While the estate tax and gift tax capture much of the limelight, the generation-skipping transfer (GST) tax is another federal transfer tax lurking in the background that can cause surprises and at many times, confusion.
Originally enacted to prevent families from avoiding estate taxes by making gifts that skip a generation, the GST tax has significant implications for high net-worth individuals seeking to pass their wealth to their grandchildren or other beneficiaries beyond their children.
The complexity of the GST tax rules appears to know no bounds. This article highlights some of the essential considerations for advisors guiding their clients through effective use of the GST tax exemption as part of their estate planning. It also identifies a few pitfalls to consider and addresses some of the very recently proposed tax changes that may limit the use of the GST tax exemption.
A Brief History of the GST Tax
The GST tax has its roots in the evolution of the U.S. estate tax regime. Beginning with the Revenue Act of 1916, estate taxes have long been levied on transfers of wealth in the United States from one generation to the next. Prior to the introduction of the GST tax, wealthy families could utilize various planning strategies to pass assets directly to their grandchildren or more remote descendants, and therefore bypass estate taxes that would have been due if the assets had been transferred to their children first.
To address this loophole, Congress first enacted the GST tax as part of the 1976 Tax Reform Act. The GST tax portion of the 1976 Act focused on situations, for example, where a parent would place a large amount of wealth in a trust that could benefit multiple generations, avoiding an estate during the term of the trust. To limit such estate tax avoidance, the 1976 Act sought to impose a tax at the time of death of the child or grandchild, in the example above, of substantially the same size as would have been imposed had the wealth passed directly from the child to the grandchild and to the great-grandchild.
Congress later enacted the Tax Reform Act of 1986 that reworked and expanded the scope of the GST tax to ensure that wealth passing directly to “skip persons” (those two or more generations below the transferor) would be subject to tax at each generation and that certain trust distributions and terminations would also be subject to the tax.
When Does the GST Tax Apply?
Today, the GST tax, a flat tax that is equal to the highest estate tax rate (currently 40%), is imposed upon certain transfers from a “transferor” to “skip persons” and on certain transfers from trusts to skip persons, including when the trust terminates, or when distributions are made from the trust to a skip person.
Generally, a “skip person” is an individual (and certain trusts) that are two or more generations below the transferor, like a grandchild. If the recipient is not related to the transferor, the individual is considered a skip person if they are more than 37 1/2 years younger than the transferor. The term “skip person” also includes a trust if all the interests in the trust are held by skip persons.
The GST Exemption Today
Today, GST tax exemption is available to shelter certain transfers from the GST tax. The federal GST tax exemption, unlike the gift tax exemption, is separate from the federal estate tax exemption currently $13.61 million per individual ($27.22 million per married couple) in 2024, and is indexed for inflation each year.
When provisions of the Tax Cuts and Job Act (TCJA) sunset on Dec. 31, 2025, the GST tax exemption, like the estate-tax exemption, will revert to its pre-2018 levels, adjusted for inflation. Starting on Jan. 1, 2026, the GST tax exemption for individuals will be $5,000,000, adjusted for inflation, estimated to be around $7,000,000 per individual.
To benefit from use of the GST tax exemption, a transferor can use the exemption when making transfers to skip persons, like grandchildren. However, a transferor can potentially benefit multiple generations by allocating GST tax exemption to trusts where grandchildren and more remote descendants are beneficiaries. In some instances, this allocation to trusts may happen automatically under current tax rules; other times, the transferor may need to file a gift tax return to affirmatively elect to allocate GST tax exemption to a trust.
This allocation of GST tax exemption can also happen at death, automatically or by the election of the deceased transferor’s executor.
Planning Strategies Using GST Exemption
Much of the planning today with the GST tax involves effective use of the GST tax exemption. In fact, it can be argued that maximizing the use of the GST tax exemption is a cornerstone of estate-tax planning. By leveraging tools such as GST exempt trusts, individuals can transfer assets to their grandchildren and more remote descendants while minimizing or eliminating estate and GST taxes. The following provides a few planning considerations.
GST “Grandfathered” Trusts
The GST tax does not apply to transfers made under a trust that was irrevocable on or before Sept. 25, 1985. These trusts, called “grandfathered” trusts, generally are not subject to the GST tax rules except to the extent there is a transfer made from assets added to the trust after this date.
GST Exempt “Dynasty” Trusts
Unlike grandfathered trusts (which are not subject to the GST tax rules), GST exempt “dynasty” trusts are irrevocable trusts created after Sept. 25, 1985 that are typically designed to continue from generation-to-generation, free from estate and GST taxes. To accomplish this, because these trusts are subject to the GST tax rules, the transferor (or the transferor’s executor following the transferor’s death) will allocate all or a portion of their GST tax exemption to the trust.
