Estate planning is the process of deciding how, and in what manner, your assets will pass to your loved ones. For many, a large component of the design of an estate plan focuses on minimizing taxation that occurs upon the transfer of wealth. While estate and gift taxation are the primary focus of many individuals, another transfer tax, the generation-skipping transfer tax (of GSTT), is often overlooked. When transferring assets, it is important to consider when and how the GSTT may apply.
This federal tax is triggered when an individual transfers assets to a skip-person (i.e., someone who is more than one generation below than the transferor). Such a transfer can be direct (e.g., when a grandparent makes a gift directly to a grandchild) or it can happen indirectly (e.g., when a transfer is made to a skip-person through a trust). The ability to transfer wealth to multiple generations without taxation, which is particularly relevant is states where dynasty planning is available (like New Jersey), is an extremely powerful estate planning option.
Generation-Skipping Tax Defined
The Internal Revenue Code imposes gift and estate taxes on transfers of wealth above certain limits. For 2021, an individual can exclude gifts of up to $15,000 from the gift tax, with that limit doubling for married couples who agree to split the gift. The lifetime exemption from federal estate tax in 2021 is $11,700,000 per person. Thus, for 2021, an individual can pass wealth having a value of as much as $11,700,000 free of federal estate tax. Note that the lifetime exemption can also be applied against lifetime gifts made in excess of the annual exclusion amount.
The gift and estate tax rate is 40% on the value of assets over the lifetime exemption amount. In addition to the gift and estate taxes, the IRS imposes the generation-skipping transfer tax on the passage of any wealth that skips one or more generations. Assets subject to the generation-skipping transfer tax are also taxed at a 40% rate, in addition to the federal estate tax. However, like the estate tax, there is a lifetime exemption from the GSTT, which in 2021 is $11,700,000.
How to Apply the GSTT
Generation-skipping transfer tax covers the transfer of assets (directly or indirectly) to skip-persons. Typically, the GSTT is applied on the transfer of wealth from a grandparent to a grandchild when the grandchild’s parent (who is also the child of the transferor grandparents) is still alive. If a transfer is made to a grandchild whose parent has predeceased the transferer, then the GSTT would not apply.
As noted above, the GSTT is a separate tax from the federal estate tax and it applies alongside it. Similar to estate tax, this tax kicks in when an estate’s value exceeds the lifetime exemption limit.
This is how the IRS covers its bases in collecting taxes on wealth as it moves through multiple generations. If an individual were to pass his/her wealth to a child, who then passes it to their child, then no GSTT would apply; however, the federal estate tax would be triggered upon the passing of each generation. If wealth is to be passed directly to a grandchild, that removes a link from the taxation chain. The GSTT essentially allows the IRS to replace that link, but, as noted above, there is a lifetime exemption that can be applied against generation-skipping transfers which renders such assets to which the exemption is applied exempt from taxation regardless of how many generations to which it subsequently passes.
The Power of Avoiding The Generation-Skipping Transfer Tax
Transferring assets to a trust that has the ability to remain in effect for multiple generations (such trusts are commonly referred to as “dynasty trusts”) and allocating lifetime exemptions against estate tax and GSTT is a tremendously powerful estate planning tool. The compounding effect avoiding transfer taxes over multiple generations can lead to some amazing results. The following illustrates the differences in result for a $1,000,000 contribution into a dynasty trust that will last for 120 years. The savings potential is often greater than illustrated since the example ignores the fact that property received outright will probably be reduced further due to (1) divorce settlements, (2) creditor problems, and (3) the fact that assets are less likely to be dissipated in a trust than if held outright even if the invasion rights in a trust are extremely broad and generous.
|Annual After-Tax Growth||Value After 120 years|
For those seeking to maximize wealth preservation, avoiding the generation-skipping transfer tax is an essential component to an estate plan. In addition to the divorce and creditor protection that dynasty trusts offer, the ability to transfer assets to multiple generations of beneficiaries and avoid transfer taxation, and in particular the GSTT, is a feature that anyone looking to protect assets and maximize wealth should utilize.