What you need to know about generation-skipping gifts (and their tax implications)

Gifting to your children is an excellent way to reduce estate tax liabilities, but sometimes it makes more sense to give directly to grandchildren, rather than to your children. Because these gifts “skip” a generation, they are referred to as generation-skipping transfers (GST) or gifts and have special tax treatment.

There are a few important things to keep in mind when considering a generation-skipping transfer gift, including the generation-skipping transfer tax. We’ll break the tax down for you and give you a few more important pointers to pay attention to.

What is the generation-skipping transfer tax?

The generation-skipping transfer tax (or “GSTT”) imposes a 40% tax on assets gifted to a grandchild or great-grandchild, or anyone unrelated who is 37.5 years or more younger than the donor. The GSTT is imposed on gifts made directly to those individuals, but is also on gifts to certain trusts that can benefit those individuals. The GSTT was established to combat people getting around the estate tax by putting a large pool of assets into a multi-generational trust, which would then never be taxed again.

However, there are a number of exceptions to the imposition of GSTT, some of which we’ve outlined below.

First, if the gifts to the grandchild are in the form of qualified education or medical expenses paid directly to the educational organization or medical provider, the gifts are not subject to the GST tax and there’s no limit to how much a person can give. To qualify for this exception, the gifts must be made directly to the educational institution or medical provider.

Second, each individual has an annual exclusion gift amount that he or she can give to as many individuals as desired, free of gift and GST tax each year. In 2022, that exclusion is $16,000 for individuals ($32,000 for couples), and in 2023 it goes up to $17,000 for individuals ($34,000 per couple). With one exception highlighted below, for a gift to qualify for both the gift and GSTT annual exclusion, it must be made directly to the grandchild outright.

Third, you can set up a special GST trust and make an annual exclusion gift to this trust without triggering the GST tax. Sometimes making the annual exclusion gift to a grandchild outright is not always practical or desired and so a trust would be the ideal way to benefit the grandchild without giving them direct control over or access to the funds. See below for special considerations when setting up this particular type of trust.

Note that most gifts that fall outside of the exceptions outlined above would be GST taxable. However, in addition to the annual gift and GST tax exclusion amount, each individual also has a lifetime exemption from gift and GST tax of $12.06 million ($12.92 million in 2023), after which the 40% taxes are applied.

5 key considerations your clients need to know about generation-skipping transfer trusts

1. Be clear about what age the recipient has full control of the funds.

It’s important to be clear about the age at which the recipient has full control of the assets in question. Depending on the circumstances, this could range from 18 years old to 25 or even 50, as each person and situation is different. When setting an age for transferring full control to a recipient, it should be old enough that they are mature enough and ready to handle their own funds responsibly.

2. The grandkids will need to have a withdrawal right in the trust.

The IRS specifies that for the gift to a trust to be eligible for the exclusion from the gift and GST tax, the beneficiary must have an unrestricted right to take control of the assets for a certain period of time (generally the first 30 days of the gift). So while the trust may have language about when the beneficiary, usually the grandkid, can have access to some or all of the trust funds, every year when the grantor, your client, makes a gift, there’s a window during which the grandchild can withdraw the newly gifted funds. Practically speaking, when the beneficiary is under the age of 18, the legal guardian (usually your client’s child and the parent of the grandchild) should be there to provide guardrails. But once the beneficiary turns 18, there is a window during which he or she can take the gifted funds directly instead of investing them in the trust.

3. The beneficiary needs to be notified about the gift. And that needs to be documented.

The trustee must notify the grandchild of their withdrawal right, and this notification needs to be documented so that it can be verified in the future. This notification (called a Crummey letter or notice) can be done in a variety of ways, such as through letters or emails, or even through an official document recorded by a trustee. For minors who are receiving gifts, the parent or legal guardian typically signs  the notification to acknowledge receipt. The importance of being diligent in sending out notifications about gifts cannot be overstated; not only does it establish that an annual exclusion gift was made, but it goes a long way towards creating trust and establishing loyal relationships between recipients and givers alike. So, while there’s bound to be a lot of jubilation that the grandchild will be getting helped out with college or a future home, the trustee (often the parent) is also signing up for years of paperwork!

4. The beneficiaries need to be named specifically

A trust that benefits a large group of family members (sometimes referred to as a “pot trust”) is a great way to pass wealth to the next generation. But, unfortunately pot trusts don’t work if you want the gift to the trust to be eligible for the annual exclusion from the GST tax. For a generational-skipping gift to claim the annual gift and GST tax exclusion, the trust has to name a specific grandchild as sole beneficiary. In addition, the trust assets must be includible in the estate of the specifically named grandchild in order for the gift to the trust to be eligible for the GST tax exclusion.

5. The trustee may have to file taxes annually

Imagine the conversation when your client tells their daughter or son that each of their children will be getting $32,000 a year for many years to come. It’s a pretty happy moment right? Well fast forward to the moment your client’s kids realize they now may have to file a tax return per kid a year for these trusts. Of course one way around minimizing income activity in the trust is to invest the trust assets in non-income producing assets. But the reality is that the best thing to do from a fiduciary standpoint is to invest in growth funds that will grow the assets with compounding benefits over the holding period. But remind them, to the extent a return is needed – filing the tax returns are cheaper than paying for college!

Despite the hassle of managing a trust, the benefits of a generation-skipping transfer trust far outweigh the downsides, both for the grantor, who can lower the value of their taxable estate, as well as the grantor’s child, who can rest more soundly knowing that years of compound interest will be in the reserves to help their own child with whatever life throws at them.

As always, it’s best to consult with an estate planning attorney before setting up any kind of trust in order to ensure that all legal considerations are taken into account.

Happy gifting!

About Vanilla

Vanilla is the Estate Advisory Platform, purpose-built to enable financial advisors to build deeper relationships with their clients and empower clients to build and protect their legacy. From robust and easy-to-understand visualizations of complex estates, detailed diagrams of how assets transfer to future generations, to ongoing estate monitoring, Vanilla is reinventing the estate planning experience, end-to-end. Learn more about Vanilla at https://www.justvanilla.com/.

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This article is for educational purposes only and should not be considered legal advice. If you feel that the information in this article is pertinent to your situation, you may wish to consult a qualified attorney for advice tailored to your circumstances.