When it comes to federal taxes, most people are very aware of the federal income tax because, if they earn a paycheck, they cannot help but notice the deductions each pay period. But there are lesser-known taxes such as the capital gains tax (a form of income tax), the estate tax, the gift tax, and the generation-skipping transfer tax, which is perhaps the least-known tax scheme. Giving to the grandkids will require generation-skipping (GST) tax planning.
The generation-skipping transfer (GST) tax is a federal tax on an individual’s property transfer to a person at least two generations below the individual. The IRS imposes GST tax whether the transfer occurs as a gift during the grandparent’s lifetime or at the grandparent’s death through inheritance by will or trust. Generally, GST tax applies to gifts made by an individual to grandchildren or descendants of the grandchildren. Gifts made by an individual to unrelated persons other than the individual’s spouse can also trigger GST tax. The regulations call the recipients who would trigger GST tax "skip persons.”
Congress introduced the GST tax in the mid-1970s to close a loophole that allowed wealthy individuals to evade inheritance taxes by transferring property directly to grandchildren and skipping the grandchildren’s parents. This avoided estate taxes at the first generation.
While the GST tax follows the gift and estate tax lifetime exemption limits, the GST tax is a separate tax that applies alongside and in addition to any gift and estate taxes.
The GST tax typically applies when the amount transferred to skip persons (persons thirty-seven-and-a-half years younger than the transferor) is greater than the transferor’s lifetime GST tax exemption, which is $12.06 million in 2022. All lifetime gifts and transfers made at death by will or trust count against the exemption amount. For example, if you give $100,000 to each of your five grandchildren in 2022, then the IRS counts that $500,000 against your lifetime exemption of $12.06 million. If total transfers (during life and at death) to grandchildren exceed the exemption amount, the IRS will assess a flat 40 percent tax on the overage.
There is an exception to the GST tax if your child predeceases you. The transfer of property to a grandchild where the grandchild’s parent has already passed away does not result in the imposition of the GST tax. Since transfers from a parent to a child are not considered generation-skipping, the grandchild essentially steps into the shoes of the predeceased child (their parent).
The GST tax does not apply to tuition or medical care payments made directly to an institution (e.g., a school or doctor, hospital, etc.). For example, a grandparent can pay for a grandchild’s college tuition without worrying about GST tax if the payment is made directly to the school.
While most people will not have to deal with GST tax issues at present because the value of the property transferred is not greater than $12.06 million, it is essential to be somewhat familiar with the GST tax and when it applies. This is because, under current law, the GST tax exemption amount reverts to $5 million (adjusted for inflation) in 2026. Likewise, legislators regularly introduce proposals to lower the exemption amount. Thus, the GST tax exemption amount could change at any time, so if you are considering transferring property to grandchildren, you should be aware of the GST tax.
Another thing to keep in mind is that, although married couples have essentially double the exemption amount, the GST tax exemption is use it or lose it. Unlike with the estate tax, where the surviving spouse can use the first spouse’s unused exemption amount, any unused GST tax exemption amount disappears at the first spouse’s death.
The careful reader of this short explanation of the GST tax may well have even more questions. Suffice it to say that this topic can be very challenging. Few tax advisors or attorneys are familiar with the GST tax’s complexities. That is why you must seek experienced legal and tax counsel if you own property sufficient to trigger the GST tax that you intend to pass on to future generations. Doing so will ensure that you make the most of the tax rules and related GST tax planning strategies available to advisors today. And because these rules can and do change regularly, you should regularly revisit multigenerational planning with your advisors.
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