3 Reasons Why You Should Have Generation Skipping Transfer Tax Language in Your Trust
Generation skipping transfer tax (the “GST” tax) is yet another way the government tries to generate revenue from your family upon the death of a loved one.
In other words, you have 4 different types of taxes to worry about:
the income tax - taxes you owe the government on the income (wages, dividends, interest, rents, etc.) that you make every year;
the estate tax - taxes you owe the government if your estate is above a certain threshold (in Massachusetts, if your estate is worth more than $1 million, then the entire estate is taxable after the surviving spouse dies without proper estate planning in place) - life insurance proceeds are generally includable for estate tax purposes;
the gift tax - which is a tax owed at the federal level (and some states) for gifts exceeding $16,000 per year per donee (as of 2022) - excess gifts are subtracted from the federal exemption threshold;
then, finally, you have the Generation Skipping Transfer (GST) tax, which is an additional tax placed on transfers between you and your grandchildren (or persons unrelated to you that are 37.5 years younger than you/the donor)
Keep in mind that states vary on the type of taxes they impose on their residents.
Massachusetts doesn’t have a state level gift tax, but it does have an estate tax and reduces the estate tax exemption for gifts made over 16k each year per donee. In other words, if you gifted your grandchild (or anyone other than your spouse) 200k in a single year (without gift splitting), then you would have effectively reduced your Massachusetts estate tax exemption from $1 million to 816,000. Thereby increasing the estate tax you would pay in Massachusetts assuming you are over the $816,000 threshold at the time of your death.
Why did the government create this additional GST Tax?
Because a bunch of wealthy families realized that if they create a trust for the benefit of their children, then they (the parents/donors) could give that child the ability to benefit from the property and then the child could appoint that property to future generations (through something called a limited power of appointment), without having the property ever be considered part of the child’s estate for estate tax purposes.
In other words, rich people figured out that if you create a trust that avoids the child’s estate, then they (the parents) effectively saved their family’s wealth from being double-taxed - once at the parent’s death and then again at their child’s death (preserving more wealth for the benefits of grandchildren and future generations to come).
The government didn’t like this loophole, so in 1976 they enacted the Generation Skipping Transfer Tax to make sure that the government gets their full cut on transfers that are intended to skip generations - hence the name generation skipping transfer tax.
So, why is the GST tax relevant to your trust? And why don’t you remember it being an issue or concern when you were doing your estate planning? And why do you need to make sure GST tax provisions are in your trust now?
That’s a great question, so here are the four reasons why you should have GST tax language in your trust:
Potential Sunset of High Federal GST Tax Exemption
In 2017, the Tax Cuts and Jobs Act was signed into law and became effective in 2018. So, if you had created a trust between now and 2018, then you were dealing with a federal exemption amount of over $10 million for a single person or $20 million for a married couple, adjusting for inflation. As of this writing in 2022, that figure is $12.06 million for a single person or over $24 million for a married couple.
With such high federal exemption thresholds, it's said that only 0.15% of estates currently need to file a federal estate tax return and only .07% have a federal estate tax due. Now that could be partly because of advanced estate planning techniques, but the idea here is that virtually 99.93% of households seem to not be impacted directly by federal estate taxes at this point in time because the federal threshold is so high.
How does this tie into the GST tax?
The GST tax is benchmarked to the federal estate tax exemption amount. So when I said you have about $12 million exemption per person, that means you could give $12 million to your grandchildren and not have to worry about the GST tax (if allocated correctly).
But here’s the GST Tax problem.
That federal exemption rate is scheduled to “sunset” or be cut in half in 2026. This means that the federal exemption amount of $12 million will look closer to $6 million at that point in time.
2. Potential Increase in Net Worth
Now you might be thinking “hah!” I still have nowhere near that amount of money or assets at this moment, so this is still all irrelevant to me - you may be right or you may be dead wrong.
I was speaking to a client the other week who has about $2 million in assets. But when he spoke with his financial advisor and did some calculations, he realized that based on his spending habits and investment performance that he could have somewhere between $8-10 million by the time he dies.
In other words, if your house is now worth double what it was 5 years ago (thanks to this crazy housing market) and if your investment portfolio has also ballooned to push you into millionaire status, then it’s not crazy to think that you could be well within the federal estate tax and generation skipping transfer tax threshold at the time when you are expected to transition your wealth to you children and grandchildren.
And that’s just the 2026 sunset that would cut the federal exemption in half. Historically, even the $6 million per person GST tax exemption is high, meaning it’s possible (and there have been talks) that legislation may cut the federal exemption (which means the GST tax exemption) even further to about $3.5 million per person.
