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George F. Bearup, J.D. Senior Legal Trust Advisor

22-Dec-21

Generation Skipping Transfers – Avoiding a Few Traps Along the Way

Take-Away: The federal generation skipping transfer tax (GST) is highly complicated, both in its application, and when and how the GST exemption(s) are available and applied (intentionally or automatically.) With the growing interest in funding dynasty trusts now, before 2026 when the GST exemption is expected to be cut in half, it is important to be aware of some of the ‘traps’ that are associated with the GST and application of the GST exemptions.

Background: The generation skipping transfer tax (GST) is designed to ensure that when assets are passed to descendants other than the transferor’s children, like a gift from a grandparent to a grandchild, a tax is imposed in lieu of federal estate or gift taxes that would have been due had the assets been transferred one generation at a time. The GST tax is imposed at the same flat rate as the federal estate and gift tax: 40%.  [IRC 2602; 2641.] The GST tax is imposed in addition to a federal estate or federal gift tax if the transfer is to a skip person, who is described as two or more generations below that of the transferor. If the transferee is an unrelated person who is at least 37.5 years younger than the transferor, that transferee will also be treated as a skip person. Transfers to a non-skip person, e.g. the transferor’s child, is not subject to the GST tax.

Predeceased Child Exception: An important exception to the skip person definition is what is called the predeceased child exception.[IRC 2651(e)(1).] If a child of the transferor dies before a gift or bequest is made, the descendants of the predeceased child are treated as being one generation closer to the deceased child’s parents. Accordingly, a grandchild is treated as only one generation below their grandparents, and therefore the grandchild is not treated as a skip person.

Example: Don’s will provides that his estate is to be divided and distributed to his children in shares of equal value. If a child of Don dies prior to Don, his Will provides that the deceased child’s share passes to the deceased child’s descendants per stirpes, e.g. Don’s grandchildren. Don’s daughter, Diane, died before him. Diane’s share passes to her living children on Don’s death. While Don’s grandchildren are technically skip persons,  due to the predeceased child exception, Diane’s children will be treated in the generation next to Don, i.e. they will be treated as non-skip persons.

Example: Don dies leaving his estate to a bypass or credit shelter trust for the benefit of Don’s wife Wendy and their children, and upon Wendy’s death the trust is distributed to Don’s children, including Diane, if living and if not to the deceased child’s descendants. After Don’s death his wife Wendy is the lifetime beneficiary with the child. Diane dies while her mother is still alive. The trustee makes a distribution to Diane’s children as discretionary beneficiaries. Diane’s children are not treated as non-step persons; rather, they are step persons subject to the GST tax. The ‘transfer’ occurred on Don’s death, while Diane was still living. Therefore, Diane’s children do not step into their deceased mother’s generation. Had Diane died prior to Don’s death, i.e. before the transfer of his estate to the credit shelter trust that was subject to transfer taxes, and before the bypass or credit shelter trust was funded, those grandchildren would be treated as non-step persons.

GST Exemption: The current generation skipping transfer tax (GST) exemption is $11.7 million, and is now scheduled to increase to over $12 million beginning in 2022. [IRC 2631(a).]

However, this GST exemption is not portable to a surviving spouse. As such, if the GST exemption is not used during the individual’s lifetime, or applied on the individual’s death, it will be lost.

GST Annual Exclusion: A transferor may also make gifts up to $15,000 in 2021 ($16,000 starting in 2022) using the GST annual exclusion without allocating the transferor’s GST exemption. [IRC 2642(c)(3).] Like the annual exclusion for federal gift tax purposes, the GST tax must be a present interest. [IRC 2503(b)(2).

However, a transfer to a trust will only qualify for the GST annual exclusion if: (i) the trust is for a single beneficiary; (ii) it provides that no portion of the income or principal may be distributed to (or for the benefit of) any person other than such beneficiary; and (iii) any remaining property will be included in the gross estate of the beneficiary if the trust has not terminated prior to the beneficiary’s death, e.g. a general power of appointment if held by the beneficiary.

