How Does the Generation-Skipping Transfer Tax Work?

The Generation-Skipping Transfer Tax (GSTT) is a federal tax designed to ensure that substantial wealth transferred across multiple generations is subject to taxation. It serves as an additional layer of tax, applied beyond federal estate or gift taxes, to prevent the avoidance of transfer taxes by directing assets to beneficiaries several generations removed from the original transferor.

Defining the Generation-Skipping Transfer Tax

The Generation-Skipping Transfer Tax (GSTT) is a federal levy on transfers of property to individuals who are two or more generations younger than the person making the transfer. It prevents families from circumventing estate and gift taxes that would ordinarily apply at each generational level. Without the GSTT, wealth could bypass generations, avoiding successive estate taxes.

Key terms define the GSTT. The “transferor” is the individual who makes the gift or leaves the inheritance. The “transferee” is the person or entity receiving the gift or inheritance. A “skip person” is a beneficiary who is either a lineal descendant two or more generations younger than the transferor, such as a grandchild, or an unrelated individual who is at least 37.5 years younger than the transferor. A trust can also be a skip person if all its beneficiaries are skip persons.

A “non-skip person” is any individual or entity that does not meet the definition of a skip person, such as the transferor’s children or an unrelated individual less than 37.5 years younger. Transfers to non-skip persons are generally not subject to the GSTT, though they may still be subject to federal gift or estate taxes.

Types of Generation-Skipping Transfers

The Generation-Skipping Transfer Tax (GSTT) can be triggered by three types of transfers. A “direct skip” occurs when property is transferred directly to a skip person and is simultaneously subject to either federal gift tax (for lifetime transfers) or federal estate tax (for transfers at death). This is an immediate transfer, such as a grandparent gifting money directly to a grandchild. For direct skips, the transferor or their estate is responsible for paying the GSTT.

A “taxable distribution” involves any distribution of income or principal from a trust to a skip person, provided it is not already classified as a direct skip or a taxable termination. This happens after assets have been placed into a trust and are subsequently distributed to a skip person beneficiary. In the case of a taxable distribution, the recipient, or transferee, is generally responsible for paying the GSTT.

A “taxable termination” arises when an interest in property held in a trust ends, and immediately after that termination, only skip persons have an interest in the property. This often occurs when a non-skip person’s interest in a trust ceases, perhaps due to death, and the remaining trust assets then pass to skip persons. For taxable terminations, the trustee of the trust is responsible for remitting the GSTT.

Calculating the Generation-Skipping Transfer Tax

The Generation-Skipping Transfer Tax (GSTT) is calculated using a methodology that considers the transfer’s value and applicable exemption. The GSTT is imposed at a flat rate equal to the highest federal estate tax rate, which is 40 percent. The actual tax applied to a transfer is determined by multiplying this rate by an “inclusion ratio.”

The inclusion ratio is a fraction that indicates the portion of the transfer subject to the GSTT. A ratio of 0 means the transfer is fully exempt from the tax, while a ratio of 1 signifies that the entire transfer is subject to the full 40 percent rate. Ratios between 0 and 1 indicate partial taxation. This ratio is calculated using the amount of the GSTT exemption allocated to the transfer relative to the value of the property transferred.

Individuals are provided a unified GSTT exemption amount, which aligns with the federal estate and gift tax exemption. This exemption amount is adjusted annually for inflation. A transferor can strategically allocate this exemption to transfers made during their lifetime or at death to reduce or eliminate the inclusion ratio, thereby shielding assets from the GSTT. Once allocated, the exemption reduces the taxable portion of the transfer.

Beyond the lifetime exemption, certain direct skips may also qualify for an annual exclusion from GSTT. This annual exclusion, which is adjusted for inflation, allows for a specific amount to be transferred to each skip person without incurring GSTT or using the lifetime exemption. Additionally, direct payments made for a skip person’s tuition or medical expenses directly to the educational institution or medical provider are generally excluded from both gift tax and GSTT.

Reporting and Paying the Generation-Skipping Transfer Tax

The Generation-Skipping Transfer Tax (GSTT) involves specific reporting and payment requirements, depending on the type of transfer. For direct skips, the transferor or their estate is responsible for reporting and paying the GSTT. For taxable distributions, the transferee, or the skip person receiving the distribution, is typically liable for the tax. For taxable terminations, the trustee of the trust is responsible for both reporting and paying the GSTT.

Several Internal Revenue Service (IRS) forms are used to report GSTT and allocate the GSTT exemption. Form 709, the United States Gift (and Generation-Skipping Transfer) Tax Return, is utilized for reporting lifetime direct skips and for allocating the GSTT exemption to inter vivos transfers. When transfers occur at death, Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return, is filed to report direct skips and allocate the GSTT exemption from the decedent’s estate.

Trustees have additional reporting obligations for certain generation-skipping transfers from trusts. Form 706-GS(D-1), Notification of Distribution from a Generation-Skipping Trust, is used by trustees to inform skip person beneficiaries of taxable distributions they have received. For taxable terminations, trustees file Form 706-GS(T), Generation-Skipping Transfer Tax Return for Terminations, to calculate and report the tax due.

General guidelines for filing deadlines indicate that for lifetime transfers, forms are typically due by April 15th of the year following the transfer. Transfers occurring at death are generally reported with the federal estate tax return. Failure to accurately report or timely pay the GSTT can result in the imposition of penalties and interest on the unpaid tax amount.