Much as the gift tax is designed to frustrate avoidance of estate tax, the generation-skipping transfer (GST) tax is designed to deal with transferors who may attempt to avoid both estate and gift tax at successive generations by making transfers to recipients two or more generations below them. The maximum estate/gift tax rate of 40% is applied to these transfers in order to simulate the imposition of the estate or gift tax that was avoided.
The GST tax is a second transfer tax (added to the estate or gift tax, if applicable) on transfers benefiting “skip persons” two or more generations below the transferor (person who transferred the property, except in the case of a reverse QTIP election). An exception is made when the parent of the grandchild is deceased; in this case, the grandchild is not considered a skip person. Where the transferee is not a close relative of the transferor, age will determine generation level: one generation level below if more than 12.5 years younger; two levels below if more than 37.5 years younger; and so on, adding 25 years for each level.
The GST tax is imposed when all persons having a present interest in the transferred property are skip persons, or when a distribution is made to a skip person. Where the transfer is made to a trust, the beneficiaries may include both nonskip and skip persons. Multiple skips may occur if distributions from the trust continue for several generations.
There are three types of GST taxable events: direct skip, taxable termination, and taxable distribution. An example of a direct skip would be a direct gift to a grandchild, or to a trust benefiting only the grandchild. A taxable distribution occurs when there is a distribution to a skip person from a trust that continues. Taxable termination occurs when the interest of the last nonskip person terminates. Although the same nominal tax rate applies in all three situations, the cost for each differs because of differences in the way the tax is calculated depending on the type of event.
The lowest effective rate is generally with inter vivos direct skips, for which the GST tax is calculated in a “tax exclusive” manner, just like any applicable gift tax, i.e., the 40% tax rate is applied only to the amount of the transfer and not to the entire fund paying for transfer and tax. For example, on a $100,000 gift the GST tax would be $40,000 but the effective rate would be only 28.57% ($40K/$140K).
The total cost is higher in the case of a direct skip transfer at death. Although the GST tax itself is applied on a tax exclusive basis, in this case there is also estate tax calculated in a tax inclusive manner on the entire amount including transfer, GST tax, and even the estate tax itself.
The computation is always “tax inclusive” with trusts involving taxable distributions and taxable terminations. The GST tax rate is applied to the entire fund paying for both tax and net gift, so the computation is more akin to that done for estate tax.
Specifically, for taxable distributions and taxable terminations relating to an inter vivos gift to a trust, there is (1) GST tax calculated in a tax-inclusive manner on the taxable termination (or taxable distribution), plus (2) gift tax on the gift to the trust, also calculated in a tax-inclusive manner. The total cost here is the same as with the direct skip transfer at death.
The worst case, highest cost occurs with taxable distributions and taxable termination relating to a transfer at death into a trust. As with the situation involving an inter vivos gift to a trust, the GST tax is calculated in a tax inclusive manner. However, instead of merely a gift tax there is an estate tax calculated in a tax inclusive manner on the entire fund consisting of net transfer, plus GST tax, plus estate tax.
Fortunately, every individual has a GST exemption equal to the basic exclusion amount for the calendar year ($5,250,000 in 2013, and $5,340,000 in 2014). Unlike the applicable exclusion amount for estate and gift tax, use of the GST exemption is discretionary, although default automatic allocation rules exist to protect taxpayers; also, unused GST exemption is not portable, although a reverse QTIP election may be a good substitute.
In addition to the GST exemption, the transfer may be excluded under the Limited Gift Tax Annual Exclusion. GST Tax provisions incorporate the annual exclusion for gift tax (currently $14,000 per year per donee) but with some added conditions (for example, requiring that the transfer be a direct skip).
Educational and medical expenses are excluded from GST tax, even if they are trust distributions (unlike the similar exclusion from gift tax).
The GST tax is calculated by multiplying “taxable amount” (which is defined differently for each type of transfer) by the “applicable rate,” which is the “inclusion ratio” multiplied by the maximum federal estate tax rate at the time of the GST transfer. The “inclusion ratio” is the excess of 1 over the “applicable fraction.” The applicable fraction consists of a numerator that is the amount of GST exemption allocated to the trust (or to property transferred in direct skip), and a denominator that is the value of property transferred to the trust (or the value of property transferred as a direct skip). Thus, the applicable fraction is the exempt portion, and the inclusion ratio (1 minus the applicable fraction) is the non-exempt, GST-taxable portion. Generally for better estate planning and ease of administration, trustees are given authority to split trusts, if not already split, into exempt and non-exempt shares with inclusion ratios of 0 and 1, respectively. Note that the inclusion ratio may change if property is added to the trust or if additional GST exemption is added to the trust, but a distribution will never change the inclusion ratio.