Trustees Beware: The Terminator Says “I’ll Be Back” Later for Generation Skipping Transfer (GST) Tax

As tremendous wealth has been created in the U.S. over the last century, the first generation that accumulated such wealth may have used trust arrangements to pass those assets on to benefit future generations. Trusts are not new and are used to accomplish various goals, such as retaining some control over the management and disposition of assets, protecting assets from future creditors, and reducing and mitigating certain taxes.

As the beneficiaries (second generation) of these trusts pass away, or distributions begin to be made to grandchildren or great-grandchildren (third and fourth generations), there could be unexpected and adverse transfer tax consequences that are not currently on the trustees’ or more remote generations’ radar.

Gift & Estate Tax

The U.S. taxation of gratuitous property transfers has been around in various forms for well over 100 years, predating even the individual income tax by decades. The U.S. government’s stated purpose in implementing the gift and estate tax system has been to raise revenue. However, some historians believe there was an underlying policy intent related to wealth redistribution, based on the perception that much of the wealth in the U.S. had been disproportionately controlled by a relatively small group of people, going back to colonial times and later again to the Gilded Age. Regardless of the reasons, the gift and estate tax effectively limited the amount of assets one person could transfer to another.

The current gift and estate tax rules have been in place since 1986, with the main changes related to the “exemption” amount which determines the total assets an individual can cumulatively transfer during their lifetime and at death before paying gift and estate tax.¹ The current exemption for 2024 is $13,610,000 which is adjusted annually for inflation, and without legislative action, will be cut in half at the end of 2025.² Currently cumulative amounts exceeding the exemption threshold are taxed at a 40% rate. However, there is also a gift “annual exclusion” that allows a taxpayer to give anyone up to a certain amount each year ($18,000 for 2024) without having to use any of their exemption. While gifts to individuals are excluded from the annual exclusion limit, a gift to a trust that benefits the same individual will be included in the aggregate amount for that person.

In response to the gift and estate tax, clever attorneys and advisors have developed crafty ways to structure transfers within the bounds of the new tax rules. Using trust arrangements allows assets to be owned by the trust and used for the benefit of others without being subject to gift and estate tax again when those beneficiaries receive benefits from the trust or pass away.

Generation Skipping Transfer (GST) Tax

To curb the tax losses from the ever-increasing use of trust strategies to sidestep the gift and estate tax for future generations, Congress implemented the Generation Skipping Transfer (GST) Tax in 1976, which was later revoked and completely revised in 1986. The purpose of the GST tax and its basic rules seem relatively straightforward to grasp, but when applied to the trust structures that gave rise to the tax in the first place, it is by far one of the most complicated in the areas of estate, gift, and trust (fiduciary income) taxation.

What is a Generation Skipping Transfer?

A generation skipping transfer occurs when someone (transferor) makes a completed gift to another that is statutorily defined as a “skip person” which includes:

• A person related to the transferor by blood, marriage, or adoption who is two or more generations below the transferor;
• A person unrelated to the transferor and who is more than 37 ½ years younger than the transferor; and
• A trust where the only possible beneficiaries fall under the above two categories.

A “direct skip” is defined as a transfer made only to a skip person and is usually easy to identify. In an attempt to keep things simple, Congress made two categories, “skip person” and “non-skip person,” with transfers to a “non-skip person” not subject to GST tax. There is also a predeceased parent rule. This applies when the transferor’s child is deceased at the time of transfer; any grandchildren become a non-skip person.

An “indirect skip” occurs when a transfer is made to a trust with multiple beneficiaries consisting of both non-skip and skip persons. The trust assets will not be subject to estate tax when a non-skip person beneficiary passes away, and this is where things can become very complicated.

