A generation-skipping transfer (GST) occurs at the time a property is gifted or bequeathed to generations who are two or more below that transferor (Tomin & Carcone 2018). The person who is two or more generations below the transferor is defined as a skip person, could include family members or unrelated people. In the case of family members, the transferor’s grandchildren, great-nieces, and great-nephews would be assigned two generations below the transferor. The non-relative recipients who are more than 37 ½ years younger than the transferor are also treated as skip persons of GST.
The generation-skipping transfer could be subject to two potential taxes, the gift tax and the generation-skipping transfer tax (“GST tax”). And therefore, a generation-skipping transfer is very expensive. In many cases, the total cost of making a generation-skipping transfer can equal or exceed the value of the gift. In 2020, each person has an estate and gift tax exemption of $11.58 million, and a GST tax exemption of $11.58 million (IRS, 2020). Assume a grandfather gives $2 million except the annual gift exclusion to his grandson, and that the gift tax and the GST tax are triggered immediately. Assume he has used both of his gift tax and GST tax exemption. The GST tax is $800,000 ($2million times 40%); the taxable gift is $2.8 million ($2million plus $800,000 GST tax) because of the GST tax that the grandfather pays is treated as a gift. Therefore, the total tax is around $1.87 million, which almost equals the value of the gift.
Given the severity of the GST tax, how to allocate the GST exemption to avoid GST tax is very important. Setting up a generation-skipping trust (“GST” trust) is an efficient strategy in GST planning. Generally, the GST trust receives the transferor’s property for the benefit of the transferor’s child and grandchild. The child of the transferer will receive the income of the trust, and the grandchild will receive the remainder interest of the trust. The GST tax is not paid until the child’s interest ends, and the property is transferred to the grandchild. When a grantor allocates a GST exemption that matches the amount initially transferred into the trust, then no GST tax is due when the property is transferred to the grandchild. Keep in mind that the GST tax exemption will be automatically allocated when a property is transferred to a GST trust unless the donor elects otherwise.
For those who have used their GST tax exemptions, paying compensations to the generations through a private foundation rather than gifting the property to them would be an alternative strategy to avoid triggering both gift and GST tax.
To learn more about the Financial Planning Program at California Lutheran University contact Graduate Admission at clugrad@CalLutheran.edu or visit us at https://www.callutheran.edu/academics/graduate/financial-planning/.
Hratch J Karakachian, CPA, ESQ, is a senior adjunct faculty member in California Lutheran University School of Management. He has been teaching in the MBA in Financial Planning Program since 2013. He has taught Principles of Estate Planning, Income Tax and Strategy, Managerial Accounting and Foundations of Accounting and Finance courses.
Dr. Chia-Li Chien is a succession program director at Value Growth Institute, a succession consulting practice dedicated to helping business owners increase the equity value of their firms. Before her private consulting practice, she held several senior management positions in Fortune 500 companies. Dr. Chien is a director of the financial planning program in the School of Management at California Lutheran University. Dr. Chien is a frequent speaker about succession and retirement planning at national conferences and has published three books, including her most recent publication, “Enhancing Retirement Success Rates in the United States.” Dr. Chien serves on the boards of various national financial service associations. She holds a doctorate in financial planning and is a Certified Financial Planner (CFP®) as well as Project Management Professional (PMP®).
Jade Zhang is a graduate student at California Lutheran University expecting to graduate in July 2020. She is studying for a Master of Science in Financial Planning.
IRS. (2019). Instructions for Form 709 (2019); United States Gift (and Generation-Skipping Transfer) Tax Return. Received from: https://www.irs.gov/instructions/i709
IRS. (2019). Instructions for Form 706-GS(T) (11/2019); Generation-Skipping Transfer Tax Return for Terminations. Received from:https://www.irs.gov/instructions/i706gst
IRS. (2020). Estate tax. Received from: https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
Tomin, C., & Carcone, C. (2018). Principles of Estate Planning (3rd,ed.). P335. Erlanger, KY: The National Underwriter Company.