Federal Estate and Gift Taxes -- the Generation Skipping Transfers Tax

The generation-skipping transfers tax, or "GST" for short, is perhaps the hardest-hitting element of the federal wealth transfer tax system. For purposes of illustration, let's use a very simple family tree:

Grandma

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Junior

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Skippy

To begin, imagine that it's before 1976, when the first version of the GST was enacted.  (It was replaced in 1986 with the arrangement we have today.)  By virtue of his place in the family business and/or earlier gifts from Grandma, Junior is independently wealthy.  Anything that Grandma leaves to him at death will simply get added to Junior's gross estate and taxed again at Junior's passing.  What people in Grandma's position often did was to create a trust for Skippy and the other grandkids, and perhaps also later generations, and thus "skip" taxation in Junior's generation.  The trust usually could reach no farther than the grandchildren's generation because of something called the Rule Against Perpetuities, which we'll discuss another time.

As we've noted in earlier posts, one of the baseline policies of the gift and estate tax system is to tax accumulated wealth once per generation, and generation skipping transfers like these cut that down to once every other generation.  Because most people would only do this if Junior was well provided-for, these "generation-skipping trusts" were a strategy only a very very high net worth family could make use of--so that the estate and gift taxes actually fell harder on those who were wealthy enough to pay estate taxes, but not wealthy enough to play at generation skipping.

To redress this flaw and discourage generation skipping transfers, Congress enacted the GST.  The GST is imposed, in addition to the estate or gift tax, on any transfer to a "skip person."  There's a complex definition of a "skip person" in the tax code, but what it boils down to is that, in the example above, Skippy is a "skip person" if Junior is living on the date of the transfer.  If Junior dies, and then Grandma makes the transfer to Skippy, it's not a generation skipping transfer and the GST does not apply.

What makes the GST hit so hard is the rate of tax: it's equal to the highest estate tax rate then in effect.  In 1986, when the modern version of the GST entered the tax code, that top rate was 55%--so it was possible for a generation-skipping transfer to be taxed at a combined 110% (up to 55% estate/gift tax + 55% GST).  The purpose of this was not to collect a 110% tax so much as it was to make large generation-skipping transfers so uneconomical that no one would want to do them.

Well, maybe not all generation-skipping transfers.  Not wanting tax policy to interfere too much with the time-honored tradition of doting on grandchildren, Congress also provided that the GST does not apply to most annual exclusion gifts, and gave every person a $1 million GST exemption.  The exemption let each person transfer a total of $1 million to the grandkids (and other skip persons) before the GST kicked in.  (There was also a $2 million-per-grandchild temporary exemption which expired in 1989--named the "Gallo provision" in honor of the high net-worth family which "suggested" it to their Congressional representatives.)

Under the 2001 tax act ("the Bush tax cuts"), the GST exemption increased in parallel with the exemption equivalent provided by the estate and gift tax unified credit, so that it reached $3.5 million in 2009.  During the "estate tax holiday" in 2010, there was (so we thought) no GST at all.  The 2010 tax act reinstated the GST retroactive to January 1, 2010, but at a 0% rate--so if you made a generation-skipping transfer before the tax was retroactively re-imposed, you didn't get hit with a surprise tax assessment.  For 2011 and 2012, the GST exemption is $5 million.  Unless Congress acts before the end of next year, the GST exemption will "snap back" to $1 million on January 1, 2013, as part of what the media calls the "expiration" of the "Bush tax cuts."

You may think that the GST is a problem only for the super wealthy, but it can affect people of relatively modest means.  A trust for your "gray sheep" child which holds the assets for the child's life, then distributes to that child's offspring afterward, is a generation-skipping transfer that is subject to the tax unless there is sufficient GST exemption to cover it.  We'll talk about how the GST affects trust design, and some of the "work-arounds" that have been developed to counter it, in future postings.