Tax Implications of Generation Skipping

Tax Professionals' Resource
August 20, 2012 — 1,800 views  
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Generation skipping occurs when individuals looking to avoid paying estate taxes on property that is passed down, opt instead to skip a generation to a grandchild or great-nephew. To dissuade individuals from doing so, the IRS imposed a federal transfer tax known as the generation-skipping transfer tax (GSTT). While this particular form of taxation has a reputation among accountants and estate planners as being particularly treacherous and complicated, the reality of the situation is that the tax can be extremely straightforward. Here are some of the tax implications of skipping generations and a few planning techniques that can be adopted to help simplify the entire process.

According to the Journal of Accountancy, the GSTT is a simplified version of a tax that was originally instituted by Congress in 1976 as a means "to remedy the perceived abuse of using a trust to benefit several generations while avoiding Federal Estate Tax during the term of the trust." Wealthy families were exploiting loopholes by creating life estates in their assets for kids, grandkids and subsequent generations. Since life estates were exempt from federal estate taxes, substantial amounts of wealth could be moved around and kept within families without government interference. Such abuse eventually led to the creation of the modern-day GSTT.

The GSTT comes into play when a donor bequeaths assets to a "skip person" by avoiding younger generations. A "skip person" is related to the transferor by blood, marriage or adoption. According to The PNC Financial Services Group, in such a situation, the GSTT is implemented as a flat tax rate equal to the highest estate tax that is in effect at the time of the generation-skipping transfer. Additionally, some states impose their own GSTT that is different from the federal rate.

Some tricks that estate planners and accountants can recommend to their clients regarding the GSTT focus on the specifics of allocations. The Journal of Accountancy advises electing out of an automatic allocation of the GSTT exemption to direct skips. By paying the applicable GSTT, clients can preserve the exemption for the trust's future taxable distributions or termination. In addition, making a late allocation is allowed. However, this could adversely affect the amount of the exemption allocated to trust assets for any transfer under a pre-established inclusion ratio. Finally, designing more complicated trusts such as qualified personal residence and grantor-retained annuity trusts could help clients avoid the GSTT altogether.

Tax Professionals' Resource