If you want to share some of your wealth with your grandchildren, great-grandchildren or even more remote generations, special planning may be required to keep generation-skipping transfer (GST) taxes to a minimum. This 40% tax applies — in addition to gift or estate taxes — to transfers that skip one or more generations.
When it comes to GST tax planning, the good news is that a significant GST tax exemption is available. It’s the same as the gift and estate tax exemption — $5.45 million for 2016. But in some cases, automatic allocation rules that apply to the exemption can lead to undesirable results if you don’t opt out of them.
When the GST tax applies
The GST tax applies, in general, to direct gifts to a skip person. A skip person is a family member more than one generation below you, subject to certain exceptions, or a nonfamily member more than 37½ years younger than you. Importantly, the GST tax doesn’t apply to direct gifts that are covered by the annual gift tax exclusion (currently, $14,000 per recipient; $28,000 for “split” gifts by married couples). But the GST tax does, potentially, apply to two types of transfers involving trusts:
Taxable terminations. Trust assets pass to a skip person (such as your grandchild) when a nonskip person (such as your child) no longer has an interest in the trust — which may, for instance, happen upon the death of the nonskip person — and the trust terminates.
Taxable distributions. Trust income or principal is distributed to a skip person.
Allocating the exemption
In some cases, in order to qualify for the GST tax exemption, you must allocate it to particular assets via an affirmative election on a timely filed gift tax return. In other cases, the exemption is allocated automatically (unless you opt out), which can lead to unwanted results if you prefer to allocate your exemption elsewhere.
The automatic allocation rules are intended to protect you against inadvertent loss of GST tax exemptions. So, for example, if you make a direct gift in excess of the annual gift tax exclusion to a grandchild or other skip person, your unused GST tax exemption is automatically applied to the gift, without the need to make an allocation on a gift tax return.
The exemption is also allocated automatically to “GST trusts.” The rules are complex, but in general a trust is considered a GST trust if there’s a possibility it will benefit your grandchildren or other skip persons in the future.
Unintended results
In many cases, the automatic allocation rules work well, ensuring that the GST tax exemption is used where it’s needed most. But in some cases the rules lead to unintended — and potentially costly — results. Here are two examples:
Example 1. You set up a trust primarily for the benefit of your children, although your grandchildren are named as contingent beneficiaries. This may be enough to trigger the automatic allocation rules, even if the possibility that your grandchildren will receive any trust assets is remote. Depending on the size of your estate, you may be better off opting out of automatic allocation and directing your exemption to gifts that are more likely to trigger GST taxes.
Example 2. You set up a trust for the benefit of your daughter during her lifetime, with the remainder passing to your grandson. You assume that the trust is a GST trust and that your exemption will automatically be allocated to it. To minimize gift taxes, however, you set up the trust to grant your daughter certain withdrawal rights. These rights cause it to not qualify as a GST trust. Unless you proactively allocate your exemption to the trust in a timely filed gift tax return, the transfer to your grandson will be subject to GST taxes.
Work with your advisor
If you wish to provide for your grandchildren or other skip persons after you’re gone, beware of GST tax traps. The rules regarding allocation of the GST tax exemption are complex, and mistakes can be costly. To avoid an unexpected tax bill, consult your estate planning advisor.
