A generation skipping trust is a trust established to avoid the imposition of generation skipping transfer tax. Most people do not need to worry about this tax because only transfers in excess of the $11.7 million federal exemption in 2021 may be subjected to generation skipping transfer tax. However, for persons or couples with wealth higher than the lifetime estate, gift, and generation skipping transfer tax exemption, the generation skipping trust is important because without it, the federal tax rate on generation skipping transfers is equal to the maximum federal estate tax rate in effect, which is 40% in 2021. Moreover, generation skipping transfer tax is imposed in addition to the estate or gift tax. For this reason, any transfers to so-called skip persons in excess of the $11.7 million exemption should be carefully planned to ensure that there is no unnecessary reduction of wealth due to the imposition of taxes.
If you are looking to set up a generation skipping trust, we at the Law Offices of Albert Goodwin are here for you. You can call us at 718-509-9774 or send us an email at firstname.lastname@example.org.
Generation skipping transfer tax
The generation skipping transfer tax is imposed when the transfer avoids the imposition of a gift or estate tax on a generational level. For example, when you leave property to your grandchild in excess of your gift or estate exemption, the property is transferred from you to the grandchild, skipping your child. Had the property been transferred first to the child, there would have been an estate tax, and then your child would have transferred it to your grandchild, garnering another imposition of estate tax. Since you transferred it straight to your grandchild, there was only one imposition of estate tax. To compensate for this missed tax, the IRC imposes a generation skipping transfer tax, in addition to the estate or gift tax. So your transfer of property to your grandchild in excess of the exemption would be subjected both to an estate or gift tax and a generation skipping transfer tax.
What transfers are taxed by the generation skipping transfer tax? Under the Internal Revenue Code, the generation skipping transfer tax is imposed on generation skipping transfers, which are direct skips, taxable distributions, and taxable terminations. Generation skipping transfers do not include annual gifts of $15,000 per donee in 2021 and gifts that qualify as health insurance, educational expenses, and medical expenses that are directly paid to the educational institution, medical facility, or insurer.
What is a direct skip?
A direct skip is a transfer to the transferor’s grandchild, a relative two or more generations away from the transferor, or a person 37.5 years younger than the transferor. However, under IRC § 2651, if a grandchild steps in to substitute his parent who has pre-deceased the transferor-ascendant, this is not considered a transfer to a skip person. The transferor pays for the generation skipping transfer tax in cases of direct skips.
For example, in your will, you left a house with a fair market value of $3 million to your grandchild in excess of the lifetime estate and gift tax exemption. In this case, your estate will pay for the generation skipping transfer tax of 40% on top of the estate tax.
What is a taxable distribution?
Under the IRC, a taxable distribution is any distribution from a trust to a skip person (other than taxable termination or a direct skip). The transferee pays for the generation skipping transfer tax in taxable distributions.
Who is a skip person? A skip person is the transferor’s grandchild, a relative two or more generations away from the transferor, or a person 37.5 years younger than the transferor. A trust may also be considered a skip person if all of the beneficial interests of the trust are held by skip persons, or even if no current beneficial interests are held by skip persons, no distributions can be made to non-skip persons.
For example, you create a trust with yourself, your son and your son’s three children (your three grandchildren) as beneficiaries. Any distribution made by the trust to your grandchildren (your son’s three children) is considered a taxable distribution. It will be taxed if the distribution is made in excess of your lifetime gift and estate tax exemption amount of $11.7 million.
What is a taxable termination?
Under the IRC, a taxable termination is a termination of an interest in property held in trust unless: (a) immediately after such termination, a non-skip person has an interest in such property; or (b) at no time after such termination may a distribution be made to a skip person. The trustee will pay for the generation skipping transfer tax in taxable terminations.
In the example above, the taxable distribution is the distribution of income or principal made by the trust to your grandchildren. When you die, the trust interests are held by your son and his three grandchildren. There is no taxable termination because your son is a non-skip person and he still holds an interest in the trust. However, when your son dies, all the interests in the trust will be held by your three grandchildren, who are all skip persons. Thus, there is a taxable termination, subject to generation skipping transfer tax. The taxable amount is the value of all property involved in the taxable termination.
