The generation-skipping tax, also called the generation-skipping transfer tax, generally impacts families where individuals decide to leave part or all of their assets to younger individuals in the family. In most instances, the assets are left to children or grandchildren. However, this is not required. The generation-skipping tax would apply to any gifts or transfers made to other family members or unrelated individuals who are at least thirty-seven and a half years younger than the donor.
Basics Of The Generation-Skipping Tax
The generation-skipping tax gets its name because it involves estate planning that skips a generation in the family; usually, this would refer to the donor’s children. However, the assets would not follow the general path of going to the donor’s children first. Instead, they would go directly to the grandchildren or other younger beneficiaries.
As an estate planning tool, the generation-skipping strategy is employed to prevent an inheritance from being subject to estate taxes twice – once when the donor’s children assume ownership and again when their children receive the assets. By decreasing the total tax liability, the beneficiaries receive more assets.
Evolution Of The Generation-Skipping Tax
The generation-skipping tax is derived from a tax law enacted in 1976. At that time, many wealthy families were using the life estates created for each generation in their family to avoid paying the Federal Estate Tax. The 1976 version of the bill was heavily criticized, though, ultimately resulting in its repeal in 1986. Nevertheless, the generation-skipping tax was included in the 1986 Tax Reform Act, which imposed a tax equal to the highest estate tax on any generation with a $1 million exemption per taxpayer. In 1995, allowances for inflation were added along with scheduled increases of the exemption amount.
Today, the amount that can be directly transferred to grandchildren or other eligible beneficiaries without incurring the generation-skipping tax is equal to the lifetime exemption limits of federal estate and gift taxes. This amount was increased to $11.18 million in the 2018 Tax Cuts and Jobs Act. It is $11.7 million for 2021. Anything above this exemption amount will be taxed at a rate of 40%. Additionally, this exemption amount was not made permanent in the Tax Cuts and Jobs Act; it is set to revert to $5.49 million at the end of 2025, provided that Congress takes no action to extend it further or make it permanent. For married couples, the exemption amounts can be doubled.
Implications Of The Generation-Skipping Tax For Estate Planning
For families that anticipate wealth transfer that is greater than the individual exemption amounts, their estate plan may want to factor in the generation-skipping tax benefits. These benefits are especially vital for families where the children have minimal financial needs. In these instances, the federal estate tax would only be levied once rather than twice.
Many estate plans create an irrevocable generation-skipping trust to employ this strategy, which transfers the assets from the donor to the grandchildren or other eligible beneficiaries. Since the children never take title of the assets, they would not be liable to pay the otherwise applicable estate taxes. The children, or skipped generation, are able to access earnings from the trust, provided that the assets remain in the trust for the ultimate beneficiary or beneficiaries. This benefit ensures that children or others in the skipped generation will receive some income until the assets are transferred. If the value of the transferred assets to each beneficiary falls below the exemption amounts, no taxes will be assessed at the time of transfer. If the asset values exceed this amount, the excess amount will be taxed at 40% under current tax law.
When drafting an estate plan, there are a few key points about the generation-skipping tax to keep in mind.
- If you are married, the exemption amount per individual is doubled. For instance, for 2021, the exemption amount is $11.7 million. For a married couple, this means that they could bequeath up to $23.4 million without incurring the federal estate tax.
- The increase of the exemption limit related to the Tax Cuts and Jobs Act expires on December 31, 2025. On January 1, 2026, the exemption amount will revert to the permanent $5 million limit enacted in the American Taxpayer Relief Act of 2012. Because of this change, it can be very advantageous for many high-wealth individuals to engage in estate planning now since it can result in tremendous tax savings (if the $11.7 million exemption applies rather than the $5 million one) for their beneficiaries. (Note: The new tax rulesunder consideration in spring 2021 propose eliminating generation skipping tax breaks.)
- The generation-skipping tax does not apply to qualified nontaxable gifts made by the donor to beneficiaries while they are still alive. The gift tax allows individuals to give up to $15,000 per recipient per year without incurring a gift tax. Payments for tuition, medical care, or medical insurance made directly to a school, doctor, or hospital are also exempt from the gift tax and do not count toward the gift tax exemption limit of $15,000. In order to reduce the overall amount of transferred assets, donors or grantees may want to consider providing gifts to their intended beneficiaries during their lifetime.
Like many other tax concerns, the generation-skipping tax has a long history that includes many rate changes and exemption limit changes. Unfortunately, there is no way to know what the future may look like, particularly regarding anticipated changes to the rate and limits. Despite this, we do know that it is far more beneficial for many individuals to make these plans now to take advantage of the $11.7 million exemption limit since it can make a huge difference in the total tax liability of the assets.
Most individuals will fall below the exemption amounts whether they choose to skip a generation or not in their estate plan. For high net-worth families who are – or might be – over the exemption amount, however, a generation-skipping trust can be a useful tool to achieve one’s goals. These trusts can be incredibly complex and must be executed diligently to be legally binding. It is always a good idea to consult with an estate planning attorney if you want more information about the generation-skipping tax and related trusts.
