The Generation-Skipping Transfer Tax

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The generation-skipping transfer (GST) tax is a topic that frequently causes confusion for clients and potential anxiety or concern for their lawyers, CPAs and other advisors. This article will discuss why the GST tax was enacted, some of its key terms and features, and how careful tax planning can help prudent clients navigate its complexities.

What is the GST tax?

The GST tax is a federal “transfer tax.” This means that it applies to the transfer of property from one person to another. The other key federal transfer taxes are the estate tax and the gift tax. The GST tax applies to gifts to persons who are deemed to be more than one generation younger than the transferor. This tax applies to gifts made during a lifetime or that take effect as a result of the transferor’s death. The GST tax was adopted in its current form as part of the Tax Reform Act of 1986.

The purpose of the GST tax

Congress designed the GST tax to reduce the potential for very wealthy families to bypass estate and gift taxes for generations. Specifically, the tax was designed to limit the use of long-term trusts, often called “dynasty trusts,” that allowed families to pass down significant wealth for generations with little or no federal tax. In a typical arrangement, the head of the family would establish a trust that granted meaningful, but not excessive, interests to younger beneficiaries. Under the trust terms, the younger generations may have enjoyed the right to the trust income and a right to seek discretionary distributions of principal from the trustee. However, the creators of such plans were often careful to not give the younger generations enough of an interest to subject the trust assets to estate taxes when those younger beneficiaries passed away.

GST tax rate

The GST tax imposes a flat tax on gifts and bequests above a certain amount if the gift skips one or more generations, such as occurs with gifts to grandchildren. For 2025, each transferor’s GST exemption amount is set at $13.99 million, which is equal in value to the federal gift and estate tax exemption but is treated as a separate and distinct exemption under the tax code. For clients whose lifetime or testamentary gifts to grandchildren or other skip persons exceed their available GST exemption, the resulting tax liability can be significant, with an imposing 40% GST tax on the transferred amount, in addition to any applicable gift or estate tax.

GST terms and concepts

Certain older trusts are exempt under the GST tax, meaning that the GST tax has no application to them because they predated the tax. These include a trust that became irrevocable on or before September 25, 1985, assuming no additions to principal or modifications of the trust have been made since that date.

The transferor

One key term to understand in relation to the GST tax is “transferor.” The transferor is typically the donor of a direct gift to a recipient. For gifts made through trusts, the transferor is usually the grantor or settlor of the trust. However, there are exceptions. For example, if a trust beneficiary holds a testamentary general power of appointment over the trust assets, that person becomes the GST transferor of those assets upon the power holder’s death, regardless of whether the power is exercised.

Skip person

Another important term when discussing GST tax is “skip person.” A skip person is generally someone who is two or more generations younger than the transferor.

Generation-skipping transfer

A “generation-skipping transfer” refers to any transfer made, directly or through a trust, to a skip person during the transferor’s lifetime or at death. Among the transferor’s relatives, skip persons typically include grandchildren, great-grandchildren, and great-nieces or great-nephews of the transferor or the transferor’s spouse. For unrelated individuals, a skip person is anyone born more than 37-1/2 years after the transferor. For example, if the transferor is 70 years old, a 30-year-old neighbor or partner would be considered a skip person. A “non-skip person” is simply anyone who is not a skip person.

Predeceased ancestor exception

Also important in determining skip persons is the “predeceased ancestor exception.” This GST rule provides that a person (a) who is a descendant of the transferor or the transferor’s spouse or former spouse and (b) whose parent or other ancestor was deceased at the time of a generation-skipping transfer, is “moved up” one generation for purposes of determining whether he or she is a skip person.

For example, suppose the transferor’s daughter was deceased when the grantor died and left a surviving child of her own, who is a grandchild of the transferor. Suppose that the child of the transferor’s predeceased daughter receives a postmortem distribution under the transferor’s will or revocable trust. Under the predeceased ancestor exception, that grandchild is “moved up” one generation for purposes of determining the grandchild’s GST status. Once moved up, the grandchild would be deemed to be only one generation younger than the transferor and thus would not be a skip person. Therefore, the transfer to the grandchild would not be a generation-skipping transfer.

There are two key exclusions relevant to the definition of “generation-skipping transfer.” When speaking about generation skipping trusts, these exclusions are: (1) distributions in payment of a skip person’s tuition, made directly to a qualifying educational institution and (2) payments made directly to the provider of medical services or goods for a skip person. Such transfers are not subject to the GST tax.

Allocation of GST exemption

One important part of effective GST planning involves strategic allocation of the client’s available GST exemption. The exemption amount can be “affirmatively” allocated by the taxpayer on the federal gift tax return (Form 709) if the generation-skipping transfer was made by a lifetime gift. If the generation-skipping transfer was made as a result of the transferor’s death, then the affirmative allocation would be made on the federal estate and GST tax return (Form 706) for the transferor.

A transferor’s available GST exemption can also be “automatically” allocated by operation of law pursuant to applicable federal regulations. However, certain trusts do not qualify for automatic allocation. In addition, the transferor can “elect out” of automatic allocation via the transfer tax return, presumably to save the available exemption for allocation to some other trust or gift.

Financial advisors should stay informed about recent and ongoing changes to the exemption amount. Advisors must understand how the GST exemption can be allocated to both trusts and non-trust gifts, whether affirmatively or automatically, and ensure that GST planning is well-integrated with the client’s overall estate strategy. Additionally, clients of substantial means and their advisors should take care to securely and permanently archive all transfer tax returns (Forms 709 and 706), along with any related correspondence and documentation concerning generation-skipping transfers, the returns or GST exemption allocations.

Conclusion

Navigating the GST tax landscape requires careful attention and informed decision-making. The GST rules are among the most intricate provisions in the Internal Revenue Code and accompanying IRS regulations. Proceeding without expert guidance can lead to significant financial and legal consequences. However, with experienced advice and a strategic approach, clients can successfully manage the complexities of GST taxation. As always, proceed with diligence and care, and know that our Fifth Third Private Bank team is here to support you. Our team of knowledgeable professionals is committed to guiding you through these complexities with confidence and clarity.

For more information, contact your Fifth Third Private Bank Advisor.