Many people are aware of gift and estate taxes: the taxes that the IRS assesses on the transfer of assets to heirs made either during one's lifetime or at death. But many people are unaware of an additional tax that could apply to transfers made to heirs more than 1 generation below them (e.g., from a grandparent to a grandchild), known as the generation-skipping transfer tax (GSTT). The GSTT is not only unfamiliar to many, but it is also one of the more confusing taxes to understand.
This article will provide a basic overview of the GSTT and discuss how proper planning and use of the GSTT exemption amount may provide a valuable tool for families to shelter their wealth from gift and estate taxation over multiple generations. This article focuses on federal gift and estate tax rules; however, please note that each state may have additional taxes that may affect transfers made during lifetime and at death.
How the GSTT came to be
Transfer taxes were initially introduced in the US early in the 20th century, with the first version of the estate tax implemented in 1916 and the first version of the gift tax implemented in 1924. The GSTT was introduced in 1976, and was implemented to prevent what the IRS perceived as wealthy families avoiding estate taxes at the death of each generation. Prior to this tax, it was possible to pass an unlimited amount of assets to a trust for the benefit of multiple generations, thus permanently avoiding estate taxes as each generation passed away.
Although current gift and estate tax laws provide US taxpayers with higher gift tax, estate tax, and GSTT exemptions than in the 40 years prior—and thus a greater opportunity to transfer wealth and preserve assets for generations to come—it can still be very expensive to move assets to heirs beyond the next generation.
The federal transfer tax system
In general, the IRS assesses a gift or estate tax1 on transfers of assets during one's lifetime or at death to anyone other than a US citizen spouse or a qualified charity, with a few exceptions:
Above and beyond these 3 exceptions, any transfers during one's lifetime or at death over the federal estate and lifetime gift tax exclusion amounts will be taxed at 40%.4
Demystifying the GSTT
The IRS assesses an additional tax (the GSTT)5 on transfers to individuals (or to a trust for their benefit) that are more than one generation below the transferor (also known as "skip" persons). This would include transfers from a grandparent to a grandchild or to other individuals who are more than 37½ years younger than the transferor (e.g., from a great uncle to a grandniece or from a 70-year-old to a non-related 30-year-old). This tax is equal to the highest federal gift and estate tax rate at the time of the transfer (40% in 2019), and is in addition to any federal gift or estate tax that may be owed.
Similar to the gift and estate tax exclusion discussed above, every US resident also has a GSTT exemption of $11.4 million (or $22.8 million for a married couple).6 In other words, a married couple could transfer up to $22.8 million to a skip person without having to pay GSTT. However, it is important to understand that this is not a standalone exemption. Transfers to a skip person may be subject to both the gift/estate tax and GSTT.7
Let's look at a few scenarios, assuming that a single individual who has not used any of their lifetime gift or GSTT exemption, transfers assets to their child and grandchild.
The example in the bottom row of the table above illustrates how expensive it can be to transfer assets to skip generations once the lifetime exemptions have been used. Total combined gift tax and GSTT of $8,128,000 would be paid for the $15 million gift to the grandchild.
The GSTT annual exclusion
Similar in concept to the annual gift tax exclusion ($15,000 currently), there is also an annual GSTT exclusion. Thus, if a grandparent wanted to make a $15,000 gift directly to a grandchild (e.g., by depositing funds to a bank account in that grandchild’s name), no gift tax or GSTT would be due (as long as the gift is less than the annual exclusion limit for the year in which the gift is made).8
When does the GSTT apply?
Direct skip example
A grandfather gifts $1 million to his grandson or to an irrevocable trust for his sole benefit.
The GSTT is imposed on 3 types of taxable events:
1. Direct skips
Property is transferred from one individual to a skip person, either outright or in trust. Direct skips are taxed only once, regardless of how many generations are skipped, and there is no distinction among skip persons regardless of how many levels the beneficiary’s generation is below the transferor's generation. For direct skips, the transferor (or their estate) pays the tax (or utilizes the GSTT exemption) at the time the transfer takes place, based on the value of the property received by the transferee.
Taxable termination example
Assets owned by a trust set up for Sally by her mother are distributed to Sally's children upon her death. Due to the provisions of the trust, the trust assets were not included in Sally's taxable estate. This would be a taxable termination assuming Sally's mother did not apply her GSTT exemption to the assets she transferred to the trust (as discussed below). This would also be considered a taxable termination if, upon Sally’s death, the assets remained in trust for her children since there are no longer any non-skip beneficiaries (e.g., no one in Sally's generation is a beneficiary).
2. Taxable terminations
An interest in property held in trust terminates (e.g., due to the death of a beneficiary or the expiration of the trust term), there are no other non-skip beneficiaries, and the termination is not subject to estate or gift tax (e.g., if the trust assets are not included in the deceased, non-skip beneficiary’s estate). This doesn't necessarily mean that the trust terminates. The trust could continue but only have skip beneficiaries remaining. The trustee is responsible for paying the GSTT when the taxable termination occurs.
