The generation skipping tax is a means the IRS uses to prevent dynastic families from spreading their wealth past the next generation. Despite this tax, the IRS does allow some leeway in leaving wealth to grandchildren. Under current IRS law, you can leave up to $1,000,000 without GST tax liability. GST skips can be defined as direct and indirect skips.
Direct Skip
A direct skip is a transfer to a skip person where the transfer is subject to estate or gift tax. A direct skip is an outright skip of one generation, typically mentioned in a will. If a direct skip gift is made within the annual federal exemption, then only gift or estate tax is owed. If the GST exemption has already been used up, then the giver owes both gift or estate and gift tax (the highest estate tax rate).
When the direct skip amount is a gift, then the tax liability falls to the giver. For example, if Mr. Oswald wants to give his grandson $750,000 in 2011 and he has already used up his GST exemption, he would owe a 35% gift tax amounting to $262,500 and a 55% GST tax amounting to $412,500. So, he would pay $675,000 in taxes for his $750,000 gift.
When the direct skip amount is an inheritance, then the liability falls upon the estate. So, in 2011, if he dies and bequeaths $750,000 to his grandson, then he would need to leave a total of $1,162,500 for the gift in order for the entire tax amount to be fully paid and the bequest made in full.
Indirect Skip
An indirect skip occurs when the funds are placed into a trust with funds being allocated to a generation skip person. There are two ways that this happens; either the funds are directly given to a skip person, or the trust terminates while the allocated person is a skip person. In both scenarios, all amounts removed from the trust must be taxed at the standard gift and GST tax rates.
Exceptions
There are two exceptions to the GST rules. First, if the skip person’s parents are deceased, then that person moves up one space in the generational line as far as taxes are concerned and are no longer considered a skip person. So, if Grandpa George’s grandson wants to leave his entire estate to his orphaned grandson, he is free to do so without any GST tax consequences. Second, under current IRS law, any gifts given for the direct benefit of the recipient do not fall under gift taxes or GST taxes. So, you can freely use your money to pay someone’s medical bills or college tuition with no tax consequences, regardless of generational standing.
Crummey Trust
The only way to form a trust that avoids GST tax liability is through a crummey trust. Under IRS law, you can establish a trust for the care of any child under the age of 18. As long as they have annual access to the trust, then it is valid and will not fall under the GST requirements. So, under this rule, you can form trusts for any grandchildren or great grandchildren under the age of 18 without paying GST taxes.