GST Exemption & Allocation

Each person has a cumulative GST exemption that is the same as the Gift and Estate Exemption, also indexed for inflation each year ($13,610,000 in 2024), that can be applied cumulatively to direct or indirect skip transfers during life and at death. There is also a GST “annual exclusion” for direct skip transfers to individuals each year ($18,000 for 2024) that is first used before the allocation of GST exemption. Certain transfers to direct skip trusts may also be eligible for the GST annual exclusion. To qualify, there may only be one trust beneficiary. This person may withdraw the amount transferred (for a short period, creating a present interest), and the trust’s assets will be included in the beneficiary’s taxable estate at death. Note that GST and gift and estate exemptions initially start at the same amount but may differ over time. While all transfers are subject to gift and estate tax, transfers to skip persons and indirect skip transfers are subject to GST tax. Therefore, some transfers may qualify for the gift annual exclusion but not the GST one.

Note that GST tax is payable only after the exemption has been fully used and is a separate tax in addition to the gift and estate tax, both of which are each taxed at a rate of 40% once each exemption has been used. Additionally, when GST tax is paid by the transferor, that amount is considered an additional gift and therefore taxed another 40%.

GST exemption is automatically allocated towards direct skips unless an election is made to pay the GST tax when the transfer occurs. For indirect skips to trusts, up until December 31, 2000, taxpayers had to affirmatively allocate GST exemptions to those transfers on a timely filed gift tax return. Due to a clear lack of understanding of the GST tax rules for indirect skips and misinterpretations of trust documents, many tax practitioners missed these allocations, which led to adverse results that were sometimes discovered over a decade later. As a result, Congress implemented Internal Code Section 2632(c)(1), stating that if an individual makes an indirect skip during their lifetime, any unused portion of their GST exemption shall be allocated to the property transferred. Congress later clarified in Treasury Regulation §26.2632-1(b)(2)(i) that GST exemption is automatically allocated to indirect skips whether or not a gift tax return (Form 709) was filed reporting the transfer.

GST Taxation on Indirect Skips

Much to the surprise of trustees, beneficiaries, and many tax practitioners, indirect skip transfers may come with a significant tax liability at some point in the future if a trust were not fully allocated a GST exemption either on a timely filed gift tax return (Form 709) or automatically by statute. Such a tax event would occur if the trust was not fully exempt from GST tax when a taxable distribution (to a skip person) or a taxable termination (when the last non-skip person dies) was made.

Trusts that make distributions to skip persons years after the initial transfer may be subject to GST tax at the time of the distribution, at a tax rate of up to 40% on the distribution received. Also, the GST tax levied on the distribution must be paid by the beneficiary. If the trustee pays it, the payment of the tax is treated as an additional distribution. It is also prudent for the trustee to alert the beneficiary of their tax obligation to ensure tax liabilities are addressed prior to all funds being spent.

The lesser-known taxable termination, which largely inspired the GST tax in the first place, occurs when the last non-skip person with an interest in an indirect skip trust passes away. Please note that the GST taxable termination does not require the trust to terminate or expire but occurs when the only remaining beneficial interests in the trust are for skip persons. Upon the taxable termination, the IRS does not usually wait patiently to collect the GST tax, with the payment due April 15 of the year following the termination, regardless of the liquidity of the trust’s assets. Similar to the taxable distribution, this tax is equal to 40% of the trust assets unprotected by the transferor’s GST exemption.

Final Considerations

Many trustees are not aware of the looming GST, and even when the trustee is aware of the taxable termination, many trusts do not have enough liquidity in the trust to satisfy the tax when it is due. Trustees and their advisors need to be aware that when trusts have beneficiaries of various generations, distributions and the passing of beneficiaries can create a tax liability they have not prepared for. As we get close to forty years since the implementation of the GST tax, it is a good practice for trustees and their advisors to review the trusts under their care and prepare to be terminated.

Sources

1. Rising from $500,000 in 1986 to $5,490,000 in 2017 before being doubled through 2025; although another substantial change effective starting in 2011 was Portability of a spouse’s unused Exemption (discussed below) transferring it to the surviving spouse.
2. Current estimates are that the exemption will be around $7,000,000 starting January 1, 2026.
3. Generally, the beneficiary will need to have the right to withdraw an amount up to the annual exclusion to qualify.