For an AI-generated “podcast” review of this article from Google NotebookLM, please check out this audio:
Table of Contents
Background
The generation-skipping transfer (GST) tax is one of the most highly misunderstood taxes. In fact, my own understanding of GST tax has evolved over time – even after publishing a comprehensive 21-part video series on GST tax. There are parts of that series that I got wrong, or that were incomplete. After speaking to (and frustrating) several audiences with the nuances of GST tax, perhaps a different approach is in order. So, this article (and the audio above) is designed to serve as a quick-start foundation for more intermediate and advanced content on GST tax.
Why GST Tax Exists
Skipping (pun intended) the legislative history and policy discussions underlying this principle, the estate and gift tax were intended to apply once per generation. During times when the estate tax applicable exclusion was much lower and the estate tax rate was much higher, this could mean significant depletion of wealth across generations. To assuage this outcome, crafty taxpayers discovered that they could “skip” living members of the next generation and transfer wealth to grandchildren or even younger generations – thus avoiding a layer of gift or estate tax by going against the common law default that the objects of one’s bounty are immediate descendants.
So, GST tax in its current form was enacted in 1986 to create an additional layer of transfer tax when transfers intentionally skip living members of one or more younger generations. This could be a transfer to grandchildren that eschews children, for example. But, it could also be a transfer that skips multiple generations – for example, both children and grandchildren could be eschewed in favor of great grandchildren.
It stands to reason that the skipping of multiple generations would trigger multiple layers of GST tax. This is not the case, however. The GST tax only applies once, even when multiple generations are skipped. So, it is not a perfect solution.
Interaction with Gift and Estate Tax
Because the GST tax is an additional layer of transfer tax, a necessary prerequisite to its application is the existence of a transfer that itself is first subject to gift or estate tax. This doesn’t necessarily mean that gift or estate tax liability is incurred. It could also mean that gift or estate tax applicable exclusion is being used to offset these taxes. And perhaps confusingly, it could also mean that gift tax annual exclusion is being used for certain types of transfers.
A difficult concept to understand is that the GST tax is itself a separate tax, but also that it is dependent on the existence of a transfer that is first subject to gift or estate tax to begin with. While generous exemptions now reduce the likelihood that any of these taxes might be paid out of pocket, there is a potential for double taxation on transfers that are subject to the GST tax to the extent exemptions are exhausted. This creates a chicken and the egg problem, of which tax is applied first to the same value of a transfer. For gift tax, any GST tax actually paid will increase the gift value. However, estate tax is first apportioned to a transfer before determining the net amount subject to GST tax.
And while the gift tax and estate tax are separate (yet cumulative) taxes applying respectively to inter vivos transfers and transfers at death, there is no such bifurcation for GST tax. In other words, the GST tax itself can apply to both inter vivos transfers and transfers at death. While there are some specific differences between these two types of transfers in terms of the application of the GST tax itself, there is another important timing distinction in the GST tax itself which we will subsequently discuss. First, however, we must set the stage by introducing the exemption from GST tax.
GST Tax Exemption
The calculation of GST tax liability, and corresponding use of exemption, works differently than for gift or estate taxes.
For gift or estate tax, the applicable exclusion amount is applied as a credit against the tentative tax on either current-year taxable gifts for transfers during life or the tax base (taxable estate plus adjusted taxable gifts) for transfers at death. This applicable exclusion is made up of the basic exclusion amount ($13,990,000 for 2025, increasing to $15,000,000 for 2026 under the OBBBA) and, if any, a deceased spouse’s unused exclusion amount (DSUE) preserved for a surviving spouse through a valid portability election. In other words, tentative gift or estate tax is first calculated before the applicable credit is applied. As we will see below, however, GST exemption is first applied to determine the actual rate, and corresponding amount, of GST tax.
The GST tax exemption is equal to the estate tax basic exclusion amount. Unused GST tax exemption cannot be preserved for a surviving spouse through a portability election. But, this GST tax exemption is applied separately and independently from the applicable exclusion. So, a transfer might use both applicable exclusion and GST tax exemption – and the rate of use may not always be perfectly correlated. There is also a GST tax “annual exclusion” for certain lifetime transfers that qualify for the gift tax annual exclusion; however, many transfers in trust do not qualify for this GST tax annual exclusion (even if they qualify for the gift tax annual exclusion). In other words, keeping in mind our ordering rules above (that GST tax applies before gift tax), the gift tax annual exclusion itself will not reduce the value of a transfer for GST tax purposes – only the GST tax annual exclusion can do so.
