Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

Generation Skipping Transfer Tax: A Primer-Part I

Take-Away: A tax that we tend to ignore, or simply want to forget because it is overly complex so that we really do not fully understand it, is application of the federal generation skipping transfer (or GST) tax. This and subsequent missives will attempt to provide a basic overview of the GST tax and situations when the GST tax is assessed.

Caveat: Don’t kill the messenger. I was asked to explain the GST tax in ‘simple terms.’ After laughing at that request, I promised to give it a try.

Caution: This and the following GST missives are guaranteed to put you to sleep. (Who knows, maybe all of my missives put you to sleep!) If you are not interested in the GST, feel free to skip this email and those that follow. If you do read these GST summaries, do not drive or operate any heavy machinery for at least 24 hours.

Background: The GST tax is imposed on the transfer of wealth to a person (or trust) which is in a generation two (2) or more removed from the transferor’s generation. That person who receives the transfer is called a skip person. The classic example of a generation skipping transfer (GST) is a grandparent who transfers wealth directly to a grandchild, or to a trust that is established for a grandchild’s benefit. The purpose for the GST tax is that Treasury intends to generate revenue from federal estate taxes, but if a generation (children) is skipped with the transfer to a much younger person, e.g. the gift skips the child and goes to the grandchild, no estate tax will be imposed when the child dies because the child did not own the transferred asset.

  • Example: Grandmother creates and funds a trust that benefits her child but her child does not own the transferred asset; when the child dies the asset held in trust is then transferred to her grandchild, free from any federal estate tax. Treasury loses the opportunity to impose an estate tax on the death of the child. Consequently, the GST tax is intended to replace those lost federal estate tax revenues that would have, hypothetically, been collected had the transfer been made directly from the mother to her child.

Dynasty Trusts: A dynasty-type trust is used to exploit the settlor’s GST exemption. It is used when assets are transferred to a long-term trust. The assets transferred into this type of trust provide for the benefit of the settlor’s child, grandchild, grandchildren, great grandchildren, etc. without the assessment of any federal estate tax when one of those beneficiaries dies; none of those beneficiaries owns the assets held in the dynasty trust.  In Bernie Sander’s proposed legislation “For the 99%,” the GST tax would be imposed regardless of the terms of the trust or its perpetual duration, after a trust has been in existence for no more than 50 years. Consequently, any distributions from a dynasty trust after 50 years would be subject to the GST transfer tax. Like it or not, we may be reading a lot more about the GST tax in the years to come.

Tax Rate: Currently the GST tax is a flat 40% transfer tax that is imposed on the transfer of wealth, either by a lifetime gift or a transfer at wealth at death by Will or by trust or expiration of a life estate. The GST tax is imposed in addition  to the federal gift or federal estate tax- it is not an ‘alternate’ tax. Rather, it is a ‘double’ transfer tax dependent upon the age of the recipient.

GST Exemption: The GST exemption is $11.4 million in 2019, per individual. That exemption is scheduled to drop back to $5.0 million (adjusted for inflation) after 2025. Bernie Sanders’ proposed “For the 99% Act” would reduce the GST exemption to $3.5 million and the federal gift tax exemption to $1.0 million per individual. As a result, today most large gifts can be sheltered from the GST by virtue of the transferor’s very large GST exemption amount. That will not be the case if the GST exemption falls back to $3.5 million per person.

Think ‘Teflon’: I used to describe to clients the use of the GST exemption as equivalent to using a can of spray Teflon to avoid, forever, the GST tax. [Poor analogy, I concede, but it usually seemed to help their understanding- yes, their eyes still glazed over even with my Teflon analogy, but they came away understanding the importance of wisely using their GST exemption.]

