Generation-Skipping Transfer Tax Overview

The Generation-Skipping Transfer Tax (GSTT or GST tax) is a federal transfer tax designed to prevent wealthy families from avoiding an entire generation of estate or gift taxes by transferring assets directly to grandchildren or more remote descendants.

Purpose: Without the GST tax, a grandparent could transfer $50 million directly to grandchildren, skipping the estate tax that would have been due when the children died. The GST tax ensures that each generation pays its share of transfer taxes.

Key Terminology

Skip Person

A skip person is the recipient of a generation-skipping transfer. A person qualifies as a skip person if they are:

1. Family Members: Assigned to a generation two or more generations below the transferor

   • Grandchildren and great-grandchildren are skip persons
   • Children are NOT skip persons (only one generation below)

2. Unrelated Persons: Anyone who is more than 37.5 years younger than the transferor

   • Example: A 70-year-old transferor gifts to a 30-year-old friend (40 years younger) = skip person

3. Trusts: A trust is a skip person if:

   • All current beneficiaries are skip persons, AND
   • No distributions can be made to non-skip persons

Non-Skip Person

A non-skip person is anyone who is NOT a skip person:

• Children of the transferor
• Spouse of the transferor
• Siblings, parents, or anyone in a higher or same generation
• Anyone less than 37.5 years younger (if unrelated)

Predeceased Ancestor Rule (Move-Up Rule)

When a parent of a potential skip person has predeceased the transferor, the grandchild "moves up" one generation and becomes a non-skip person.

Example:

• Grandfather wants to leave assets to grandson
• Grandson's parent (grandfather's child) died before grandfather
• Grandson moves up to the child's generation = NOT a skip person
• No GST tax applies to the transfer

This rule recognizes that grandchildren stepping into their deceased parent's shoes should not face additional transfer tax.

The Three Types of GST Transfers

The GST tax applies to three types of transfers, each with different characteristics:

Comparison of GST Transfer Types

1. Direct Skip

A direct skip is an outright transfer (not in trust) directly to a skip person, or a transfer to a trust where all beneficiaries are skip persons.

Characteristics:

• Most straightforward GST transfer
• Tax paid by the transferor (donor or estate)
• Tax-exclusive calculation (more favorable)

Examples:

• Grandmother writes a $500,000 check directly to grandson
• Grandfather dies and leaves $2 million to great-granddaughter in his will
• Parent creates trust where only grandchildren can receive distributions

Tax Calculation (Tax-Exclusive):

Transfer: $1,000,000 to grandchild
GST Rate: 40%
GST Tax Due: $400,000 (paid by transferor)
Amount Received: $1,000,000
Total Cost: $1,400,000

2. Taxable Termination

A taxable termination occurs when an interest in a trust terminates (usually by death, lapse of time, or distribution) and immediately after, only skip persons hold interests in the trust.

Characteristics:

• Typically occurs at death of non-skip beneficiary
• Trustee pays the tax from trust assets
• Tax-inclusive calculation (less favorable)

Example: Grandfather creates a trust:

• Income to son (non-skip) for life
• At son's death, remainder to grandson (skip person)

When son dies:

• Son's interest terminates
• Only grandson (skip person) remains
• Taxable termination occurs
• Trustee pays GST tax from trust assets

Tax Calculation (Tax-Inclusive):

Trust Value at Termination: $1,000,000
GST Tax Due: $400,000 (paid from trust)
Amount to Grandchild: $600,000
Effective Rate: 40% of total value

3. Taxable Distribution

A taxable distribution is any distribution from a trust to a skip person that is NOT a direct skip or taxable termination. This typically occurs when a trust has both skip and non-skip beneficiaries.

Characteristics:

• Occurs during ongoing trust administration
• Recipient (skip person) pays the tax
• Tax-inclusive calculation (least favorable)

Example: Grandfather creates a discretionary trust:

• Trustee may distribute to children and grandchildren
• $100,000 distribution made to grandchild

This is a taxable distribution because:

• Not a direct skip (trust has non-skip beneficiaries)
• Not a taxable termination (children's interests continue)
• Distribution to a skip person from trust

Tax Calculation (Tax-Inclusive):

Distribution: $100,000 to grandchild
GST Tax Due: $40,000 (paid by grandchild)
Net Amount: $60,000
If trust pays the tax: Additional taxable distribution!

GST Exemption and Applicable Rates

2025 GST Exemption: $13,990,000

Each person has a lifetime GST exemption equal to the estate tax exemption:

*Following the One Big Beautiful Bill Act passage in 2025

GST Tax Rate: Flat 40%

Unlike estate and gift taxes with graduated rates, the GST tax is a flat 40% rate on the taxable amount.

Inclusion Ratio and Applicable Fraction

The GST tax uses an inclusion ratio to determine what portion of a transfer is subject to GST tax.

Applicable Fraction Formula:

Applicable Fraction = GST Exemption Allocated / Value of Property Transferred

Inclusion Ratio Formula:

Inclusion Ratio = 1 - Applicable Fraction

Effective GST Tax Rate:

Effective Rate = Maximum GST Rate (40%) x Inclusion Ratio

Examples:

Fully Exempt Transfer:

• Transfer: $5,000,000
• GST Exemption Allocated: $5,000,000
• Applicable Fraction: 5,000,000 / 5,000,000 = 1.0
• Inclusion Ratio: 1 - 1.0 = 0
• Effective GST Rate: 40% x 0 = 0%

Partially Exempt Transfer:

• Transfer: $10,000,000
• GST Exemption Allocated: $5,000,000
• Applicable Fraction: 5,000,000 / 10,000,000 = 0.5
• Inclusion Ratio: 1 - 0.5 = 0.5
• Effective GST Rate: 40% x 0.5 = 20%

Non-Exempt Transfer:

• Transfer: $2,000,000
• GST Exemption Allocated: $0
• Applicable Fraction: 0 / 2,000,000 = 0
• Inclusion Ratio: 1 - 0 = 1.0
• Effective GST Rate: 40% x 1.0 = 40%

GST Planning Strategies

1. Allocate GST Exemption to Dynasty Trusts

Create trusts that can continue for multiple generations (where state law permits), maximizing the leverage of the GST exemption.

2. Avoid Taxable Distributions and Terminations

Structure trusts so that only direct skips occur, benefiting from tax-exclusive treatment.

3. Leverage Annual Exclusion Gifts

Direct skip transfers that qualify for the gift tax annual exclusion also qualify for an automatic GST exclusion (no exemption needed).

4. Use Predeceased Ancestor Rule

When a child has died, transfers to grandchildren avoid GST tax entirely.

5. Timely Allocation of Exemption

GST exemption must be allocated on a timely filed gift tax return or estate tax return. Automatic allocation rules apply to direct skips but may require opt-out for non-skip trusts.