Posted by Lee Sausen, CPA
When most people think about what will happen to their assets after they’ve passed, they envision everything going first to their spouse and then to their children. With the estate tax lifetime exemption at $5,490,000 in 2017, most taxpayers don’t have to worry about the federal estate tax. If the value of your assets at the time of death exceeds that figure, your estate will be subject to filing IRS Form 706 – U.S. Estate (and GST) Tax Return. The form allows an unlimited marital deduction for assets left to a spouse; however, when leaving assets to children, tax is usually assessed. Eventually, when those children pass, they will leave assets to their children, file Form 706, pay their estate tax and the cycle repeats. Some wealthy taxpayers along the way figured if they gave assets directly to their grandchildren (whether outright or in trust), they could effectively skip one generation of estate taxes. Once Congress caught on to this practice, the Generation-Skipping Transfer (GST) Tax was born.
Currently, all taxpayers are allotted a GST tax exemption equal to the estate tax lifetime exemption ($5,490,000 in 2017). With the annual exemption at $14,000 for both regular gifts and generation-skipping transfers, a taxpayer can gift $14,000 to each grandchild per year, every year, without having to file IRS Form 709 – U.S. Gift (and GST) Tax Return. If you gift over the annual exemption to any “skip person” in a single year or if your annual gifts in excess of the annual exclusion exceed the lifetime exemption, you will be subject to the GST tax which is set at a flat rate equal to the highest estate tax rate (40% in 2017).
A “skip person” is a grandchild or any other relative two or more generations younger than the transferor. Generally, any individual can be considered a skip person so long as they are at least 37.5 years younger than the transferor. Spouses, ex-spouses, charitable trusts, and tax-exempt organizations are never considered skip persons. Another exception to this rule is when a donor’s child dies, their children are not considered skip persons – they shift up one generation along with their descendants.
As “direct” skips are easy to think about (an outright transfer of property or cash, subject to gift or estate tax, made to a skip person), “indirect” skips require more analysis. Indirect skips involve assets held in trust of which the grantor/transferor named skip persons as beneficiaries. “Dynasty” trusts are common vehicles used to shift assets to lower generations and include indirect skips. Both the GST tax annual and lifetime exemptions can be allocated between direct and indirect skips via Forms 709 and 706. For example, if the exemption is not allocated by the due date of Form 706, the remaining exemption is automatically allocated, first to direct skips which occurred at death, second, to all transfers to GST trusts for which the deceased taxpayer is the most recent transferor. GST tax implications related to indirect skips can change depending on when the transferor funds the trust and when the skip person beneficiary will actually receive distribution from the trust. Therefore, allocation of your exemption between direct and indirect skips requires careful consideration.
If you would like to discuss your estate, gift, and/or trust plan in more detail, please reach out to a member of our Estate and Trust Section.