Generation-Skipping Transfer Planning

The generation-skipping transfer (GST) tax is a federal tax imposed on transfers to persons who are two or more generations below the transferor. This tax exists to prevent wealthy families from avoiding estate tax at each generation by transferring assets directly to grandchildren or more remote descendants. Understanding and properly utilizing the GST exemption is essential for multigenerational wealth planning.

The Purpose of the GST Tax

Without the GST tax, a grandparent could transfer $20 million directly to grandchildren, avoiding estate tax that would otherwise apply when the children's generation dies. The GST tax closes this gap by imposing a flat 40% tax on such transfers, in addition to any gift or estate tax that may apply.

The GST tax applies to three types of transfers:

1. Direct Skips: Outright transfers to skip persons (gift or bequest directly to grandchild)
2. Taxable Distributions: Distributions from a trust to skip persons
3. Taxable Terminations: When a trust's interest terminates and skip persons become the remaining beneficiaries

Who Is a Skip Person?

A skip person is someone who is:

• Two or more generations below the transferor, OR
• An unrelated individual more than 37.5 years younger than the transferor

Generation Assignment Rules:

For family members, generations are determined by family relationship:

• Grandchildren are skip persons (two generations below)
• Great-grandchildren are skip persons (three generations below)
• Nieces and nephews are not skip persons (same generation as children)

For non-family members, generations are assigned by age difference from the transferor:

• 0-12.5 years younger: Same generation
• 12.5-37.5 years younger: One generation below
• 37.5-62.5 years younger: Two generations below (skip person)

Predeceased Parent Exception:

If a grandchild's parent (the transferor's child) is deceased at the time of transfer, the grandchild moves up one generation and is no longer a skip person. This prevents double taxation when the natural chain of inheritance is broken.

The GST Exemption

Each individual has a GST exemption that can be allocated to transfers to skip persons, shielding those transfers from the 40% GST tax.

2024 GST Exemption: $13.61 million per person

This amount equals the estate and gift tax exemption but operates independently. A person could use their entire $13.61 million estate tax exemption for transfers to children and separately use their entire $13.61 million GST exemption for transfers to grandchildren.

Key Differences from Estate Tax Exemption:

• GST exemption is not portable between spouses
• GST exemption allocation is irrevocable once made
• GST exemption can be allocated to trusts, not just direct transfers
• Unused GST exemption is lost at death

Allocating GST Exemption

GST exemption can be allocated to:

1. Direct gifts or bequests to grandchildren
2. Trusts that may benefit skip persons
3. Life insurance policies held in trust for grandchildren

Automatic Allocation Rules:

The tax code provides automatic allocation of GST exemption to certain transfers:

• Direct skips automatically receive GST exemption allocation
• Transfers to trusts meeting certain requirements (GST trusts) receive automatic allocation
• Taxpayers can elect out of automatic allocation on Form 709

Inclusion Ratio:

When GST exemption is allocated to a trust, the trust receives an inclusion ratio:

• Inclusion ratio of 0: Fully exempt from GST tax
• Inclusion ratio of 1: Fully subject to GST tax
• Inclusion ratio between 0 and 1: Partially exempt

Inclusion ratio = 1 - (GST exemption allocated ÷ value of property transferred)

For planning purposes, it is generally preferable to have trusts with inclusion ratios of either 0 or 1, not mixed ratios.

Dynasty Trusts

A dynasty trust is a long-term or perpetual trust designed to hold assets for multiple generations while avoiding estate tax at each generation. The trust is structured so that assets never become part of a beneficiary's taxable estate.

How Dynasty Trusts Work:

1. Grantor funds trust with assets up to GST exemption amount
2. GST exemption is allocated to make inclusion ratio zero
3. Trust provides for children, grandchildren, and more remote descendants
4. Trustee has discretion over distributions (prevents estate inclusion)
5. Assets remain in trust, potentially perpetually, avoiding estate tax at each generation

State Law Considerations:

Traditional trust law limited trusts to approximately 90 years under the Rule Against Perpetuities. Many states have now abolished or significantly extended this rule:

• No limit (perpetual trusts permitted): Alaska, Delaware, Idaho, Nevada, New Hampshire, South Dakota, Wyoming, and others
• Extended terms (360-1,000 years): Colorado, Florida, Tennessee, Utah, and others
• Traditional rule (~90 years): Most remaining states

Establishing a dynasty trust in a favorable jurisdiction allows the GST-exempt trust to continue for many generations, with compounding growth sheltered from transfer taxes.

