Generation-Skipping Transfer Tax

*Photo by Brian Lamb is licensed under CC 2.0. *

Closely related to, yet distinct from, the federal estate and gift tax is the generation-skipping transfer tax. This is a tax that specifically applies to transfers of property, whether at death or as a gift, in which two generations separate the transferor from the transferee. The most obvious example is a transfer from a grandparent to a grandchild.

Origination of the Generation-Skipping Transfer Tax

As with most complex tax schemes, after the estate tax was implemented in 1916, accountants and lawyers went to work to find loopholes and develop schemes to avoid paying the tax. One of the most popular means of avoidance was to create trusts that would benefit heirs without actually vesting them with the property. Since the heirs never actually inherited the property, the estate tax was avoided.

To use a simple example of how this scheme worked, say that an individual had a very large estate that he wanted to leave as a legacy to his descendants. If he left his estate outright to his children, an estate tax bill would be due at his death, and then when the property was passed to his grandchildren, another estate tax bill would be due, and so on. So, the estate tax would be paid multiple times on the same property.

If, however, he set up a trust for the benefit of his children with the property eventually vesting with his grandchildren, the estate tax would not be due until his grandchildren inheritted his property. Even in this simple example, however, if the estate were large enough, the estate tax would have additional bites at the apple when the grandchildren died. For this reason, trusts were often set up to benefit multiple generations before vesting.

Thus, this scheme limited the number of estate tax bills due, preventing the government from taking a large portion of the same underlying property at each generation. Indeed, for the duration of the trust’s existence, no estate tax would be due.

The government, however, eventually caught on. Unwilling to miss the chance to triple or quadruple tax the same income, in 1976 Congress put the generation-skipping transfer tax in place. (In an odd twist, the original 1976 version of the generation-skipping transfer tax was considered so complicated and convoluted, even by the federal government, that Congress retroactively repealed it and replaced it with the simpler—a relative term when dealing with the tax code—version we have today.)

Determining Applicability of the Tax

In determining the applicability of the generation-skipping transfer tax, the original transfer is evaluated to see if there is a skip of a generation. If the transfer is to a person two or more generations below the generation of the transferor or to a trust for the benefit of such a skip person, as they are generally called, with no interest belonging to a non-skip person, then the generation-skipping transfer tax is implicated. All that to say, in most circumstances, the transfer is from a grandparent to a grandchild, and so determining whether the gift is to a skip person is an easy matter.

There are three types of events that trigger the generation-skipping transfer tax:

1. A Direct Skip: A direct skip occurs when there is a transfer from the transferor to a skip person. To implicate the generation-skipping transfer tax, the transfer must be one that would otherwise be subject to the estate or gift tax.
2. Taxable Distributions: A taxable distribution occurs when there is a distribution of income or principal from a trust to a skip person for any reason other the termination of the trust. This is to prevent the tax-avoidance scheme described above. The taxable amount equals the value of the property that the transferee receives less any expenses that the transferee incurs.
3. Taxable Termination: A taxable termination occurs when a skip person receives a distribution from the trust as a result of the termination of the trust. The amount that is subject to the tax is the fair market value of the property in trust at the time of the termination.

The generation-skipping transfer tax has the same exemption amount as the estate and gift tax, and it may be allocated to any transaction in life or death that would result in a generation skip taxable event. Direct skips during the transferor’s lifetime are the first to receive an automatic allocation of the exemption, so if such an automatic allocation is not desired, the transferor must affirmatively opt out of it.

In addition, so long as the skip person is the sole beneficiary of the trust and the skip person must include the gift in his or her estate, the gift can take advantage of the annual gift exclusion amount, currently set at $14,000.

This is just a brief overview of the generation-skipping transfer tax, which can be quite complex. I will discuss addition details of the tax in a future post.

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See Also:

The Federal Estate Tax

The Federal Gift Tax