On that note, the same valuation rules generally apply for gift/estate tax purposes and GST tax purposes. The applicable exclusion and GST exemption, respectively, are applied to the same value of a transfer. The only difference in effect on the value of the transfer, as alluded to above, is derived from actual payment of gift or estate tax – which payment is first added (for gift tax) or subtracted from (for estate tax) the value to which GST exemption is applied and GST tax is calculated. However, one cannot choose to pay gift or estate tax – these only apply once the applicable exclusion is exhausted. On the other hand, one can choose whether or not to pay GST tax by electing the scope of use of the GST tax exemption.
Which brings us to calculation. Timing matters as we will discuss below, but the GST tax itself is a product of how much of a transfer is “included” in the GST tax by comparing how much GST exemption is allocated to the dollar value of a transfer (called the inclusion ratio). This allocation and corresponding ratio occurs at the time the gift or estate tax applies, and the ratio is subtracted from one and then multiplied by the (flat) applicable GST tax rate, which is the highest estate tax rate at the time of the calculation of the GST tax itself (currently 40%). If there is a perfect dollar-for-dollar allocation of GST exemption to the value of a transfer, this creates an inclusion ratio of zero (1 minus 1/1) which, when multiplied by the applicable rate, gives us a GST tax rate of 0%. On the other extreme, no allocation of GST exemption means an inclusion ratio of one (1 minus 0/1) and a GST tax rate of 40%.
Timing Issues
Perhaps the most difficult aspect of the GST tax is found in the nature of its timing. In principle, GST tax is quite simple to calculate using the principles above when there is a direct transfer to someone in a lower generation. This is because the potential gift/estate tax liability, and the potential GST tax liability/use of exemption, apply at the same time. But, this concurrence of the application of the two transfer taxes gets separated when there is a transfer in trust. This is where a whole host of other complicated GST tax rules come into play.
Why? Because for GST tax purposes, the type of individual beneficiary matters. Any completed transfer to an irrevocable trust can result in immediate gift or estate tax liability, or use of applicable credit, since this is a transfer to living and potential beneficiaries. But, a trust can have living and potential beneficiaries in multiple generations. Since the GST tax can only apply to transfers to someone two or more generations younger than the transferor (known as a skip person), it means a transfer to a trust having mixed generations of beneficiaries might not generate immediate GST tax liability.
So while the GST tax is not split into a gift and estate tax equivalent, it is split into two separate sets of rules that determine whether there is immediate GST tax or deferred GST tax. These rules distinguish between a direct skip, and an indirect skip. With a direct skip, the calculation of gift/estate tax and GST tax is immediate and concurrent. However, with an indirect skip, a trust is usually involved for which gift/estate tax applies at the time of an irrevocable, completed transfer to the trust (that is not subject to an estate tax inclusion period, or ETIP – a more intermediate subject for another time) yet for which GST tax is deferred until some finite value later passes to a skip person.
Taking this a step further, an indirect skip does not actually generate GST tax liability itself. One must wait until some subsequent event – either a taxable distribution, which is a distribution from the trust to (or for the benefit of) a skip person, or a taxable termination, which is where the interests of all non-skip persons have terminated. For this purpose, “interests” in a trust are confined to the current rights to receive income, or principal, or both. But, the presence of living or unborn remainder beneficiaries as skip persons is enough to create an indirect skip at the time a trust is funded. At the same time, a trust itself might be treated as a skip person – and thus the transfer to the trust itself might be a direct skip – if the only beneficiaries with current interests in the trust are skip persons.
If this wasn’t complicated enough, what compounds the difficulty of applying GST tax to trusts is that it requires us to identify two parties – a transferor, and a recipient who is a skip person. For GST tax to apply, two or more downstream generations must separate the transferor and skip person. An upstream transfer (i.e., to an ancestor) is not subject to GST tax. Thus, an important element is the generation assignment of both the transferor and recipient. There are complicated rules surrounding this generation assignment, and these rules can make the generation assignment dynamic over time. The identity of the transferor can also change over time, as the GST tax rules consider the transferor to be the person who was most recently subject to gift or estate tax with respect to a transfer. For this reason, a beneficiary who (for example) dies holding a general power of appointment over a trust might replace the trust’s settlor as the new transferor of that portion of the trust that is included in their gross estate by virtue of the general power of appointment. This change in transferor can also redefine who is considered a skip person, by comparison of generation assignment to the new transferor.