Example of Tax Savings:

$13.61 million in a dynasty trust growing at 6% annually:

• After 30 years: $78.2 million
• After 60 years: $449.5 million
• After 90 years: $2.58 billion

If these assets were instead distributed outright at each generation and subject to 40% estate tax every 30 years:

• After 30 years: $78.2 million → $46.9 million (after tax)
• After 60 years: $269.7 million → $161.8 million (after tax)
• After 90 years: $930.2 million → $558.1 million (after tax)

The dynasty trust preserves $2.58 billion versus $558 million with generational estate taxes—a difference of over $2 billion.

Worked Example: $20 Million Trust for Grandchildren

Background:

William and Eleanor Harrison have three children and eight grandchildren. They have an estate of $50 million and want to establish a trust primarily for their grandchildren's benefit while allowing distributions to children if needed.

Structure:

Each spouse creates a separate GST-exempt trust with the following terms:

• Initial funding: $10,000,000 each ($20,000,000 total)
• Primary beneficiaries: Eight grandchildren
• Secondary beneficiaries: Three children
• Trustee: Professional trustee with family advisor
• Jurisdiction: South Dakota (no state income tax, perpetual trusts allowed)
• Distribution standard: Health, education, maintenance, and support, plus discretionary distributions

GST Exemption Allocation:

William allocates $10,000,000 of his $13.61 million GST exemption to his trust. Eleanor allocates $10,000,000 of her $13.61 million GST exemption to her trust.

Each trust has an inclusion ratio of 0: Inclusion ratio = 1 - ($10,000,000 ÷ $10,000,000) = 0

Both trusts are fully exempt from GST tax.

Gift Tax Treatment:

Each $10,000,000 transfer is a taxable gift. William uses $10,000,000 of his $13.61 million gift tax exemption. Eleanor does the same. No gift tax is due.

Tax Treatment Over Time:

Trust Administration:

The trustee makes discretionary distributions to grandchildren for:

• College education expenses
• Down payments on homes
• Starting businesses
• Medical emergencies

Assuming $200,000 average annual distributions per grandchild ($1,600,000 total annual distributions), the trust continues to grow despite distributions.

Outcome at Year 30:

Trust value: Approximately $115 million (after distributions) Distributions made: $48 million total Estate tax saved (versus outright gifts with estate tax at each death): Approximately $46 million

Division Among Grandchildren:

At some future date, the trust could divide into eight separate trusts, one for each grandchild's line. Each subtrust remains GST-exempt and can continue for that grandchild's descendants perpetually.

GST Planning Considerations

Use It or Lose It:

Unlike the estate tax exemption (which can be ported to a surviving spouse), GST exemption is not portable. If a spouse dies without allocating their GST exemption, it is lost.

Gift Splitting:

Married couples can split gifts, allowing one spouse's gift to be treated as made half by each spouse. This allows access to both spouses' GST exemptions for a single transfer.

Late Allocation:

GST exemption can be allocated on a timely-filed gift tax return (Form 709) or on a late return. Late allocation uses the value at the time of allocation, which is disadvantageous if assets have appreciated.

Exemption Utilization Before 2026:

The current $13.61 million exemption is scheduled to decrease to approximately $7 million in 2026. Individuals considering dynasty trusts should evaluate establishing and funding trusts before this reduction.

Income Tax Considerations:

Dynasty trusts are typically structured as non-grantor trusts. They pay income tax at trust rates, which reach the top 37% bracket at only $14,450 of taxable income (2024). Distributing income to beneficiaries in lower brackets may be more tax-efficient.

Pre-Implementation Checklist

• Inventory potential skip persons (grandchildren, great-grandchildren, younger individuals)
• Calculate available GST exemption for both spouses
• Determine total amount to be transferred to dynasty trust
• Select favorable trust jurisdiction (consider perpetual trust states and state income tax)
• Engage estate planning attorney experienced in dynasty trust drafting
• Define distribution standards and trustee succession provisions
• Consider whether trust should be grantor or non-grantor for income tax purposes
• Evaluate trust protector provisions for future flexibility
• File Form 709 allocating GST exemption by April 15 following year of gift
• Confirm automatic allocation rules and elect out if necessary
• Coordinate with overall estate plan (use of remaining estate tax exemption)
• Review impact of potential 2026 exemption reduction
• Establish trust accounting and administration procedures
• Consider funding with life insurance to leverage exemption
• Plan for ongoing trust investment management and tax compliance