Generation-skipping transfer Tax

The U.S. generation-skipping transfer tax (a/k/a “GST tax”) imposes a tax on both outright gifts and transfers in trust to or for the benefit of unrelated persons who are more than 37.5 years younger than the donor or to related persons more than one generation younger than the donor, such as grandchildren. These people are known as “skip persons.” In most cases where a trust is involved, the GST tax will be imposed only if the transfer avoids incurring a gift or estate tax at each generation level.

The GSTT is a simplified version of a tax originally instituted in 1976. Back then, Congress explained that the tax was designed “to remedy the perceived abuse of using a trust to benefit several generations while avoiding Federal Estate Tax during the term of the trust.”

Assume, for example, a donor transfers property in a trust for the donor’s child and grandchildren and that during the child’s lifetime, the trustee may distribute income among the child and grandchildren in accordance with their needs. Assume further that the trust instrument provides that the remaining principal of the trust will be distributed outright to the grandchildren following the child’s death. If the trust property is not subject to estate tax at the child’s death (by reason of a general power of appointment, e.g.), a GST tax will be imposed when the child dies. This is called a “taxable termination.” In that case, the trustee is responsible for filing a GST tax return and paying the tax. On the other hand, a “taxable distribution” occurs if the trustee distributes income or principal to a grandchild before the trust terminates. In that case, the beneficiary is responsible for paying the tax. These taxable events are sometimes overlooked by people who may be unaware of the existence of the tax or its application to their situation. See IRS Forms 706 GS (D-1)) and 706 GS(T).

Strategies for Exemption Allocation

The GSTT comes into play whenever a donor gifts assets to what the tax law calls a “skip person.” Such a transfer skips one or more younger generations to a person related to the transferor by blood, marriage or adoption. Grandchildren and great-grandchildren are the most common skip persons. But under the deceased parent rule (IRC § 2651(e)), descendants are moved up to their parent’s level if the parent dies before the date of transfer. Thus, a grandchild who might be a skip person to his or her grandparent will not be treated as a skip person if his or her parent dies before the grandparent. An unrelated person is a skip person if he or she is more than 37½ years younger than the transferor.

A trust is a skip person in two circumstances:

(a) All of the beneficial interests of the trust are held by skip persons.

(b) No current beneficial interests are held by skip persons, but no distributions can be made to “non–skip persons” (the term for anyone who isn’t a skip person). A person has a beneficial interest in a trust in two circumstances:

(a) He or she has a present right to income or principal.

(b) He or she is a permissible income or principal recipient (for example, there are no current mandatory income or principal beneficiaries, and the trustee has the right to sprinkle income or principal to a group that includes the person in question).