The Generation Skipping Tax (GST), created in 1986 by the IRS Tax Reform Act, taxes gifts and inheritances that are given to skipped generations in the same way that gifts and inheritances are taxed that are given to the immediate heirs. The reason that the IRS felt compelled to add this tax requirement is to reduce people’s ability to form dynastic trusts with gifts being given to unborn great-great grandchildren.
The rule in general states that any gift given to a skip person must have not only the standard gift or inheritance tax (depending on when the gift was given), but also an additional tax that is set to the highest inheritance bracket at the time of the gift. This causes most givers to pay equivalent to the gift or often more than the gift itself in taxes.
Who Are Skippers?
According to the IRS Rules, any relative that is more than one generation away from the giver is considered a skip person. This includes grandchildren, great grandchildren and great nieces and nephews. However, if the person you are gifting is an orphan, then they move up one space and are no longer considered a skip person. So, leaving an entire estate to a granddaughter whose parents are deceased will not incur a GST tax. These same rules also apply for relatives by marriage.
Unrelated people also fall under the GST tax rules. If the unrelated person is more than 37 years younger than the giver, then this person is considered a skip person and the GST tax may apply. GST tax does not apply to charities, no matter how young the charity is.
Are there any exceptions?
There are two exceptions to the GST tax rule. One exception is gifts given to minors within a crummey trust. The other exception is gifts given for the medical care or education of another. A crummy trust can be drafted by an attorney with the proper restrictions and instructions included. Crummy trusts are unlimited, so you can make one for every grandchild and great grandchild if you so desire. When giving gifts for the purpose of medical care or education, the funds may be paid directly to the specific institution. So, you can pay for your grandson’s college education or even your great grandson’s private preschool and there are no required GST taxes.
GST Tax and Gifts
Gifts are defined by the IRS as large amounts of money given while still alive. Both gifts and generation skipping gifts have an annual exclusion amount which is a set amount that you can give out each year without paying any taxes. For example, for 2011, the annual exclusion amount for gifts and GST is $13,000. Additionally, married couples can engage in the practice of “joint giving” and give a tax-free amount of $26,000. After the exemption is used up, any additional amount is taxed under the current IRS gift and GST tax figures. For 2011, these figures are 55% GST rate and 45% gift tax rate.
GST Tax and Inheritances
GST inheritances also incur taxes, but have greater leeway in amount. For 2011, the total estate and GST lifetime exemption amount is $5,000,000. This means that so long as your estate is below $5,000,000 and you have not previously given away and gifts, then you are clear to give away your estate without any tax consequences. Above this amount, all funds are taxed using both estate taxes and GST taxes.
Example:
In 2011, the federal lifetime gift exemption amounts are $1,000,000 and the GST and Estate tax amounts are $5,000,000. Additionally, you can annually gift $13,000 as a single person or $26,000 as a married couple without any tax consequences.
Consider the following situation: you wish to give your 16-year old grandson a $300,000 property and are trying to determine the best way to give it.
Scenario One: You can give the property outright while you are still alive. In order for your grandson to own the property free and clear, you’ll need to pay $294,150 in gift taxes and $292,850 for GST taxes, bringing the total taxes you must pay to $587,000.
Scenario Two: You can give the property in your will to your grandson after you die. Assuming this is still less than the total annual exclusion for the year you die, there will be no taxes owed.
Scenario Three: You wish to elect the use of your lifetime gift exclusion and you give the house outright using this and your GST exclusion amount. There are no taxes owed, but your annual gift exclusion amount is reduced to $700,000.
Scenario Four: You can “sell” the house to your grandson and have him sign a promissory note for the property. The deed transfers to your grandson without any initial gift or GST taxes. You then “forgive” $13,000 annually if you are single or $23,000 annually if you are married on the property until the entire amount of the property is transferred over. In this case it would take 24 years as a single person or 12 years as a married couple.
General Conclusion
If you are considering gifting or leaving funds to a relative other than your immediate heirs and children, consult with an estate planning attorney to determine the best course of action for you. There are always alternative routes and planning strategies available to cut your tax liability and give more to your loved ones.