  • Example: Assume that in 2020 an individual is given a can of ‘spray’ GST exemption-Teflon that covers $11.6 million worth of their assets. If the full can of GST exemption-teflon is sprayed to fully ‘cover’ $11.6 million of transferred assets, no GST tax is incurred on the transfer, due to the full use of the transferor’s GST exemption.  Nothing sticks to Teflon, especially taxes. The Teflon spray also stretches (part of my mental fantasy) to continue to cover those assets, even when those assets grow in value. Accordingly, if a transferor transferred $11.6 million in trust for the benefit of his grandchildren, that initial transfer will be exempt from GST tax because the transferred assets were initially sprayed and covered with the grandfather’s GST exemption–teflon. More importantly, since Teflon stretches (my fantasy), if the $11.6 million in assets  transferred to the trust appreciate over the years to $23 million, any distribution of those $23 million in assets from the trust to a grandchild will also not be subject to the GST tax because the Teflon stretched to cover all of that future appreciation. That is why using the transferor’s GST exemption to shelter assets transferred to a trust is very valuable, as it will stretch to cover any growth in those transferred assets, making the appreciation  exempt from the GST tax as well.
  • Example: Father creates an irrevocable life insurance trust (ILIT) and transfers $1.0 million of assets to the ILIT which are used to pay future premiums owed on a $10.0 million life insurance policy on Father’s life. Father uses $1.0 million of his GST exemption to cover the $1.0 million of assets that he transferred assets to the ILIT, used in later years to pay the premiums on the life insurance policy. Father, the insured, dies. The life insurance company pays to the ILIT trustee $10 million in death benefit; the payment of the death benefit will be income tax-free. [IRC 101(a)(1).] The ILIT terminates and distributes its $10 million of assets to Father’s grandchildren. The entire $10 million is GST tax-free since the $1.0 million GST exemption that was used ‘stretched’ to cover the entire death benefit that is paid to the trust’s beneficiaries, the grandchildren, who are skip persons.

Observation: This is why the intentional use of when the transferor’s GST exemption is so important. More assets than just the initial GST exemption amount can be later transferred free from GST taxation because the initial exemption amount ‘stretches’ to cover all subsequent asset appreciation.

  • Example: Similarly, an individual’s GST exemption can also be wasted by how a trust is written. Assume a mother’s GST exemption is used to shelter the transfer of her assets to an irrevocable trust that is established for her daughter and for her daughter’s descendants. The daughter is given an annual withdrawal right of 5% of the trust assets (the often encountered 5+5 withdrawal right which is a statutory exception to the general power of appointment rules.). The daughter exercises her 5%  withdrawal right each year. The presence of the daughter’s withdrawal right means that part of the assets that could be transferred to the mother’s grandchildren GST-free  is ‘wasted’ when the assets are withdrawn from the trust by the daughter. Note that there is no GST tax imposed on any distributions from the trust to the daughter, ever, since the daughter is not a skip person– she is in the next generation to mother, not two or more generations removed .

Basic GST Rules: Many of the ‘rules’ that apply to the GST tax are complex. Some of those rules are not covered simply because they are so arcane that you would probably close to falling asleep now anyway (if you are not already asleep reading this!)  Avoiding the GST tax requires a lot of attention in the administration of a trust that has skip persons as beneficiaries, which often results in multiple portions or shares created to effectively distribute assets that are, or are not, subject to the GST tax. Only a few of those rules follow.

‘Skip Person/Non-Skip Person:’ What makes a donee or trust beneficiary a skip person should be pretty straightforward, but whenever we expect Congress to simplify a tax, we always come away disappointed. In its simplest form a skip person is an individual who is assigned to a generation that is two or more generations below the transferor (a donor or the settlor of the trust- for ease of reference, I will aggregate the roles and use the term transferor.) As mentioned above, a trust while not an individual, will nonetheless be treated as a skip person if either: (i) only skip persons hold an interest in the trust, e.g. grandchildren; or (ii) no person holds an interest in that trust and at no time after the transfer to that trust will a distribution be made to anyone other than a skip person. It should then come as no big surprise that if a donee or trust beneficiary does not fall within the definition of a skip person, he/she is labeled a non-skip person, g. a child of the transferor. 

  • Example: The key point is that if a non-skip person, g. a child of the transferor, holds present interest in the trust as a beneficiary, the trust itself will not be treated as a skip person, which means that a distribution, either mandatory or discretionary, could be made to the non-skip person. Assume a mother creates and funds trust for the benefit of both her son and his children, her grandchildren. Because the son is a non-skip person, the trust established for his benefit, and that of his children is not a skip person. Accordingly, mother’s transfer of her assets to the trust does not, at the time of transfer, generate a GST taxable event, even though her grandchildren (who are skip persons) could receive distributions from the trust.

