are substantial, but even if no tax is due with the return, there can be consequences. First, the three-year “IRS Challenge Time Period” doesn't begin until you file it. The sooner you file it, the better. You are also required to file a timely return to use a few exotic tax-saving techniques (automatic allocation rules, gift splitting, 529 plan five-year gifts). Most importantly, if you file Form 709 late, you cannot use the value on the date of transfer; you will need to use the value on the date of filing, which might be substantially more. This could use up more of your exemption and result in more of your transfer being subject to that onerous 40% tax rate. If a property is likely to fall in value, that could be beneficial. But most of the time, you'll want to make sure Form 709 gets filed on time.
On a separate note, if one of your wealthy parents died recently, you may want to file this form even if no tax is due to preserve the “portability” of the first-to-die parent's estate/GSTT exemption, especially given the planned 2026 decrease in those exemptions.
What About Dynasty Trusts?
“Dynasty Trust” is a generic term that applies to any trust that will affect multiple generations. A dynasty trust is always an irrevocable trust. The person who funds the trust (the grantor) has the option to pay the income taxes on trust assets until they die (a good way to maximize how much is passed on), but after that, the trust will owe income tax at relatively high trust income tax rates.
The transfer (estate and GSTT) tax exemptions will generally be used or the gift/GSTT taxes will be paid WHEN THE TRUST IS FUNDED, not when the trust is distributed. The longer the money is left in trust, the more transfer tax savings there may be. The estate and GSTT are just paid once instead of every generation as money is left from parent to child. As the estate/GSTT exemption amounts rise with inflation, additional gifts into the trust can be made each year. With the exemption amounts set to be cut in half at the end of 2025 under current law, there will likely be a rush to set up and fund these sorts of trusts in 2025.
More information here:
Dynasty Trusts: A Multi-Generational Estate Planning Tool
How Long Can a Trust Last?
Can you leave money to someone seven or eight generations from now? It actually depends on the state in which you set up the trust. Every state has a different “law against perpetuities.” The general common law rule here is that you can't set up interests in property that vest later than 21 years after the lifetimes of the youngest beneficiary alive at the time of death, aka “life in being plus twenty-one years.” The US has basically put a 90-year rule in place instead, and 31 states have adopted that rule. These states include Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Florida, Georgia, Hawaii, Indiana, Kansas, Massachusetts, Minnesota, Montana, Nebraska, Nevada, New Jersey, New Mexico, North Carolina, North Dakota, Oregon, South Carolina, South Dakota, Tennessee, Utah, Virginia, Washington, West Virginia, the District of Columbia, and the US Virgin Islands. However, that leaves a number of states that have done something different.
Several states have the traditional rule against perpetuities (life in being plus 21 years). Some states have no rule against perpetuities. Others specify a time period other than 90 years—such as 30 years, 110 years, 150 years, 360 years, or even 1,000 years in my state of Utah. That's a lot of generations to skip transfer taxes on.
Note that you don't have to set up your trust in your state of residence, so trust location can be an important aspect of estate planning to avoid GSTT.
Direct and Indirect Skips
When you really get into the weeds on this topic, you will discover that there are both “direct skips” and “indirect skips” when it comes to the GSTT. Remember that a skip person (or trust) is someone at least 37 1/2 years younger than the decedent. If you leave property worth more than your exemptions to your great-grandkid at your death, that's a direct skip. You or your estate must pay the estate taxes and GSTT due. Pretty simple.
An indirect skip is when there are intermediate steps, usually involving a trust. There are two types of these: taxable terminations and taxable distributions.
An example of a taxable termination is a typical spendthrift trust. For example, let's say Grandpa sets up a spendthrift trust for his daughter (a non-skip person) that will pay out the income each year as long as the daughter is alive, and then whatever is still in the trust will go to the daughter's son (a skip person). When the daughter dies, GSTT must be paid out of the proceeds after any remaining GSTT exemption from Grandpa is used up. The estate tax was paid (or exemption was used up) when the money went into the trust, but no GSTT was due at that time.
An example of a taxable distribution might be a spendthrift trust set up for a grandchild where no estate tax was due at the time of funding of the trust. Once Grandma's GSTT exemption is used up, any additional income distributions to the grandchild will be subject to GSTT, paid by the recipient.
The estate planning technique relevant to these direct and indirect skips is for Grandpa to pay the GSTT upfront, saving future GSTT from being paid by the heirs in future years. This maximizes the inheritance and reduces the rest of Grandpa's estate outside the trust that will be subject to estate taxes.
Want to get further into the weeds on this topic? Try this article from the Journal of Accountancy.
The GSTT is an important estate planning consideration for wealthy households, and it will apply to even more white coat investor households after 2025. Those wealthy enough to have an “estate tax problem” need to also understand how the GSTT works and how to effectively plan to minimize it.
If you need help with estate planning or if you’re looking for tips on the best ways to preserve your wealth for future generations, hire a WCI-vetted professional to help you figure it out.
What do you think? Have you done any planning to avoid GSTT? What's your plan? Comment below!
