By Financial Advisor Peter Egolf
Like many things in the tax code, what once was an opportunity to avoid tax (gifting assets to other generations to avoid paying additional estate taxes) has been replaced with a tax.
The generation-skipping tax falls into this category and applies to large estates gifting assets to other generations. If you use up your generation-skipping tax lifetime exemption of $13.61 million (per transferor as of 2024), you will pay a 40% federal tax.
A typical estate sequence is a grandparent → child → grandchild. Here, there are three separate estates. People started transferring assets from grandparents to grandchildren to skip the middle estate of the child, thereby saving on estate taxes. A “skip” person is someone two generations or more below the transferor.
Now, how bad could the taxes be? This penalty is in addition to any estate or gift tax owed. Thus, when you leave money to skip a generation, you will use your gift tax exclusion (for the gift) and your generation-skipping tax exclusion (for a gift to the skip generation). Thus, if you’ve used up both your estate and gift tax exclusion and your generation-skipping tax exclusion, you could pay up to a 40% gift tax and a 40% generation-skipping tax for a federal tax rate of up to 80% on transfers beyond the exclusion limit.
Given the steep cost, it’s prudent to skip the generation-skipping tax. This tax is imposed on the transferor, not the beneficiary. 1
Related Persons - The skip person is related to the transferor and is two or more generations below. For example, this could be a grandchild or a great-niece of a grandparent.
Unrelated Persons - A skip person is anyone over 37.5 years younger than the transferor. A generation is defined in a span of 25 years. A person of the same generation as the transferor would be within 12.5 years of the transferor’s age.
In the case of the grandparents above, what if they left assets to their grandchild, but the grandchild’s parent is deceased? In this case, the grandchild moves up to the non-skip position of their parent, the grandparent's child. Now, the great-grandchild becomes the skip person in this situation!
Nearly all transfers excluded from gift taxation would be excluded from the generation-skipping tax—for example, annual exclusion gifts, direct payment of healthcare, and direct payment of tuition.
The generation-skipping tax only begins once you have used up your generation-skipping tax exclusion. Thus, you can transfer $13.61 million to skip persons under the exclusion. It’s important to note that while unused estate and gift taxes are portable to your surviving spouse, the generation-skipping tax exemption is not portable between spouses, so the surviving spouse can only use their generation-skipping tax exemption ($13.61 million). The surviving spouse could still have up to $27.22 million available to apply toward their estate and gift taxes. Therefore, if you are concerned about maximizing your generation-skipping tax exemption, your estate plan must utilize the first deceased spouse's exemption amount, given that any unused portion will not be ported to the surviving spouse.
If you leave assets to a trust, that gift may not trigger generation-skipping taxes. However, if the trust eventually is terminated/distributed to a skip person, that would trigger generation-skipping taxes if applicable.
The generation-skipping tax applies to a limited number of very high-net-worth individuals. However, a prudent estate plan is mindful of utilizing these exclusions to avoid the otherwise steep 40% federal tax.
1. If trusts are the cause of the skip, a taxable termination would be taxable to the trust. A taxable distribution to a skip person would be taxable to the skip person.
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