Basics of Generation-Skipping Transfer Tax, Parts III and IV
A strong foundation for stronger understanding of the GST tax
As mentioned in my last post, one of the projects on my vision board for over a year has been a comprehensive course on the basics of generation-skipping transfer (GST) tax. Why? Because when I was a newer attorney, this would have been a wish-list item of mine. For those practitioners who feel like this is a gap of knowledge which should be filled, I am creating this free resource.
The GST tax is driven by terms and definitions, so each video focuses on one or two key terms, while also tying each key term to other key terms to be covered in upcoming installments. In the past week, I produced two parts covering direct skips and the GST exemption amount, respectively.
Direct Skips
In Part II, I covered the parties needed to establish a generation-skipping transfer - a transferor and a skip person. In this Part III, I introduce the three categories of generation-skipping transfer - a direct skip, a taxable termination, and a taxable distribution. However, the focus of the presentation is the direct skip.
Direct skips can be distinguished from taxable terminations and taxable distributions (to be covered later) based on the timing of the application of the GST tax. With a direct skip, there is a concurrency with the gift tax (for a lifetime generation-skipping transfer) or the estate tax (for a generation-skipping transfer occurring at the transferor’s death). More succinctly put, the direct skip is the only form of transfer that does not defer the GST tax because we know exactly how much is transferred to or for the benefit skip persons. With the other forms of generation-skipping transfer, we do not know how much a skip person might receive until there is a taxable termination or taxable distribution.
Interestingly, on the rare occasion that GST tax is paid out of pocket on a direct skip, this GST tax is included when calculating the taxable gift. In other words, you could end up paying gift tax on GST tax. This is because for lifetime transfers, the gift tax and the GST tax are both tax-exclusive, meaning that the gift and GST taxes (if any) do not reduce the gift. Contrast this with the estate tax and the GST tax for testamentary transfers, which are tax-inclusive (i.e., the transfer is net of estate and GST tax), which means that GST tax liability does not affect estate tax liability in the same way.
To learn more about this deferral mechanism for GST tax, however, one must understand the GST exemption amount and how it is used.
GST Exemption Amount
While it seems that taxable terminations and taxable distributions would be the logical next topics to cover, one cannot understand these types of generation-skipping transfers unless one understands the applicable GST tax rate. This sends us into a special set of definitions which start in IRC 2631(a), where we learn that each individual has a GST exemption amount to allocate to transfers of property for which the individual is the transferor for GST tax purposes. This Code Section also clarifies that the purpose of allocation of the GST exemption amount is to determine the inclusion ratio (which, as we will later discover, determines the applicable rate).
This allocation mechanism can lock in the inclusion ratio, and thus the applicable rate, for that point in the future (i.e., a taxable termination or taxable distribution) at which the amount passing to or for the benefit of a skip person can be determined. The applicable rate, which we cover later, will end up being between 0% and the maximum federal estate tax rate (currently 40%). So, through proper allocation of the GST exemption amount, one can lock in a 0% GST tax rate until such time (if any) that the transferor changes. This rate is not changed by the appreciation in the value of the transferred property to which the GST exemption amount was allocated.
The GST exemption amount is defined in IRC Section 2631(c) as the basic exclusion amount under IRC Section 2010(c). This amount is currently $12,060,000, adjusted for inflation each year, but could be reduced by one-half on January 1, 2026 (if not sooner changed or extended by legislative action).
What is important to note is that the term “basic exclusion amount” does not include any of a deceased spouse’s unused exclusion amount for estate and gift tax purposes. What this means is that a deceased spouse’s unused GST exemption amount cannot be preserved through a portability election. This is, perhaps, the most important takeaway from this Part IV.
To tee up future discussions, IRC Section 2631(a) goes on to state that an individual may allocate their GST exemption amount to transfers. We will later cover this elective allocation under IRC Section 2632, as this sends us down a rabbit hole of new and important terms such as indirect skip, GST trust, estate tax inclusion period, and others.
A Review So Far
For those following along, it is helpful to track the definitions and terms we have covered thus far. To check your understanding, you should now be familiar with the following terms:
generation-skipping transfer
transferor
skip person
direct skip
GST exemption amount
Conclusion
Keep following along to join this series. I would also like to learn more about you - if you would be willing to complete this survey (you may remain anonymous), it helps me know my audience and what they (or you) need and want. The link to the survey is https://forms.gle/q4PPY5nuSqCDv2H1A
This series is free, but will eventually be part of two paid course offerings to train estate planners. One will be designed for the employee (such as an associate attorney, trust officer, or wealth strategist), and one will be designed for the entrepreneur (such as a solo practitioner or advisor starting a firm or switching practice areas). If you would like to contribute (as a presenter, author, or beta tester), please reach out. You can find my e-mail address in the videos above.
Thank you, and stay tuned for more!