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Federal Generation-Skipping Tax Exemption

Estate taxes can present a heavy burden to the assets transferred either as a gift or inheritance to family and heirs, especially when a significant amount of assets that carry a high value are transferred, gifted, or bequeathed. One tax planning benefit that taxpayers can consider is the federal Generation-Skipping Tax exemption. In a prior blog post, we briefly discussed the specific taxes involved with estate planning: the estate tax, the gift tax, and the generation-skipping tax. This blog dives deeper into the nuances of the generation-skipping tax, sometimes referred to as the generation-skipping transfer tax.

What is the Federal Generation-Skipping Tax?

The federal generation-skipping tax (GST) is a tax that applies to transfers of property that “skips” a generation to avoid estate taxes. The purpose of the GST is to prevent families from avoiding estate taxes by skipping a generation who otherwise would have received the assets by gift or bequest, and thus would have been subject to estate and/or gift taxes. A generation-skipping transfer is generally assumed to have occurred if the individual receiving the gift or inheritance is either (1) a grandchild or great-grandchild of the grantor—however, others (including non-family members) can qualify as well; or (2) more than 37.5 years younger than the donor. Notably, the GST only applies if the transfer actually causes avoidance of the gift or estate tax.

For example, if a grandparent makes a bequest or gift directly to their grandchildren or great-grandchildren, rather than to their children, the transfer of the assets would be subject to the GST. The GST seeks to place the grandchildren or great-grandchildren in the same financial position they would have been in if their parents had received the assets first, the assets had been taxed on the transfer from grandparent to parent, and then the parents gifted or bequeathed the assets to the children.

What is Not Considered a Generation-Skipping Transfer?

Certain situations do not fall under the IRS’s definition of a generation-skipping transfer. When a grandchild assumes the place of their parent because the parent is deceased, the transfer will not be considered generation-skipping for tax purposes. Additionally, the Internal Revenue Code exempts certain qualified transfers for education or medical expenses that would otherwise be subject to the GST—e.g., tuition payments and medical care costs when paid directly to the institution or medical provider.

What is the Federal GST Exemption?

The Internal Revenue Code allows for a significant exemption to the GST. The exemption amount has a base of $5 million by statute, and is adjusted for inflation annually. However, the current 2022 exemption amount is about $12 million for individuals and about $24 million for married couples (this larger exemption expires after 2025). Simply put, up to approximately $12 million of assets transferred as part of a generation-skipping transfer are exempt from being taxed. Anything over the exemption amount is subject to a flat 40 percent tax rate.

Computation of the Federal GST Exemption

The GST is imposed when the transfer or gift of the assets occurs. To calculate the GST exemption amount, take the amount transferred and subtract the current exemption amount. The remaining amount will be subject to the 40 percent tax rate.

Example:

Assume the exemption amount is $5 million dollars. A grandparent transferred $25 million in assets to their grandchild, skipping over their children (who are still living). The first $5 million of the $25 million is exempt from tax. The remaining $20 million is taxed at a rate of 40 percent, meaning $5 million is due in taxes.

Save Money in Taxes With the Federal Generation-Skipping Tax Exemption

Since the federal GST exemption is so high, few families will be subject to the GST. However, for those who are, the aid of professional tax and estate planning can help lessen the tax burdens imposed. 

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