‘Transfer:’ An actual transfer of property is not required to trigger the imposition of the GST tax. [Treas. Reg. 26.2652-1(a) (1).] The GST is imposed if the transfer is subject to either the federal estate tax or gift tax. However, no property actually has to pass between transferor and transferee for the GST to be assessed.

‘Inclusion Ratios:’ The GST tax is assessed using an inclusion ratio concept. (This is when my mind goes numb.) This allocation often results when the transfer of assets are made to the same trust but at different times, or different people transfer assets to the same trust using, or not, their GST exemption. If the transfer to  the  trust is covered by the transferor’s GST exemption, it will have a GST inclusion ratio of 0.0. If, however, no GST exemption is applied to the transfer of assets to the trust, then the transferred asset will have an inclusion ratio of 1.0. A transfer from a trust with an inclusion ratio of 0.0, even if made to a grandchild, will completely avoid the GST tax. A distribution from a trust with an inclusion ration of 1.0 will result in a flat 40% tax imposed on the trust distribution to the grandchild.

  • Example: If there is more than one transferor to a trust, and each transferor has or applies a different amount of GST exemption, a trust can end up with an inclusion ratio that ranges between 0.0 and 1.0. Things get confusing if the transferor previously used some of his/her gift tax exemption so that there are different exemptions available to shelter a transfer. Assume grandmother makes a gift in trust of $3.0 million for her grandchildren, but that transfer will only be sheltered by $1.0 million of the grandmother’s then available federal gift tax exemption, while the transferor’s full $11.6 million GST exemption is available to shelter the gift from GST taxation. She will still owe a federal gift tax, but not a federal GST tax.  Or, just the opposite, the assume the entire transfer of assets to the trust by the grandmother is completely free of federal gift tax because the grandmother has a full $11.6 million gift tax exemption available to shelter the gift to the trust,  but due to her earlier lifetime GST gifts to her grandchildren, the grandmother only has $1.0 of her GST exemption to apply to the $3.0 million transferred to the trust. In this later example  the GST inclusion ratio for that trust would be 0.67 (one third of the assets transferred to the trust are GST exempt) so that any time a distribution is made from the trust to a grandchild, two-thirds of that distribution will be subject to the GST’s flat 40% tax.

‘Transferor:’ An individual who makes a transfer in trust, or a contribution to an existing trust, is the transferor only as to that property held by the trust that is attributable to the transferred property. However, there can be several transferors to a single trust where the GST is implicated, each with their own inclusion ratio. [Head spinning yet?]

Multiple Transferors- ‘Separate Trust Rule:’ Because some trusts might be hold assets transferred by multiple transferors, that trust could have different inclusion ratios, Treasury Regulations permit a trust with multiple transferors to be divided at any time into separate trusts, on ‘trust’ for each of the transferors. Each separate trust will thus have its own inclusion ratio. [Treas. Reg. 26.2642-1(a) (3).]

  • Example:  Mom and dad create an irrevocable trust for their children and transfer assets to that trust, using mom and dad’s gift tax exemption. No need to use their GST exemption as the trust is for their children, non-skip persons. Grandparents of those same children think the trust is a great idea. Consequently, each set of grandparents decide to make large gifts of their assets to the trust created for their grandchildren. But the grandparents’ transfers to that trust each carry different inclusion ratios; paternal .50, maternal .80,  depending on both the availability of their GST exemption, and their decision to elect to use their available GST exemption. Consequently assets would flow into one trust from three separate sources- parents; maternal grandparents; and paternal grandparents, each carrying its own unique GST inclusion ratio. This is when the trustee can elect to divide the trust corpus into three separate trusts, one with an inclusion ratio of 1.00, one with an inclusion ration of 0.50 and one with an inclusion ratio of 0.80.

Single Transferor- ‘Separate Portions:’ The authorization given to the trustee to divide a single trust into separate trusts with their own separate inclusion ratios is different than the trustee’s division or portions of a single trust where there is only one transferor to the single trust. In the latter situation the GST exempted amount is segregated into a portion away from the non-exempted portion or amounts. These separate portions are then used when the trustee makes distributions from the trust among multiple trust beneficiaries, some of whom are more than one generation removed from the transferor as skip persons (e.g. grandchildren),  the distribution to whom will trigger the GST tax, and other trust beneficiaries who are in the next generation to the transferor non-skip persons (e.g. children) to whom a trust distribution will not trigger the GST tax.