Example: A gift by the settlor to conventional irrevocable life insurance trust (ILIT) with a Crummey withdrawal rights that benefits more than one descendant of the insured-settlor could qualify as an annual exclusion gift for federal gift tax purposes (due to the Crummey withdrawal right), but not for GST annual exclusion gift purposes.

Allocating the GST Exemption: The transferor’s decision whether to allocate their GST exemption depends upon their goals and the design of the trust (if the transfer is to a trust with skip person beneficiaries.) With the scheduled sunset of the very large GST exemption set for December 31, 2025, some transferors may want to use their GST exemption, even if that allocation is ‘late.’ By allocating the GST exemption to transfers, the transferred asset (or the trust corpus) will be exempt from GST taxation regardless of how much the transferred assets grow in value. In other words, the transferor’s GST exemption is leveraged; when making a timely allocation of the transferor’s GST exemption, the amount of exemption required to fully shelter the asset from the GST grows with the value of the GST-exempt asset over time.

Sometimes it will make sense to not allocate any of the transferor’s GST exemption, e.g. a trust receives the gift that is primarily for the benefit of the transferor’s spouse and his children. In that situation, the transferor may want to ‘save’ their GST exemption and use it for other transfers where grandchildren might be the ultimate beneficiaries. Or, in a situation where a dynasty trust is funded, like an ILIT, that is intended to benefit multiple generations of the settlor’s descendants, it would be wise to allocate the transferor’s GST exemption to that lifetime transfer.

Example: An ILIT owns a permanent life insurance policy on the insured-settlor. The ILIT is expected to benefit multiple generations of the insured-settlor. The insured-settlor, when transferring funds to the ILIT, applies the insured’s GST exemption. The GST exemption is leveraged because, when making the timely GST allocation, the amount of exemption required to fully shelter the death benefit of the policy paid on the insured’s death from GST taxation is only the value of the property, i.e. the gifted life insurance premiums. The death benefit is thus federal estate, federal GST, and federal income tax-free.

Example: If the life insurance policy held in the ILIT was a term insurance policy, the amount of the insured-settlor’s GST exemption needed to fully protect the death benefit proceeds from GST tax may be as little as the current amount of the unused term insurance premium. Assume that the insured-settlor made annual exclusion gifts of $15,000 a year for 10 years to cover term life insurance premiums, and the insured-settlor did not allocate any of his GST exemption to those premium payments. In the 11th year the insured-settlor is diagnosed with a terminal illness. With the term life insurance policy held in the ILIT, the insured-settlor’s GST exemption amount needed to fully protect the term insurance death benefit may be as little as the current amount of the unused premium. Accordingly, the insured-settlor may make a ‘late’ allocation of his GST exemption have to use less than $15,000 of his GST exemption to fully protect several millions of death benefit that is paid on his death free from any GST exemption.

Automatic Allocation of GST Exemption: This is when the GST  rules get horrifically complicated. [Head-spinning would be a gross understatement!] The Tax Code provides for the automatic allocation of a transferor’s GST exemption unless the transferor expressly opts out of the use of his/her GST exemption. These rules are intended to prevent a transferor from inadvertently triggering the GST tax.

However, these automatic GST allocation rules may also cause the transferor’s GST exemption to be allocated inefficiently.

Direct Skip Transfers: Under the allocation rules, if an individual makes a direct skip transfer during his/her lifetime, their GST exemption is automatically allocated to the extent the individual has any remaining GST exemption available. The transferor’s GST exemption is also automatically allocated to a lifetime transfer that is made to a GST trust [IRC 2632(b).]

GST Trust: A GST trust is defined as one that could have a GST tax imposed as a result of a taxable termination or a taxable distribution, unless one of six exceptions apply. These exceptions result in some serious head-spinning as to whether to permit the automatic allocation of the transferor’s GST exemption, or to formally opt out of the automatic allocation.

