Jim Sinai

Dec 22, 2022

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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) 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”) is 40% tax on assets transferred to someone who is more than one generation younger than you, like a grandchild or great-grandchild, or anyone unrelated who is 37.5 years or more younger than you. The GSTT is separate and in addition to any federal gift and estate tax that may be owed on account of the transfer. The GSTT is imposed on transfers made directly to those individuals, but may also be imposed on terminations or distributions from certain trusts that 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 made on their behalf in the form of qualified education or medical expenses paid directly to the educational organization or medical provider, the gifts are not subject to either gift tax or the GST tax, and there’s no limit to how much you can give. To qualify for this exclusion, keep in mind the gifts must be made directly to the educational institution or medical provider.
• Second, each individual has a GSTT  annual exclusion amount and a gift tax annual exclusion amount that you give to as many individuals as desired, free of any gift and GSTT each year. In 2023, that exclusion amount is $17,000 for individuals ($34,000 for couples) for both the GSTT and gift tax annual exclusions. With one exception highlighted below, for a gift to qualify for both the gift and GSTT annual exclusions, it must be made directly to the grandchild.
• Third, you can set up a generation skipping trust and make annual exclusion gifts to this trust without triggering gift or GST tax. Sometimes making annual exclusion gifts to a grandchild outright is not always practical or desired and a trust is a more ideal way to benefit the grandchild without giving them direct control over or access to the funds. There are special considerations to take into account when setting up this particular type of trust to ensure it qualifies for the annual exclusions, which are detailed below.

Any transfers that fall outside of the exclusions outlined above would be subject to gift and GST taxes. However, in addition to the annual gift and GST tax annual exclusion amounts, each individual also has a lifetime exemption from gift and estate tax of $12.92 million in 2023 as well as a lifetime GST tax exemption of$12.92 million in 2023, It’s not until these exemptions are used up that taxes are applied. 

What is a generation-skipping trust and how does it work?

A generation-skipping trust is a legal trust agreement created to pass down assets to a generation beyond the grantor’s children (typically the grandchildren) thus “skipping” the immediate children of the grantor.

Grandchildren are the most common beneficiaries of this trust, but the recipient can be anyone more than one generation younger than the grantor, provided they are not a spouse or ex-spouse. The generation-skipping trust is irrevocable, meaning you typically can’t change or modify it. Still, it offers greater estate tax and asset protection and can be an effective wealth-preservation tool. 

Since the grantor’s children are not beneficiaries of the original assets of the trust, the grantor is essentially skipping any transfer taxes that would come with transferring asset ownership to this generation.  However, the Generation Skipping Trust Tax may still apply to the trust.

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

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

It’s important to be clear about the age at which the trust beneficiary 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 beneficiary, it should be an age that you feel they are mature enough and ready to handle their own funds responsibly.

2. The GST trust beneficiaries 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). This is called a withdrawal right. So, while the trust may have language about when the beneficiary, usually the grandchild, can have access to some or all of the trust funds, every year when a gift is made to the trust, 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 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 allowing them to remain 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 all parties invovled.

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 transfer to be eligible for 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 included in the estate of the specifically named grandchild in order for the gift to the trust to be eligible for the GST tax annual exclusion.

5. The trustee may have to file an income tax return annually

Imagine the conversation when your client tells their daughter or son that each of their children will be beneficiaries of a trust that will be there for them for many years to come.. It’s a pretty happy moment right? Well fast forward to the moment your client’s children realize they now may have to file a tax return for their children each year on account of distributions from the trust. 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 funds that are in alignment with the intended purpose and the time horizon for the use of the funds. Growth funds, for example, may make sense if the trust beneficiary is younger meaning that generally the time horizon for needing to use trust assets is longer.

While there are some things to keep in mind when considering a GST trust, they can be a very powerful estate planning tool. The GST trust provides a wayfor the grantor to lower the value of their taxable estate, a way for the family to avoid paying estate taxes twice, and peace of mind for the grantor’s children, who can rest more soundly knowing that years of compound interest will be in the reserves to help their own child when the time comes..

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

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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.