Ideally, trusts will be completely exempt from GST tax or fully subject to GST tax. However, it is possible that a trust can end up with both GST exempt and non-exempt assets. Action is normally taken to avoid such a situation. For example, a trust can be divided to create two new trusts, one being fully GST exempt and the other being a fully non-exempt trust. The benefit creating these two new trusts is it helps avoid payment of unnecessary GST tax — and complex reporting — when distributions are made to skip persons. This is especially helpful if both skip persons and non-skip persons are beneficiaries.
Late Allocation of GST Exemption
Sometimes a non-exempt trust could benefit from having a GST tax exemption allocated to it long after the trust was created. This is especially true if the transferor hasn’t used all of their remaining GST tax exemption on prior transfers. For example, a parent may have created a trust years ago without allocating the full $13.61 million GST tax exemption to it. However, today that parent could allocate some of their remaining GST tax exemption to the trust as a “late allocation” of GST tax exemption.
When making a late allocation, the use of GST tax exemption will be based on the value of the assets as of the date of allocation, not the date of the initial transfer. Therefore, timing of the allocation could have a significant impact on the effectiveness of the overall strategy.
Not All Annual Exclusion Gifts Are Created Equal
Leveraging the annual gift tax exclusion (currently $18,000 per recipient in 2024) can be an effective strategy for reducing the size of a person’s estate that may be subject to estate taxes in the future. However, such gifts become more complicated when the GST tax is factored in.
Like the gift tax annual exclusion that allows a transfer of assets to a recipient up to a threshold without using gift tax exemption (or causing a gift tax), there is also what is in effect a GST tax annual exclusion. The tax code generally allows for certain gifts to skip persons to be nontaxable for GST tax purposes (and therefore GST exempt) up to the extent that the gift qualifies for the gift tax annual exclusion. However, it should be noted that the GST tax annual exclusion does not always apply when the gift tax annual exclusion does.
An example
Let’s say a grandparent makes an $18,000 gift to a grandchild in 2024. Assuming no other gifts are made to that grandchild for the year, that gift will qualify for both the gift-tax annual exclusion as well as the GST-tax annual exclusion. However, if the grandparent instead makes an $18,000 gift to the grandchild in a Crummey trust (a trust designed to qualify for the gift-tax annual exclusion by providing the beneficiary certain rights of withdrawal), and that trust is designed to be a dynasty trust, the scenario changes.
While the transfer will qualify for the gift tax annual exclusion, it likely will not qualify for the GST tax annual exclusion. This is because the terms of most dynasty trusts do not meet the requirements to qualify for the GST tax annual exclusion. But a Crummey trust, can receive transfers that qualify for the gift tax annual exclusion. As a result, assuming that the grandparent has sufficient GST tax exemption available, the gift will use $18,000 of the grandparent’s remaining GST tax exemption. This situation frequently arises in the context of irrevocable life insurance trusts (ILITs) and can lead to a difference between one’s remaining GST exemption and their remaining lifetime estate/gift tax exemption.
Proposed Tax Law Changes that Impact GST Exemption
Several GST-related items are included in the Biden Administration’s Fiscal Year 2025 Budget Proposal released March 11, 2024. One such item would limit the duration of GST tax exemption. The proposal would make the GST exemption applicable only to (a) transfers and trust distributions to beneficiaries no more than two generations below the transferor, and to younger generation beneficiaries who were alive at the creation of the trust, and (b) taxable terminations occurring while any person described in (a) is a beneficiary of the trust. The proposal would apply on and after the date of enactment to all trusts subject to the GST tax, regardless of the GST exempt status of the trust on the date of enactment.
Other GST-related items under the proposal would require adjustment to the GST exempt status for certain transactions between trusts, and would consider loans from a trust to beneficiaries as distributions for GST tax purposes. Repayment of loans from trusts to grantors or their spouse would also be treated as a new contribution for GST tax purposes.
These are merely proposals. However, one must recognize that Washington is eyeing the GST tax and exemption planning as a potential source of tax revenue. As indicated in the Green Book, the proposals related to the modification of income, estate, gift and GST tax rules for creating trusts could raise an additional $24.67 billion in revenue from 2025-2029.
Conclusion
By staying informed about the GST tax rules, identifying potential GST tax issues, and helping to implement tailored strategies to minimize tax exposure, financial advisors can help their clients preserve their wealth for future generations and assist them in achieving their long-term estate planning goals.
Keith K. Grissom, Esq., LL.M. taxation, is a partner at Armstrong Teasdale LLP. He focuses his practice on tax and estate planning, closely held business succession planning and asset protection. Keith counsels both businesses and individuals on tax matters including addressing income, estate, gift and generation-skipping transfer tax issues related to estate planning and trust administration. He can be reached at kgrissom@atllp.com.