  • Example: An earlier example was where a single trust found itself with an inclusion ration of 0.67. In this situation the transferred assets  cause the inclusion ratio of more than 0.0. The trustee wants to isolate the assets that had an inclusion ration of 1.0, while segregating the other trust assets that have an inclusion ration of greater than 0.0, or 0.67. The trustee can create separate shares with different inclusion ratios. Distributions from the trust to child beneficiary will be from the 0.67 inclusion ratio portion, while distributions from the trust to grandchildren will be from the 0.00 inclusion ratio portion. Rather than waste GST exempt assets on distributions to the child non-skip person beneficiary, those distributions by the trustee to the child are made from the non-exempt portion, which do not implicate the GST tax because the child is a non-skip person. Consequently,  distributions from the GST exempt trust portion to grandchildren will not be subject to the GST tax because those distributed assets are exempt from the GST. Restated, any trust distributions from the non-GST exempt portion to child will not waste any GST exempt assets.

Peculiar GST Rules: Numerous rules apply to the GST tax, which often make you feel like Alice in Wonderland going down the rabbit hole. Just a few of the more notable GST rules follow. It is important to always think about GST implications prior to making a direct skip gift or distributions from an irrevocable trust to skip persons.

No Portability of the GST Exemption: Unlike the unused federal estate and gift tax exemption that can be ported to the decedent’s surviving spouse, there is no portability of the deceased spouse’s unused GST exemption amount.

  • Example: If the married couple’s long-range estate plan is to benefit their grandchildren, then the first spouse to die should fund a credit shelter trust on his/her death and not rely on the unlimited marital deduction or a joint spousal trust. This is because the decedent spouse’s GST exemption can be applied to the credit shelter trust that will someday ultimately pass to the couple’s grandchildren. This assures between both spouses that both of their GST exemption amounts can be applied to their transfers to their grandchildren (or trusts for the grandchildren’s benefit) on each of the grandparent’s death. If the first spouse to die leaves all of his/her assets to the surviving spouse, while the surviving spouse can transfer up to $23+ million (currently, up until 2026) directly to their grandchildren federal estate tax-free, only $11.6 of the $23+ million assets so transferred on the surviving grandparent’s death will be GST exempt, and the first grandparent to die’s GST exemption will be completely wasted or unused.

GST Exemption Allocation- Automatic an Opt-Outs: These highly technical rules are based on the fact that the transferor’s GST exemption can be allocated, or not allocated, as a matter of choice. Because of mistakes in the past that resulted in the failure to allocate the transferor’s GST exemption which resulted in incurring a GST tax when it could have been avoided with the effective allocation of the transferor’s GST exemption, complex rules were put in place which automatically allocate the transferor’s GST exemption to the transfer in certain situations, unless the transferor (or the transferor’s estate representative) formally opts out of the GST exemption allocation. The decision to opt out of the GST allocation often results in a lot of guesswork. No one wants to waste their GST exemption by allocating it to assets that may never be distributed to a skip person. Consequently, an analysis must be made that looks at the likelihood of a non-skip person beneficiary living to an age where perhaps the trust assets are distributed outright to that beneficiary, and the younger skip person remainder beneficiaries will never receive a distribution from the trust.

