22 Sep The Tax That Hits Your Grandchildren

Everyone who’s done serious estate planning knows the headline number: $15 million. That’s the federal estate tax exemption per person, $30 million for a married couple, But there’s another federal tax at the same 40% rate, and it applies specifically when wealth passes to grandchildren or further down the family tree. It’s called the generation-skipping transfer tax. If your estate plan doesn’t address it separately, you’re carrying a risk you probably don’t know about.

Why It Exists

The GST tax exists because wealthy families found a workaround. Without it, a family could transfer wealth directly to grandchildren or into a trust that spanned multiple generations. The estate tax applied once, at the initial transfer. But as the trust continued, passing wealth from grandchildren to great-grandchildren and beyond, no additional transfer tax applied. Each generation the trust covered was another 40% the family avoided.

Congress closed that door in 1986. The rule: any transfer to a “skip person” gets hit with a flat 40% tax, on top of any estate or gift tax that already applies.

A skip person is anyone two or more generations below you. Your grandchildren. Your great-grandchildren. Any unrelated person more than 37.5 years younger than you. And any trust where all current beneficiaries are skip persons.

Three Ways It Triggers

The GST tax doesn’t apply in just one way. It has three triggers, each with its own rules for who pays.

A direct skip is the simplest. You give property directly to a grandchild, either during your lifetime or at death. The transferor pays the tax.

A taxable distribution happens when a trust distributes income or principal to a skip person. If you set up a trust for your children and grandchildren and the trustee writes a check to a grandchild, that distribution triggers the tax. The grandchild pays.

A taxable termination happens when the last non-skip beneficiary’s interest in a trust ends and only skip persons remain. If your child was the trust beneficiary and they die, leaving only grandchildren as beneficiaries, the trust itself owes the tax.

In all three cases, the rate is the same: 40%.

The Exemption That Isn’t Portable

Every person gets a $15 million GST exemption, separate from the estate tax exemption. But there’s a critical difference: the GST exemption is not portable between spouses.

With the estate tax, if one spouse dies without using their full exemption, the survivor can elect to pick up the unused amount. That’s portability. It’s a safety net that forgives imperfect planning.

The GST exemption has no safety net. If your spouse dies without allocating their $15 million in GST exemption, it’s gone. You can’t pick it up. You can’t claim it on your own return. Every dollar of unused GST exemption is a dollar of protection your family loses permanently.

This is one of the most commonly missed opportunities in estate planning. It’s also one of the most expensive.

It’s Not Just for the Ultra-Wealthy

You might think this only matters for estates well above the exemption. Maybe. But consider two things.

First, the GST tax doesn’t just apply to outright gifts. It applies to trusts. If you’ve set up a trust that benefits multiple generations, the GST tax could apply to distributions and terminations decades from now. The value of the trust at that future point is what matters, not the value when you funded it.

Second, life insurance. If you own a $3 million policy in an irrevocable life insurance trust and the trust benefits your grandchildren, you may need to allocate GST exemption to that trust. If you don’t, the death benefit could trigger a 40% GST tax when it passes to the next generation. That $3 million just became $1.8 million.

What This Means for Your Planning

The GST tax isn’t something you plan for after you’ve handled the estate tax. It’s a separate analysis, with separate rules, separate exemptions, and separate deadlines. Getting the estate plan right doesn’t automatically get the GST planning right.

If you have grandchildren, if you have trusts that could last beyond your children’s generation, or if you own life insurance in an irrevocable trust, the GST tax is something you need to address with your advisors as part of a coordinated plan.

In the next article in this series, I’ll walk through one of the most powerful tools available for multigenerational wealth transfer: the intentionally defective grantor trust.

Does your estate plan account for the generation-skipping transfer tax?

For advisors: Have a client dealing with this? I do quick consult calls for advisors working through complex planning situations.

Schedule a call: https://lgarzalaw.com/schedule-online/

For business owners and families: At Garza Law, we are selective in choosing our clientele. We work with a select group of families every year to help them protect their legacy. If what you read here raised questions about your own situation, you can apply here:  Apply Here

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