The Generation Skipping Transfer Tax (GSTT), also known simply as the Generation Skipping Tax (GST) impacts high-net-worth individuals who are planning to use their Estate Plan to pass down assets to their grandchildren or other future generations.
Learn everything you need to know about the GST exemption, including who it impacts and how, and the likelihood of whether or not this tax will apply to your estate and your beneficiaries.
What is Generation Skipping Tax?
Generation skipping tax (GST) is also called generation skipping transfer tax. It’s a federal tax aimed at preventing someone from intentionally skipping over their children in their Estate Plan. This idea is a very affluent Grantor would attempt to leave assets to younger generations - in an effort to try and avoid estate tax.
The federal tax known as GST comes into play if there’s ever an inheritance being left to a beneficiary who’s 37 ½ or more years younger than the Grantor who is leaving the assets. The tax was implemented in the mid-1970s and was introduced in an effort to close the loophole that once allowed inheritances to skip a generation solely for the purpose of avoiding certain taxes.
How Does a Generation Skipping Transfer Tax Work?
Keep in mind, the Generation Skipping Transfer Tax only applies to a gift or inheritance to a beneficiary who’s 37.5 years younger than the person giving them money. GST taxes ensure that assets placed in a Trust are taxed. The beneficiary receives any amount over the tax credit. Note that leaving money to your own children is not considered “generation skipping.” Likewise, if a direct child has passed away, leaving money to their children also does not result in the “generation skipping” category.
Generation skipping tax is different from the traditional estate tax - it’s actually in addition to it.
Understanding Direct vs. Indirect Skips
GST taxation can be a direct or an indirect skip.
A direct skip is subject to gift or estate taxes. An example is a grandfather leaving property to a granddaughter. The transferor has to pay the taxes for this type of skip.
An indirect skip has intermediate steps. In one type of indirect skip, called a taxable termination, there's a skip person and a non-skip person. The primary beneficiary acts as the non-skip person and the skip person will receive the assets upon the death of the primary beneficiary. Taxes on an indirect skip are due when the estate passes to the skip person.
How Much Is the Generation-Skipping Transfer Tax?
GST taxes are currently 40 percent (ouch!) and, again, are in addition to any federal estate tax. What is the Generation Skipping Tax exemption for 2021? As of 2021, the GST tax exemption for individuals is $11.7 million, double for married couples.
Only the value in excess of this exemption is subject to that 40 percent tax. So, if someone passes on an estate worth $12.7 million, the applicable GST tax would be 40 percent of the extra $1 million.
Who Pays the Generation Skipping Tax?
Who pays the generation skipping tax depends on what type of skip is involved. In a direct GST, the Grantor (person setting up the Trust) pays the tax when setting up the GST provisions. In an indirect GST, the skip beneficiary pays the taxes.
In an indirect GST, when the estate is settled, it passes tax-free to the primary beneficiary. However, the skip beneficiary (often a grandchild) must pay the taxes when they inherit the money after the primary beneficiary dies.
Generation Skipping Tax Example
A Generation Skipping Tax example might help make it a bit more clear exactly how a GST works.
Example of a direct skip, Mary transfers assets in cash of $14.7 million to her grandson Christopher, who is the skip person. Mary reports this transfer and pays taxes on the $4 million in excess of the GSTT threshold of $11.7 million.
Example of an indirect skip. Mary sets up an indirect skip as a taxable termination to her son Adam, a non-skip person. Under the terms of her Trust, the estate will then pass to Christopher when John passes away. When Christopher receives the cash and assets, he must pay the GSTT.
Is Generation Skipping Tax Something I Need to Worry About?
Most people don't have to worry about the GSTT because of the high threshold that is adjusted every year for inflation. Remember, the tax only applies to inheritance in excess of the exemption. To learn more about Trust and Estate Planning tax, refer to the following resources:
Guide to Financial and Estate Planning (includes info on 2020 CARES Act)
Conclusion
What is GST Tax? By now, you have learned that a GSTT applies to the transfer of property by inheritance or gift to someone 37.5 years younger than you. The GSTT closes a loophole where wealthy people used to leave all their assets to a grandchild to avoid paying estate taxes. Although most people don't have to worry about being subject to this tax, it applies to any inheritance $11.7 million or more for individuals, and the tax rate is a flat 40 percent.
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