Taxable distribution example
A trust that was set up for Sally and her children by Sally's mother makes a distribution to Sally's children during Sally's lifetime. This would be a taxable distribution assuming Sally's mother did not apply her GSTT exemption to the assets she transferred to the trust (as discussed below).
3. Taxable distributions
An irrevocable trust has been created and a distribution of income or principal is made by the trust to a skip person (but the distribution is not defined as a direct skip or a taxable termination). The GSTT is paid by the recipient when the distribution occurs.
Allocating the GSTT exemption
Allocating the GSTT exemption example
Paul established an irrevocable trust in 2019 for the benefit of his grandchildren and future generations, funded the trust with $10 million, and allocated his GSTT exemption to this transfer. If that trust subsequently grows to $20 million, no distributions to the trust beneficiaries would be subject to any additional GSTT. Thus, Paul only used $10 million of GSTT exemption to shelter what turned out to be $20 million of assets.
In order to avoid the GSTT on the initial transfer, an individual must use (allocate) some or all of one’s GSTT exemption. The GSTT exemption may be used for both outright transfers as well as transfers in trust. The allocation of the GSTT exemption is generally reported on a gift or estate tax return (IRS Form 709 or IRS Form 706), though this is not required by law.9
It is important to note that when the GSTT exemption is allocated to a transfer in trust, any growth on the assets to which the allocation was made is subsequently sheltered from any GSTT in the future.
Potential planning strategies to transfer wealth over multiple generations
Although outright gifts may be the simplest option (e.g., a $15,000 gift from a grandparent to a grandchild), there may be reasons to explore other possibilities. For instance, grandparents may be concerned that a grandchild might not use the money wisely or grandparents may want the money to be used for a specific purpose, such as to pay for college.
Contributions to 529 plans for the benefit of grandchildren (or other skip individuals)
In this case, a common strategy is to make gifts to 529-qualified tuition programs known as 529 plans. Gifts to 529 plans are considered completed gifts, even if the transferor has the right to change the beneficiary at their discretion. A grandparent contributing to a 529 plan for a grandchild's education can accelerate up to 5 years of annual gift exclusions in 1 year (currently, $75,000 for an individual, or $150,000 for a married couple). No further gifts can be made to the grandchild or the 529 plan for the next 5 years without gift tax implications, and if the grandparent dies during this period, a portion of the gift is brought back into the grandparent's estate for estate tax calculation purposes.
Dynasty trusts: multigenerational strategies that don’t exclude the next generation
Other goals related to a wealth transfer plan may be to include children in lifetime gifts or bequests (e.g., not bypassing them in favor of grandchildren and future generations) and to incorporate asset protection planning. Irrevocable trusts can be created to benefit multiple generations, allowing access to income and principal at each generational level at a trustee's discretion, while removing the assets from the gift and estate tax system and potentially sheltering the assets from the beneficiaries' creditors. These trusts are sometimes known as "dynasty trusts" and can be designed to last indefinitely. However, note that some states limit the number of years a trust may be in existence (known as the "rule against perpetuities").
Dynasty trusts are typically designed to provide for a wholly exempt trust by the allocation of the transferor's (or grantor's) GSTT exemption to all transfers made to the trust. Once a dynasty trust is exempt from GSTT, distributions and terminations will not be taxable events for GSTT purposes regardless of the level of asset growth in the trust.
In this example, an outright gift to G1 results in a loss of $14.08 million to estate taxes over 3 generations, which are avoided when gifting to a dynasty trust instead. Thus, the annual distributions made to G3 in the dynasty trust scenario (at the 4% rate mentioned above) would be $880,000 (4% of $22 million), versus just $316,800 (4% of $7,920,000) in the outright gift scenario.
A dynasty trust can be combined with other wealth transfer strategies—such as grantor-trust tax treatment, life insurance, family business entities, and loans or sales to the trusts, to name a few—to provide further leverage to a wealth transfer plan. For example, these trusts may also be established as part of an estate plan that includes an irrevocable trust, established and funded at death, generally with amounts up to the decedent's remaining GSTT exemption. Consult your tax advisor regarding what may make sense in your situation.
Dealing with the GSTT can be complex and confusing. With proper planning, the GSTT exemption provides opportunities to reduce or potentially eliminate the taxes associated with gifting or passing money to grandchildren or other skip individuals, ultimately allowing more to pass to younger generations. Your Fidelity team can help you navigate this complexity, and your attorney and tax advisor can help you effectively plan for GSTT. Contact your Fidelity advisor to discuss how GSTT strategies may relate to your personal wealth plan.
The temporary nature of current law
The provisions relating to the GSTT exemption in the current tax law are set to sunset at the end of 2025. This means that as of January 1, 2026, the GSTT exemption will revert back to the amount that was allowed under the law effective in 2017 (an inflation-adjusted $5 million, or about half of what is currently allowed). Therefore, if you are considering taking advantage of the higher current exemption amounts, the time to do so is limited, unless Congress acts to change the law once again.