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Do You Understand GST Taxes?

August 01, 2023

The federal generation-skipping transfer (GST) tax is among the most complicated and severe provisions of the tax code. Here’s what you need to know to avoid being blindsided.

Tax Triggers

Some high net-worth individuals mistakenly think they can skip over their children and make direct gifts to their grandchildren — so the gift would be taxed only once (for example, when a grandparent transfers property to a grandchild) instead of twice (when the grandparent transfers the property to the child and then again on the transfer from the child to grandchild). Uncle Sam has plugged this loophole with the GST tax. The tax applies to gifts and bequests — on top of gift and estate taxes — and it effectively prevents taxpayers from avoiding double taxation.

The recipient (also known as the “skip person”) isn’t limited to grandchildren, more remote descendants or even family. Any person who’s more than 37½ years younger than the transferor is considered a skip person, and any taxable transfer to such a person could be subject to the GST tax. Certain transfers to trusts may also be regarded as skip gifts.

Direct vs. Indirect Skip

A gift can be considered either a direct or indirect skip for GST purposes. A gift is a direct skip if it is subject to gift tax, gift of an interest in property, and is made to a skip person either directly or, in certain circumstances, through a trust. For example, a grandmother might give her grandson $100,000 outright or she could gift the money to a trust where the only beneficiary is her grandson.

An indirect skip for GST purposes, is a transfer to a trust that can make distributions to both skip and non-skip beneficiaries. The GST tax could apply either at the time of a distribution or a taxable termination. An example would be if a grandmother transferred money to a trust that benefits her son and three grandchildren.

Rates and Exemptions

The GST tax rate of 40% is applied to the amount of an estate that exceeds the GST tax exemption. The Tax Cuts and Jobs Act nearly doubled the GST tax lifetime exemption. For 2023, it’s $12.92 million ($25.84 million for married couples). The amount is scheduled to return to pre-2018 levels in 2026 ($5 million adjusted for inflation) unless Congress extends it.

The annual gift tax exclusion for 2023 is $17,000 per person, so generation-skipping transfers that fall within that protection don’t erode the GST tax lifetime exemption. Keep in mind this is only the case for direct skips. Indirect skips are not eligible for the annual exclusion.

Transfers to a grandchild whose parent (the transferor’s child) pre-deceases the transferor are also exempt. In addition, direct payments to schools, medical providers or insurers for tuition, healthcare or healthcare insurance aren’t subject to the GST tax.

Important Note with Respect to Indirect Skip Gifts: There are automatic allocation rules for indirect skip gifts made after December 31, 2000. If you choose to not take any action, your GST exemption will be automatically allocated to such gifts.

Alternatively, you can file a return to affirmatively opt out of automatic allocation, make a specific allocation, or just file to show the automatic allocation and track the amount of exemption used.

Plan Accordingly

While the GST tax can take a large bite of your estate, tools such as dynasty trusts are available to reduce or eliminate the taxes on generational transfers. Contact us for help navigating the complex rules and requirements.

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