Hypothetical illustration of generation skipping transfer tax
For example, in 2021, the lifetime federal tax exemption on gifts and estates is $11.7 million for individuals and $23.4 million for married couples. Suppose your estate is $12 million. You did not plan your estate and gave away the entire $12 million to your grandchild through a will since your only child had money of his own and was already well-off. The excess of $300,000 from the lifetime federal gift and estate tax exemption of $11.7 million is subject to the estate tax, to be paid by the estate. In addition, the $300,000 received by your grandchild is also subject to generation skipping transfer tax of 40%. This does not include state taxes that may be imposed by the New York government.
Suppose on the other hand that during your lifetime, you gave a gift to your grandson of $8 million. When you died in 2021, you gave your granddaughter your house in the Hamptons worth $8 million. In this case, your first gift to your grandson is covered by the lifetime gift and estate tax exemption of $11.7 million and is not taxable. However, your gift to your granddaughter, in excess of $3.7 million (the difference between $11.7 million and the gift to the grandson of $8 million), is subject to both the estate tax and generation skipping transfer tax.
Generation skipping trust
Putting property into a trust in order to avoid generation skipping transfer taxes is not simple. You need the help of trusts and estates attorney to guide you through the process. Creating a simple trust will not avoid generation skipping transfer taxes because distributions of a trust you created to your grandchildren are still considered taxable distributions.
Thus, there are two types of generation skipping trusts: (a) the trust which utilizes your entire lifetime gift and estate tax exemption; and (b) a trust whose property forms part of the trust beneficiary’s estate, for estate tax purposes.
The first example is a simple explanation. You don’t use any of your lifetime gift and estate tax exemption, and upon your death, you create a trust with $11.7 million worth of property with your grandchildren as beneficiaries. Since the property is within your lifetime gift and estate tax exemption, the property is not subjected to generation skipping transfer tax.
In the second example, you make the trust property form part of the beneficiary’s estate by giving that beneficiary the general power of appointment to give the trust property to anyone the beneficiary chooses upon the beneficiary’s death. In this case then, the trust property forms part of the beneficiary’s estate because the beneficiary is given absolute control to direct and dispose of the trust property upon his death. This is a generation skipping trust under IRC § 2642(c).
IRC § 2642(c) states that the trust’s inclusion rate will be zero (which means it will not be taxed the generation skipping transfer tax) if: (a) during the life of the skip person-beneficiary, no portion of the corpus or income of the trust may be distributed to (or for the benefit of) any person other than such skip person-beneficiary; and (b) if the trust does not terminate before the skip person-beneficiary dies, the assets of such trust will be includible in the gross estate of such skip person-beneficiary.
Based on the IRC provision, there can only be one beneficiary in the trust, the skip person. In order for the trust property to be included in the skip person-beneficiary’s gross estate, the skip person-beneficiary must have a general power of appointment to direct and dispose of the trust property upon the skip person-beneficiary’s death.
For example, suppose you have property valued at $20 million. You already distributed in your lifetime gifts in the amount of $11.7 million to family members. Thus, any gift of money or transfer of property below market value made in excess of the $11.7 million will be subjected to estate or gift tax and generation skipping tax, if applicable. Now you would like to leave property to your grandchild in your will in the amount of $4 million, but you are worried that this amount would be subjected to both the estate tax and generation skipping transfer tax. Because you’ve consulted with a trust and estates attorney like us, you now transfer the $4 million into a generation skipping trust with your grandchild as sole beneficiary in order to avoid the generation skipping transfer tax. Under this trust’s terms, your grandchild is given a testamentary general power of appointment to dispose of the assets remaining in the trust at his or her death. This testamentary general power of appointment makes the trust property form part of your grandchild’s estate and thus, makes it avoid the imposition of generation skipping transfer tax under IRC § 2642(c).
Generation skipping transfer taxes don’t really affect a lot of people. However, when they do, estate planning can spell the difference between paying a few ten thousands to hundreds of thousands to millions of dollars. Above simply gives a brief overview of generation skipping transfer taxes and trusts. Many factors are taken into consideration when establishing trusts to avoid certain taxes, and these include an analysis of both federal and state tax laws.
Should you need assistance in establishing a generation skipping trust, we at the Law Offices of Albert Goodwin are here for you. We have offices in New York, NY, Brooklyn, NY and Queens, NY. You can call us at 718-509-9774 or send us an email at email@example.com.