IRC 2612: Taxable Termination, Distribution, and Direct Skip

The Generation-Skipping Transfer (GST) tax is a federal tax on wealth transfers to individuals two or more generations younger than the donor. For example, a transfer from a grandparent to a grandchild could be subject to this tax, which functions as a supplement to federal gift and estate taxes. The purpose of the GST tax is to ensure wealth is taxed at each generational level, closing a gap that might otherwise allow families to use long-term trusts to avoid taxes over several generations.

The tax applies to transfers that “skip” a generation. The individuals receiving these transfers are known as “skip persons,” while those in the generation immediately below the donor, such as children, are “non-skip persons.” Internal Revenue Code Section 2612 defines three types of events that trigger the GST tax: taxable terminations, taxable distributions, and direct skips.

Defining a Taxable Termination

A taxable termination occurs when an interest in a trust ends, and as a result, the only remaining beneficiaries are skip persons. The termination of the interest can happen for various reasons, such as the lapse of time or the release of a power, but most commonly it is due to the death of a beneficiary. For the GST tax to apply, the trust property must not be subject to federal estate tax in the deceased beneficiary’s estate.

An “interest in property held in trust” refers to a current right to receive income or principal from the trust. For example, a grandparent establishes a trust that pays all income to their child for life. Upon the child’s death, the remaining assets are to be distributed to the grandchildren. The death of the child is a taxable termination because their interest ceases, and the property now passes to skip persons.

An exception exists to this rule. A taxable termination does not occur if, immediately after one beneficiary’s interest ends, a non-skip person still holds an interest in the trust. If a trust was set up for two children and one dies, the taxable event is postponed until the surviving child’s interest has also ended.

Understanding Taxable Distributions

A taxable distribution is any payment of income or principal from a trust directly to a skip person. This event is characterized by an active distribution from the trust to a beneficiary, such as a grandchild, while a non-skip person, like a child, is still a potential beneficiary of the trust. For instance, imagine a trust established by a grandparent for both their child and grandchild. If the trustee distributes $50,000 to the grandchild for a down payment on a house, that payment is a taxable distribution.

This rule prevents trusts from circumventing the GST tax by making periodic payments to younger generations while keeping the trust active for the older generation. If the trust agreement provides that the trust will pay the GST tax on behalf of the beneficiary, the amount of tax paid is considered an additional taxable distribution. The logic is that the trust’s payment of the tax provides an additional economic benefit to the skip person, so both the original distribution and the tax payment are combined to determine the total transfer amount.

Explaining Direct Skips

A direct skip is a transfer of property or money made directly to a skip person that is also subject to federal gift or estate tax. Unlike taxable terminations or distributions that involve trusts over time, a direct skip is an immediate and outright transfer. Examples include a grandparent giving a gift of $1 million in cash directly to a grandchild or leaving a specific bequest of property to a great-grandchild in their will.

A transfer to a trust can also be classified as a direct skip if all the individuals who have an interest in the trust are skip persons. For instance, if a grandparent transfers assets into a trust where the only beneficiaries are their grandchildren, the initial funding of that trust is a direct skip.

An exception is the “predeceased ancestor rule” under Internal Revenue Code Section 2651. If a transfer is made to a grandchild whose parent (the transferor’s child) is already deceased at the time of the transfer, the grandchild is moved up a generation for GST tax purposes. Consequently, the transfer to that grandchild is not considered a direct skip.

The Generation-Skipping Transfer Exemption

Each individual has a lifetime Generation-Skipping Transfer (GST) exemption to shield transfers from the tax. For 2025, the federal GST exemption is $13.99 million per person. This amount is indexed for inflation and is scheduled to be reduced by about half at the end of 2025 unless Congress acts to change the law. Any transfers made in excess of this exemption are taxed at a flat rate of 40%.

The exemption must be allocated by the transferor. A transferor can choose how to apply their exemption through what is known as affirmative allocation. This is done by reporting a transfer on a federal gift tax return (Form 709) or an estate tax return (Form 706) and explicitly stating how much of the GST exemption should be allocated to that specific transfer.

If a transferor does not affirmatively allocate their exemption on a timely filed tax return, automatic allocation rules apply by default. These rules generally allocate the exemption first to any direct skips made during the year. Any remaining exemption is then automatically allocated to trusts from which a taxable distribution or termination might occur. The purpose of these default rules is to prevent taxpayers from inadvertently failing to use their exemption.

The allocation of the GST exemption to a trust determines its “inclusion ratio,” which dictates what portion of the trust’s assets will be subject to the GST tax. If enough exemption is allocated to a transfer to a trust to make the inclusion ratio zero, the trust becomes fully exempt from the GST tax. This means that all future distributions from that trust to skip persons, regardless of how much the assets have grown, will be free of GST tax.

Determining the Taxable Amount and Liability

After a generation-skipping transfer occurs, the taxable amount must be calculated and the responsible party must pay the tax. The rules for these aspects differ depending on the type of transfer.

For a taxable distribution, the taxable amount is the value of the property received by the beneficiary, less any expenses incurred by the beneficiary in connection with the tax determination. The legal liability for paying the GST tax falls directly on the recipient skip person. If the trust pays the tax on behalf of the beneficiary, that tax payment is treated as an additional taxable distribution.

In the case of a taxable termination, the taxable amount is the value of all property held in the trust at the time of the termination event. The legal liability for paying the tax in a taxable termination rests with the trustee, and the tax is paid from the trust’s assets.

For a direct skip, the taxable amount is the value of the property received by the transferee. The liability for paying the tax falls on the person making the transfer—the donor in the case of a lifetime gift or the executor of the estate for a transfer at death. This makes direct skips “tax-exclusive,” as the tax is paid by the transferor, while taxable distributions and terminations are “tax-inclusive,” as the tax is paid from the funds being transferred.