Exceptions to the Automatic GST Allocation Rules:  The transferor’s GST exemption will be automatically applied to lifetime transfers to a trust unless it fits into one of 6 exceptions, two of which deal with transfers to charitable trusts which is pretty easy to remember. It is the other for exception categories that require some thought. For the exemption from the automatic allocation of the transferor’s GST exemption to apply-

  1. At least 25% of trust principal must be distributed to, or may be withdrawn by, one or more persons who are non-skip persons, e.g. children, (a) before attaining age 46 years of age; (b) on or before specific dates provided in the trust instrument that will occur before such non-skip person attains 46 years of age, or (c) upon the occurrence of certain events that may reasonably be expected to occur before the date such non-skip person attains age 46 years; or
  2. At least 25% of the trust principal must be distributed or may be withdrawn by one or more non-skip persons, e.g. children, who are living on the death of death of another person identified by the trust (by name or class) and who is at least 10 years older than such beneficiaries, e.g. the settlor’s spouse; or
  3. If one or more of the non-skip persons, e.g. children, die on or before a date or event that is described in (1) or (2) and more than 25% of the remaining trust principal must be distributed to the estate or estates of one or more such non-skip persons or is subject to a general power of appointment exercisable by one or more of them, i.e., the corpus will be taxed in the non-skip person’s taxable estate; or
  4. Any portion of the trust is includible in the gross estate of a non-skip person, e.g. a child, if such person died immediately following the transfer, e.g. the child had an immediate right to withdraw the entire corpus; or
  5. The trust is a charitable lead trust, a charitable remainder trust annuity or unitrust; or
  6. The trust is a charitable lead unitrust where the remainder beneficiary is a non-skip person, e.g. a child.

Example:  Don funds a non-grantor irrevocable trust for the benefit of his wife Wendy and their children. On Wendy’s death, separate age-based sub-trusts are created for each of the children that will distributed one-third of the sub-trust principal at age 30, one-half at age 35, and the remainder at age 40 years. If the children are already over the age of 30 when Don’s trust is initially funded, exception 2 will apply, otherwise this will be a GST trust to which Don’s GST exemption will automatically be applied. Note that if Don’s children were substantially younger, there is no guarantee that 25% or more of the sub-trust principal will be distributed to non-skip persons before the age of 46 because Don and/or Wendy may still be living when their children read that age. There is also no guarantee that 25% or more of the trust principal will be distributed to the children at Wendy’s death if their children are under age 30 at the time Wendy dies.

When GST Tax is Imposed: A generation skipping transfer (GST) can be triggered in three different ways:

  • Direct Skip: A direct skip transfer is a transfer that is subject to the federal estate or gift tax, [IRC 2612(c).] With a direct skip, the transferor if an individual, or a trustee if the transfer comes from a trust, is responsible for the payment of the GST tax. [IRC 2603(a)(2)-(3).]

However, any such payment of the GST tax on a direct skip by the transferor is treated as an additional gift by the transferor that, in turn, is further subject to the GST tax. [IRC 2515.]

  • Taxable Termination: A taxable termination occurs upon the termination by death, lapse of time, release of a power of an interest in trust property, unless, immediately following the termination, a non-skip person has an interest in the property or a no time following termination may a distribution be made from the trust to a non-skip person, [IRC 2612(a).] In the case of a taxable termination, the trustee is responsible for the payment of the GST tax. [IRC 2603(a)(2).]
  • Taxable Distribution: A taxable distribution is a distribution from a trust to a skip person, other than a table termination or a direct skip, [IRC 2612(b).] Upon a taxable distribution from a trust, the distributee is responsible to pay the GST tax. [IRC 2603(a)(1).]

Conclusion: We often do not think about the GST tax due to the current large GST exemption amount and, frankly, the confusion caused by the GST’ technical rules. That being said, as many wealthy clients consider creating and funding large dynasty trusts prior to 2026 in order to use their very large gift and GST tax exemptions, it is important to understand how the tax works, and more importantly how to make the most tax efficient use of the transferor’s GST exemption.