22.3 Generation-Skipping Transfer (GST) Tax: Skip Persons, Direct Skips, Exemption Allocation & Effect on Estate Planning

Why This Topic Matters

The Specialized Returns domain lists the "Effect on estate tax (e.g., generation skipping transfer tax)" under gift tax. Without the GST tax, a wealthy grandparent could leave property directly to grandchildren and skip the estate tax that would otherwise apply when the middle generation died. The GST tax closes that gap.

Key Definitions

• Transferor: The individual whose gift or bequest is subject to gift or estate tax. With a gift-splitting election, each spouse is the transferor of half.
• Skip person:
  • A relative two or more generations below the transferor (for example, a grandchild, grandniece, or grandnephew). A spouse and former spouse are always in the transferor's generation.
  • An unrelated individual more than 37½ years younger than the transferor (someone 12½ to 37½ years younger is one generation down).
  • A trust if all interests in it are held by skip persons.
• Non-skip person: Anyone who is not a skip person, such as children, nieces and nephews, and siblings.

The Predeceased Parent Exception (IRC §2651(e))

If the grandchild's parent who is the transferor's descendant (the transferor's child) is deceased at the time of the transfer, the grandchild moves up one generation and is treated as the transferor's child. A transfer to that grandchild is not a generation-skipping transfer. (The exception also applies to collateral heirs, such as a grandniece, if the transferor has no living lineal descendants.)

The Three Types of Generation-Skipping Transfers

GST Exemption and the Inclusion Ratio

• GST exemption: Each individual may allocate a GST exemption of $13,990,000 for 2025 (equal to the basic exclusion amount), $15,000,000 for 2026 under OBBBA, indexed afterward.
• Not portable: The deceased spousal unused exclusion (DSUE) applies only to estate and gift tax, not to the GST exemption. Spouses who want to use both exemptions must each allocate their own, for example through gift splitting or by having each estate fund a GST-exempt trust.
• Allocation: GST exemption is allocated on Form 709 (Schedule D) for lifetime transfers or on Form 706 (Schedule R) at death. Automatic allocation rules apply to lifetime direct skips and to certain "GST trusts," and a donor may elect out of or into automatic allocation.
• Inclusion ratio: A trust's inclusion ratio equals 1 minus the applicable fraction (exemption allocated divided by the value transferred). A trust with an inclusion ratio of 0 is fully exempt and never generates GST tax; a ratio of 1 is fully taxable.
• Tax rate: Maximum federal estate tax rate (40%) times the inclusion ratio.

Transfers That Escape GST Tax

• Direct payments of tuition or medical expenses for a grandchild (IRC §2503(e) exclusion) are also exempt from GST tax.
• Outright annual exclusion gifts to a grandchild ($19,000 for 2025) have a zero inclusion ratio. Annual exclusion gifts to a trust are exempt only if the trust is for a single grandchild and would be included in that grandchild's estate.
• Transfers covered by allocated GST exemption.
• Transfers to a grandchild whose parent is deceased (predeceased parent exception).

Worked Examples

Example 1 (direct skip covered by exemption): In 2025, Eleanor, a widow who has made no prior taxable gifts, gives $2,019,000 in cash outright to her granddaughter, whose parents are living.

1. Gift tax: $2,019,000 - $19,000 annual exclusion = $2,000,000 taxable gift, sheltered by her basic exclusion (unified credit).
2. GST: the $2,000,000 direct skip is automatically allocated $2,000,000 of her $13,990,000 GST exemption, so the inclusion ratio is 0 and no GST tax is due.
3. Form 709 is required (to report the taxable gift and the GST allocation).

Example 2 (no exemption left): If Eleanor had already used all of her GST exemption, the direct skip of $2,000,000 would incur GST tax of 40% x $2,000,000 = $800,000, paid by Eleanor, and the $800,000 GST tax she pays is treated as an additional taxable gift under IRC §2515.

Example 3 (predeceased parent): Oscar leaves $1,000,000 to his grandson Ben. Ben's father (Oscar's son) died two years before Oscar. Ben moves up a generation, so the bequest is not a direct skip and no GST exemption is needed.

Effect on Estate Planning

• Dynasty and GST-exempt trusts: Allocating GST exemption to a long-term trust shields the trust and all its growth from estate and GST tax for multiple generations (subject to state perpetuities law).
• Leveraging exemption: Allocating exemption to assets expected to appreciate (such as life insurance in an ILIT) protects the future growth at today's value.
• Coordination: A trust that benefits both children and grandchildren should be either fully exempt (inclusion ratio 0) or fully nonexempt (inclusion ratio 1); separate trusts avoid mixed ratios.
• Filing deadlines: Form 709 is due April 15 of the following year (extended with Form 4868 or Form 8892); Form 706 is due 9 months after death.