  • Example #1: Dad transfers assets to a family trust. The present beneficiary of the family trust is Dad’s daughter, with the remainder interest in the trust passing to Dad’s grandchildren (skip persons) on daughter’s death. If daughter has a long life expectancy, or she is given a withdrawal right over all the trust assets when she reaches age 60, maybe Dad (or his estate representative if the trust is created on Dad’s death) will elect to not assign any of Dad’s GST exemption to the family trust, in light of the probability that daughter will survive at least until age 60 and exercise her withdrawal right, with the grandchildren likely to receive nothing from the family trust.
  • Example #2: Same facts, but the family trust provides that the trust is for daughter’s benefit for only 10 years, after which the trust terminates and all of its assets are distributed to Dad’s grandchildren. In this second situation, there is a strong likelihood that the assets transferred to the family trust by Dad will ultimately be distributed to Dad’s grandchildren, so Dad (or the representative of Dad’s estate) will choose to allocate Dad’s GST exemption to the family trust since it is highly likely that grandchildren will receive distributions from the family trust.
  • Example #3: Grandfather establishes multiple trusts, one trust for each of his grandchildren. Each trust provides for distributions to a grandchild in the trustee’s discretion. When the grandchild attains age 30 years,  the trust terminate with distributions to grandchild. If the grandchild dies before age 30, the trust assets are payable to the grandchild’s issue, if any, otherwise to Grandfather’s other grandchildren. These gifts are reported on a federal gift tax return as indirect skips, and the Grandfather opts out of the automatic GST allocation rules, and no GST tax is paid by Grandfather. [IRC 2632(c).] It is later discovered that the transfers were direct skips. Grandfather requests an IRS ruling with regard to the GST status of the trusts and the allocation of his GST tax exemption to those transfers in trust. The IRS confirms that Grandfather’s transfers to the trusts were direct skips because all beneficiaries of the trusts were at least 2 generations below Grandfather. Therefore, Grandfather’s GST tax exemption was automatically allocated to his transfers to the trust, notwithstanding what was reported on the 709 federal gift tax return, and Grandfather’s initial attempt to elect out of automatic allocation to indirect skips had no effect because they were, in fact, direct skips. Grandfather is happy with this result. [Private Letter Ruling 201921004, December 11, 2018.] A later missive will address a perceived danger with the automatic allocation of an unused GST exemption on a transferor’s death.

‘Generation Assignment Rule:’ A spouse is treated as being in the transferor’s generation, regardless of his/her age. If a non-family person is the donee or trust beneficiary, he/she is also assigned to the transferor’s generation, but only if that non-family person was born 12 ½ years after the transferor. If that non-family person was born more than 12 ½ years after the transferor, but less than 37 ½ years, he/she will be assigned to the first generation below the transferor (they will be non-skip persons). If the non-family person is born more than 37 ½ years after the transferor, he/she will be assigned to a generation two (or more) lower than the transferor, meaning those persons will be treated as skip persons, where distributions to them will trigger the GST tax. These age differences mean that it is important to learn the age of each trust beneficiary (current and future) in order to assess whether the use of the transferor’s GST exemption should be made when the transfer is first made to a multiple beneficiary trust or outright to a donee.

Exception- ‘The “Move-up” Rule:’ The ‘move-up’ rule is an exception to the generation assignment rule just described. Under this exception a grandchild of the transferor will be treated as the transferor’s child (i.e.,  a non-skip person) but only if at the time of the original transfer, the grandchild’s parent who is a descendant of the transferor is dead (resulting in the children of the deceased child being treated as the children of the transferor.) This ‘move-up’ rule also applies to grandnephews and grandnieces.

  • Example #1: Dad dies. Dad creates a credit shelter discretionary trust on his death for his surviving spouse, Dad’s daughter and his daughter’s children (Dad’s grandchildren), all of whom are present discretionary trust beneficiaries of the credit shelter trust. The grandchildren, on the face of the trust instrument, are skip persons. Assume, however, that daughter died before Dad, but Dad never got around to changing the trust instrument to reflect his daughter’s death. In this situation, daughter’s children, Dad’s grandchildren, ‘move-up’ into their deceased mother’s (the daughter’s) generation, so that any distributions from the discretionary credit shelter trust to daughter’s children will not be subject to the GST tax- daughter’s children will be treated as Dad’s children and  not treated as skip persons.
  • Example #2: Slight change in the facts: Daughter dies, but shortly after Dad’s death. Since the original transfer to the credit shelter trust occurred on Dad’s death when the trust was initially funded, which was before daughter died, daughter’s children do not ‘step-up’ to their deceased mother’s generation. In this second situation, any discretionary distributions from the credit shelter trust to daughter’s children will be treated as GST taxable transfers to skip persons. [There will be no GST tax imposed however, if Dad’s estate representatives applied his available GST exemption to the assets that pass to the credit shelter trust.]

‘Reverse QTIP Election:’ As noted earlier, a deceased spouse’s unused GST exemption is not portable to their surviving spouse. So how does a married couple exploit the unlimited marital deduction (with a second income tax basis adjustment on the surviving spouse’s death) and still exploit both spouse’s GST exemption? With a reverse QTIP election.

