Most Americans don’t need to worry about the federal estate tax, but those who do face a tax rate of 40%. That’s a big hit, and one that prompts the wealthy to use a variety of estate planning tools to minimize their tax liability. A generation-skipping trust, also known as a GST trust or dynasty trust, is used to allow an individual to pass assets to grandchildren or younger heirs. There is a generation-skipping transfer tax, but if a GST is set up properly, it can help minimize or avoid this tax liability.
The Motley Fool’s recent article, “Do You Need a Generation-Skipping Trust?,” explains what a generation-skipping trust is and how it works.
Generation-skipping trusts involve skipping a generation in planning your estate. Most people leave their assets to a surviving spouse, and then to their children. In generation-skipping trust, assets go directly to grandchildren, great-grandchildren, or other young descendants, who are known collectively as "skip persons."
The simplest generation-skipping trust is one that involves just grandchildren as the eligible beneficiaries, but a common generation-skipping trust involves multiple generations of beneficiaries. It can take years or even decades before grandchildren and other skip persons become eligible to receive trust distributions.
Generation-skipping trusts go through a second level of taxes beyond gift and estate taxes. The 40% tax rate is applied in addition to any regular estate taxes to ensure that the assets see two rounds of taxation as they go down two or more generations. This is consistent with what would happen if the assets were first given to children and then passed to grandchildren at the child's death. Your estate planning attorney can structure a generation-skipping trust to make use of the lifetime exemption that applies to the generation-skipping transfer tax.
You can fund a generation-skipping trust with up to $5.45 million and allocate your lifetime exemption to the trust to avoid future GST tax liability. Once the trust is funded and the exemption applied, any future appreciation in trust assets is allocated to the trust beneficiaries directly. If it’s an irrevocable trust, you won't have to pay GST tax even if the value of the trust assets increase after your gift is complete.
Along with the lifetime exemption, you can make annual exclusion gifts to skip persons without incurring the GST tax. The maximum annual gift is $14,000, and gifts can be made to as many different grandchildren, great-grandchildren or others as you wish.
The extreme complexities involved with GSTs, the taxes that accompany them and how the GST works with the rest of your estate plan means that their use requires an experienced and skilled trusts and estate planning attorney to set them up correctly.
Reference: Motley Fool (August 17, 2016) “Do You Need a Generation-Skipping Trust?”