Use of Exemption
The “use” of gift and estate tax applicable exclusion is hard to mess up, and its effects are usually immediate. Since the applicable exclusion is used first to offset gift or estate tax on cumulative wealth transfers, and because this “use” can relate back to previously-completed gifts (even if unreported and later caught on audit), it is rare that prior reporting mistakes lead to positive tax liability unless or until transfers exceed the exclusion (which now increases each year starting in 2027, so long as the law remains unchanged). In other words, a failure to file a gift or estate tax return does not deprive a taxpayer of the use of applicable exclusion, or the use of the value of a transfer at the time it was made for purposes of determining how much of the exclusion gets applied.
However, at least initially, this was not the case for GST tax – particularly indirect skips. The GST tax exemption generally required allocation on Form 709, and could only use the gift tax value if timely reported. Thus, for example, a late gift tax return could use date-of-gift values for purposes of the applicable credit but had to use (presumably higher) date-of-filing values for purposes of allocating GST tax exemption to indirect skips. Alternatively, at death, all remaining GST exemption at the due date of the 706 could get automatically allocated first to all direct skips at death, and then proportionately across all non-exempt portions of inter vivos and testamentary indirect skips based on their values at death – leading potentially to a bunch of trusts having inclusion ratios between zero and one unless a different affirmative allocation was made on a timely-filed Form 706.
Effective for indirect skip gifts after December 31, 2000, automatic allocation rules were created under the Treasury Regulations for Code Section 2632 to ease some of these concerns. These automatic allocation rules allow GST exemption to be allocated to indirect skips that qualify as “GST trusts” regardless of whether Form 709 is filed. Even for trusts not qualifying, there can be an election to treat a trust as a GST trust. One election can apply to multiple tax years, or can even apply perpetually until terminated. There can also be an election out of the automatic allocation rules. But if an indirect skip trust is subject to an ETIP, the allocation of GST exemption is not effective until the end of the ETIP or (if earlier) a distribution to a skip person.
These complicated allocation rules are the third factor of the GST tax that becomes difficult to understand and navigate. It is important to note, however, that there is an ordering rule for transfers during any given year, or at death. GST exemption is automatically allocated first to direct skips, before being allocated to indirect skips. Electing out of automatic allocation may require separate elections when comparing direct skips to indirect skips, and any election requires the filing of Form 709 during life or Form 706 at death.
Conclusion
The present-day GST tax implications of a trust can relate back to previous time(s) of funding, and may depend on whether or not GST exemption was automatically or affirmatively allocated during life or even at a transferor’s death. A change in transferor can also wipe out prior allocations of GST exemption, unless the new transferor (re-) allocates based on the value subject to gift or estate tax. This is why, even with record-high exemptions, it is important to know the rules surrounding trusts and the use of GST exemption – since GST tax liability can be generated even if GST tax exemption is available, reporting mistakes can unnecessarily create deferred (or even immediate) GST tax.
Some irrevocable trusts are also grandfathered into the GST tax, to the extent of irrevocable transfers made before September 26, 1985. However, actual or constructive transfers on or after that date can require allocation of GST exemption. Further, grandfathered status can be lost if certain modifications are made to the trust that reset the perpetuities period or shift interests to a lower generation. These outcomes can lead to reporting mistakes for trusts pre-dating the enactment of the GST tax.
Transfers after that date may also have been subject to much lower GST exemption amounts, assuming the allocation of GST exemption itself was effective. It is possible to have significant deferred GST tax in a trust, which can arise if and when skip persons derive benefits from the trust. Even for a trust that has an inclusion ratio of zero, these benefits to skip persons could also create reporting obligations for the trustee.
So, my hope is that article and/or the audio above gives you a slightly-improved lay of the land when it comes to this complicated tax. Note that these concepts barely scratch the surface, but they should create a good foundation for you to dive into more complex aspects of this tax.
On that note, I value your feedback as this is one of my core areas of expertise and I am always aiming to improve how I teach and present this subject. Please feel free to reach out if you have any suggestions on how to further improve this overview and chronology (or if you need a speaker on GST tax for an upcoming program or conference). Stay tuned for what I am deeming “intermediate” GST tax principles, to supplement this article and the video series linked in the introduction.