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Beware and be aware of the generation-skipping transfer tax

Five key questions when your estate plan impacts multiple generations

August 16, 2023
#
Personal tax planning Succession planning Private client services

What you need to know about generation-skipping transfer tax

Are you familiar with the generation-skipping transfer tax (GSTT)? Not knowing about this 40% tax might affect your estate plan more than you think. Taking the time to understand the tax and make use of your available generation-skipping tax (GST) exemption can significantly impact your planning.

First let’s start with a cautionary tale. You create a trust for the benefit of your descendants. You anticipate that your child will exhaust the trust, leaving nothing for your grandchildren. You intentionally do not protect the transfers to the trust from the GSTT. The trustee is not aware of your intentions, or the GSTT, and makes $500,000 distribution to your grandchild to help them purchase a home. Now your grandchild is responsible for an unexpected $200,000 tax bill related to the distribution.

Below we answer five important questions to help you better understand the tax and how to plan for it.

1. What is the generation-skipping transfer tax (GSTT) and what is generation-skipping tax (GST) exemption?

The GSTT is separate from, and in addition to, gift tax and estate tax. GSTT is a flat tax rate equal to the maximum estate and gift tax rate, which is a 40% tax rate in 2023. The lifetime GST exemption is a separate bucket from the estate/gift tax exemption and is equal to the estate/gift tax exemption amount ($13.61M in 2024). You can allocate your available GST exemption during your lifetime or at death to protect transfers from GSTT.

Planning point: Take advantage of the increased lifetime estate/gift and GST exemptions before they sunset on Dec. 31, 2025. If you have not yet used all your available estate/gift and GST exemptions, now is a great time to consider making lifetime gifts. Absent any legislation, the temporarily increased exemption will decrease to about $7M, indexed for inflation, on Jan. 1, 2026. The increased exemption is a ‘use it or lose it’ opportunity. Consult with your RSM US LLP tax professional and estate planning attorney to prioritize your goals well before the temporarily increased exemption sunsets on Dec. 31, 2025.  

2. How is my available GST exemption allocated?

Allocating your available GST exemption to certain transfers protects the assets from the GSTT. For example, you fund a trust with $1M and timely allocate $1M of your available $13.61M GST exemption to that transfer. The assets will be exempt from the GSTT even if that $1M trust appreciates and grows to $10M

You can allocate GST exemption either during your life or at death and there are many ways your exemption can be allocated. Generally, decisions about the allocation of GST exemption during your life are reported on a timely filed gift tax return. There are also automatic allocation rules designed to function as a safety net yet have the potential to inadvertently derail planning. Allocating GST exemption at death is reported on a timely filed estate tax return. There are also automatic allocation rules at death. Unlike excess gift/estate exemption, unused GST exemption cannot be utilized by your surviving spouse.

Planning Point: When gifting to a trust, it is important to make an affirmative decision whether you want to allocate your GST exemption to the trust. Relying on automatic allocation rules during your life and at your death may not produce results in line with your intentions.

3. What is an inclusion ratio and what does it mean?

An inclusion ratio determines how much of a trust is subject to GSTT. It is important to know the inclusion ratio of the trust in order to determine the potential exposure to GSTT. The inclusion ratio is the fraction of the trust that is subject to the tax. 0.000 means none of the trust is subject to GSTT and 1.000 means all of the trust is subject to GSTT. It is calculated based on each transfer to the trust considering the fair market value of the trust assets immediately before each transfer.

If the inclusion ratio of your trust is unknown, an inclusion ratio review should be performed to understand whether the inclusion ratio is 0.000 and the trust is ‘GST exempt’, the inclusion ratio is 1.0000 and the trust is ‘GST non-exempt’, or if the inclusion ratio is something other than 0.000 or 1.000. If a trust has an inclusion ratio other than 0.000, (meaning GST exemption was not allocated or was only partially allocated to the trust), the trust is not fully protected from the GSTT.

Planning point: It crucial to know your trusts’ inclusion ratios and the related GSTT implications. The inclusion ratio of a trust can change over time with each transfer to the trust. To gain a comprehensive understanding of the inclusion ratio of a trust consult with your RSM US tax professional and estate planning attorney.