So if you are reading this and have a good investment portfolio and/or own a few investment properties, then it is certainly possible that Generation Skipping Transfer Tax could be applicable to your family’s situation in the not too distant future.
3. The Extreme Tax Liability of the Generation Skipping Transfer (GST) Tax
The thing that boggles my mind the most about the Generation Skipping Transfer Tax is how brutal the tax liability is if you fall into its grasp.
To show you an extreme example: If you were to leave $1 million at death to your grandchild (known as a direct skip), but had already exceeded your GST tax exemption amount because of improper or inadequate estate planning, then you would be paying 40% on that $1 million in GST tax - so $400,000 in additional taxes, and then that 400,000 in GST tax would still be included in your estate for estate tax purposes. So you are being taxed twice on the same amount of money at 40% each. In other words, that $1 million gift could have just cost you more than $800,000 in taxes!
As crazy as that sounds, that’s the government's way of making sure you don’t try to bypass their tax scheme.
But here’s the good news, the government isn’t all that bad - they do allow you an automatic GST tax allocation that can alleviate many of the problems.The important thing is to make sure that the allocation is being utilized correctly, which is why you need to make sure the GST tax language is properly included in your trust to ensure that gifts to your grandchildren do not incur that ridiculous double taxation example mentioned above.
The Solution to your Generation Skipping Transfer Tax Problems
If done correctly, you don’t have to worry about the government taking 80% of the gift that you intended to go to your loved ones. All of this inadvertent tax can be avoided by just having the right language in your trust stating how the personal representative should allocate the GST tax exemption accordingly.
But what are your other options to make sure there is no estate tax on gifts you give to your grandchildren or grandnieces and grandnephews?
Irrevocable Grandchildren’s Trust - you could set up an irrevocable trust for each of your grandchildren and give up to $16,000 per year per donor. So, for example, if you and your spouse gift-split then you could gift $32,000 (or the equivalent of that amount) to each of your grandchildren’s trust each year. If you have five grandchildren, then that’s $160,000 that you shielded from estate and GST taxes for each year you do the gifting program.
You’ll notice I said each grandchild’s trust because the trusts must be structured as individual beneficiary trusts in order to apply for the annual exclusion exemption. DON’T DO A POT TRUST with multiple beneficiaries - it doesn’t work for GST tax purposes.529 College Savings Plans - an even easier way to do an annual gifting program would be to set up 529’s for each of your grandchildren. You may do the same $16,000 per year as you would with the trusts or you could “front load” the plan by giving up to 5 years worth of gifts in the first year - so for a married couple they could gift split 320,000 to each grandchild’s 529 plan in year 1.
A few things to keep in mind: (a) 529’s have limited investment options and must be used for qualified education expenses to avoid penalty, (b) you cannot have the same restrictions or discretion as you would with a trust, (c) while this works great for 200-300k, after that you risk overfunding the 529 plan, and (d) if you do the front load option, you must remember that you cannot give another 16k to each grandchild until the 5 years has passed (because the front-load option is letting you take advantage of 5 years of gifting on the front end).Qualified Expenses - Medical and Tuition- the government lets you make certain direct gift payments on behalf of your grandchildren without incurring gift or GST tax penalties. This is known as the 2503 exceptions and means that you can pay your grandchildren tuition directly to the qualifying institution on behalf of the grandchild or pay medical bills (that are not reimbursed through insurance) on behalf of your grandchild. So long as the payments are direct and fall within the definition of qualifying under the above-referenced statute, you could shield hundreds of thousands of dollars from taxes. This works for most school grades (there’s a gray area for pre-k) so whether your grandchildren are in primary, secondary, undergraduate, or graduate school - that’s hundreds of thousands of dollars (on top of the annual exclusion) that you can shield from potential GST and estate taxes. As of the time of this writing, the average tuition for post-secondary education is almost $50,000 per year in Massachusetts.
If you are interested in updating your estate plan or considering whether you should be setting up a trust for your children or grandchildren, then give me a call at 781 202 6368, email jlento@perennialtrust.com, or click here to schedule your free personal consultation.
I’m always happy to help,
Joseph M. Lento, J.D.
Your Local Estate Planning Attorney
www.PerennialEstatePlanning.com
477 Main Street
Stoneham, MA 02180
Other helpful sources:
https://www.theretirementgroup.com/blog/generation-skipping-transfer-tax
Slide 45 of PPT Titled “Preliminary Matters and Draft the Will 2022” - Burnett & Sherer LLC (Author Colin O. Sherer, Esq., April 4, 2022. - From MCLE Website posted on 4/4/2022
