In my previous article I introduced you to the basic understanding of Generation Skipping Tax; its origins, purpose and theory. This Article will take you a little deeper into the actual tax terms and how it is applied. My hope is that after reading these articles my clients will have a working knowledge of the Generation Skipping Tax and, with as much enthusiasm a non-tax geek can have, embrace planning techniques that help reduce or even avoid the Generation Skipping Tax.
Triggering the Generation Skipping Tax
The Generation Skipping Tax (GST) is a tax on the transfer of assets from one person to a “skip person”. The most typical example is a transfer from a grandparent to a grandchild, but a skip person is anyone who is assigned to a generation that is two or more generations younger than the gift-giver’s generation. So a skip person can be defined by family relationship or by years. A generation is defined by 37.5 years. So, for example, if an 85 year old Philadelphian decided to give a cash gift to the a 5 year old grandson of her neighbor, the transfer would be to a skip person and subject to the GST.
Not all GST transfers result in payment of a tax. Congress gives everyone a certain dollar amount of GST gifts that can be made either during lifetime or at death that are free from payment of tax. This amount changes given Congress’ whims. As this Article is being written, the exemption amount from the GST was $3.5 million ins 2009, was $5 million in 2011, is $5.12 million in 2012 and goes down to $1 million in 2013. The GST exemption is a moving target. Each GST gift reduces the amount of exemption and what remains at death can be applied to assets passing through the deceased’s Will or other transfer to skip persons. If the total gifts exceed the exemption, then the gift giver must begin paying the tax.
Transfers Subject to the Generation Skipping Tax
Three types of transfers are subject to the Generation Skipping Tax
1. Direct Skips
- Direct Skip Type 1: A gift made directly to a skip person either during life or at death. This would also include transfers to UTMA accounts and 529 Plans. This is the classic example of a GST Transfer, when a grandparent does not give money to his child, but instead simply writes a check to the grandchild, or the grandparent’s will “skips” the child and instead gives money directly to a grandchild.
- Direct Skip Type 2: A gift made to a trust when all the beneficiaries of the trust are skip persons.
2. Taxable Terminations: A typical Estate Planning technique involves transferring assets to an irrevocable trust for children and their descendants. As long as at least one beneficiary is a non-skip person (your child) there is no tax-triggering event, as it is possible that all trust assets will end up with the child. A transfer to this trust is called an indirect skip. A taxable termination occurs when all non-skip person interests end (e.g., your child dies), and the only remaining interests are those of skip persons (your grandchildren).
3. Taxable Distribution: A taxable distribution occurs when a transfer is made from a trust to a skip person that is not caused by a taxable termination or direct skip. For example, you form a trust for your children and their descendants and make a gift to the trust (indirect skip). Later, the trustee distributes income outright not to the child, but to a grandchild. That transfer is a taxable distribution to a skip person, subject to the GST.
Generation Skipping Tax Rates
As of the date of this article a transfer in excess of the exemption amount would be subject to a 35% tax in 2012, but in 2013 the rates are scheduled to reach a top rate of 55%.
The Generation Skipping Tax Is “In Addition”
Remember that the purpose of the GST is to stop people from “skipping” a tax generation. The end result being that if you make a gift that is subject to the Gift Tax to a skip person, you pay the Gift Tax and the Generation Skipping Tax (the same result if the gift giver had died, Estate Tax and GST tax are due). The result being that a tax is paid to the IRS at the time of the gift as if you had made the gift to your child, then the child died and the tax was paid once again as if your child actually owned the amount gifted and had no exemption. The result being that the gift giver usually decides not to make a GST transfer and instead gives the gift to the child paying only the Gift Tax. This effectively ends the “loophole” of giving gifts to grandchildren whose purposes where only to avoid Estate or Gift Taxes….but there are planning opportunities! Those Clever Estate Planning Lawyers are always thinking. The next article will focus on some of those techniques.