4. When is GSTT paid?

There are three triggering events when GSTT could be due.

  1. Direct skip - When you make a gift outright to a skip person (example: your grandchild), GSTT may be due if your available GST exemption has been exhausted. You are liable for the tax.
  2. Taxable distribution – this occurs when there is a distribution from a trust to a skip person (example: your grandchild). The amount of GSTT due is dependent on the inclusion ratio. For example, the trust from the introduction above had a 1.000 inclusion ratio, meaning 100% of the trust was subject to the GSTT. Therefore, the tax due on the $500,000 distribution was $200,000 (100% of the $500,000 at a 40% tax rate). If the inclusion ratio had instead been 0.500, the tax would have been $100,000 (50% of the $500,000 at a 40% tax rate). The person who received the distribution is liable for paying the GSTT.

3. Taxable termination – this occurs when a trust no longer has any non-skip beneficiaries (example: your children) and only skip-person beneficiaries (example: your grandchildren) remain. An example would be a trust benefiting your child and grandchildren. On your child’s death a taxable termination would occur. The inclusion ratio is important here. If you fully protected the trust and it has a 0.000 inclusion ratio, 0% is subject to the GSTT and no GSTT would be due upon termination. However, if the inclusion ratio was anything other than zero, a significant tax liability could be due. If the trust was worth $5M with an inclusion ratio of 1.000, that would be a $2Mtax liability that must be paid by the trustee.

Planning point: Remember to consider the GSTT impact when making distributions to skip persons or when a trust beneficiary’s interest in a trust ends. There may be GSTT reporting requirements for the trustee or beneficiary. If your trust has a taxable termination, make sure the related GSTT is paid prior to making any distributions to the remainder beneficiaries. If you believe your trust may have had a triggering event, please consult with your RSM US tax professional to discuss next steps.

5. What should I consider when planning to use my available GST exemption?

Intentional planning is critical if you want to avoid paying GSTT. Below are a few important questions you should consider when making a transfer to a trust:

  1. What could happen if no planning is done, and I rely on the GST exemption automatic allocation rules? You could have a trust that falls under the automatic allocation rules, but there is no intention for the trust assets to be distributed to skip persons (example: your grandchildren) in the future, which could be a waste of your available GST exemption. Additionally, you could have a trust that does not fall under the automatic allocation rules where assets are distributed to skip persons, causing an unexpected GSTT liability.
  2. Do I think the trust assets will benefit skip persons? If you answer yes, then you will want to ensure the assets are protected from the GSTT by allocating your available GST exemption to the transfers to the trust. If you answer no, then you may not want to allocate your available GST exemption to the trust and you may want to save your available GST exemption for other purposes.
  3. Do I know the GST-status of my existing trusts? Knowing which trusts are protected from the tax and which ones are not can help you remedy certain trusts to avoid GSTT. There are many remedies available that can be used to make sure an existing trust’s GST status is in line with your intentions.
  4. Does my trustee know my intentions for the trust? Make sure your trustee knows the intention for the trust. You may have one trust that is fully protected from the GSTT that is a better vehicle for transferring assets to grandchildren and another trust that is not protected that is a better vehicle for transferring assets to your children. It is important that the advisors and fiduciaries involved in your estate plan wholistically understand your intentions.

Planning point: While engaging in trust-related gifting, it's imperative to ensure that the above-mentioned inquiries are thoroughly discussed with your estate planning attorney and your RSM US tax professional. Overlooking these considerations during the planning stage could inadvertently lead to undesired outcomes, potentially resulting in the unnecessary depletion of your valuable GST exemption or cause an unexpected GSTT liability.

RSM US Insight

Be mindful of the gifts you make and the trusts you create because they may be subject to unexpected GSTT. Although you might have a clear intention regarding the recipients of your gifts or the beneficiaries of a trust, it’s advisable to confer with both your estate planning attorney and RSM US tax professional to ensure comprehensive protection against GSTT implications. 

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