  • Example: Dad dies. Dad leaves all of his assets to a QTIP trust for Mom’s lifetime benefit. That transfer to the QTIP trust qualifies for the unlimited estate tax marital deduction, thus deferring all federal estate taxes until Mom’s subsequent death when the value of the QTIP assets will be included in Mom’s taxable estate, leading to a second income tax basis adjustment to those assets. Mom will be able to use Dad’s unused federal estate tax exemption amount to thus reduce or eliminate federal estate taxes on Mom’s death, while obtaining a step-up in the income tax basis of all QTIP trust assets on Mom’s death, all achieved due to a timely portability. But what about Dad’s GST exemption? Dad’s estate makes a timely reverse QTIP election after his death on his Form 706. [IRC 2056(b) (7).] That election has the effect, solely for the purposes of the GST tax, to treat the property that was covered by the QTIP election as though no such QTIP election had been made for GST purposes. This election by Dad’s estate representatives must be made for the entire portion of the QTIP trust that is covered by the standard QTIP election. The reverse QTIP election is irrevocable once it is made. The result is that on Mom’s subsequent death, while the value of all of the QTIP trust assets are included in Mom’s taxable estate for estate tax calculation purposes due to the unlimited marital deduction associated with the QTIP election, Mom’s taxable estate will have a much larger exemption from federal estate taxes due to portability, and the reverse QTIP portion will be treated, only for GST purposes, as having been transferred by Dad ( albeit at Mom’s death), and those transferred assets (including any appreciation in those QTIP assets while Mom was alive) will be exempt from GST taxation. Consequently, the reverse QTIP election, on the first spouse’s death, assures the ultimate use of the first spouses’ GST exemption, but only with the use of a QTIP marital deduction trust. Caution: If the marital deduction trust created on Dad’s death gave Mom a testamentary general power of appointment [IRC 2056(b)(5)], a special reverse QTIP election cannot be made, even if a standard QTIP election is made with respect to that marital trust.

‘Estate Tax Inclusion Period (ETIP):’ The purpose of the ETIP rule is to delay the determination of the inclusion ratio for certain trusts, such as QPRTs or GRATs. The ETIP is the period during which the value of the transferred property would be included in the gross of estate of the transferor, or the transferor’s spouse for any reason (other than IRC 2035- transfers within 3 years of death.) If, however, the actuarial probability of the estate inclusion of the value of the transferred property was less than 5%, there is no ETIP. With the ETIP, the transferor’s GST exemption is delayed in its allocation until the ETIP ends. If the transferred assets appreciate in value during the ETIP then more of the transferor’s GST exemption will ultimately have to be used to cover the ETIP appreciation.

  • Example: Grandmother creates a qualified personal residence trust (QPRT) and transfers the title of her principal residence to the QPRT. The home is valued at $500,000. Grandmother reserves the right to live in the home, under the QPRT, for a period of 15 years. After 15 years Grandmother’s exclusive use period in the QPRT terminates,  and the trustee then distributes title to the home to Grandmother’s grandchildren (skip persons.) Grandmother cannot apply any of her GST exemption to the transfer of the $500,000 home to the QPRT until after the 15 years have passed; if Grandmother had died during that 15 year exclusive use period, the full value of the home would be included in Grandmother’s taxable estate. [IRC 2036(a) (1)).]. It is only after 15 years have passed that the value of the home is fully excluded from Grandmother’s taxable estate. Because of the ETIP rule, Grandmother’s GST exemption assigned to the QPRT will be delayed until 15 years have passed: by then the home will have appreciated up to $700,000 in value, meaning more of Grandmother’s GST exemption will be applied ($700,000 vs $500,000 when the QPRT was first funded). In effect, there is no ‘Teflon-effect’ to the cover the post-transfer appreciation due to the ETIP. Had Grandmother transferred title to the home outright to her grandchildren and not used the QPRT strategy, she would have only used $500,000 of her GST exemption amount.

Charitable Trust Beneficiaries: Generally, a charity is only treated as possessing an interest in a trust if it has an absolute right to receive current distributions (as opposed to a mere possibility of receiving a trust distribution.) However, a charitable beneficiary of a charitable remainder annuity CRAT) or unitrust (CRUT) is always deemed to possess an interest