When Does the Generation-Skipping Transfer Tax Apply?

Gifts you make during your lifetime or bequests from your estate that are made to grandchildren or other descendents more than one generation younger than you could be subject to the generation-skipping transfer tax. As explained by Dachary Carey in an article for Life123, if you have a significant estate you may want to avoid having it taxed twice, once when it passes to your children and again when it passes to their children. So you give or bequeath property directly to your grandchildren. This is where the generation-skipping transfer tax enters in.

As indicated by Mark E. Powell, Esq. for the Journal of Accountancy, the intent of the generation-skipping transfer tax is to prevent using a trust to benefit future generations and avoid the federal estate tax. Taxpayers with large estates would set up a life estate to pass their assets to their children, then another life estate to pass them to the grandchildren, etc. Since life estates were not subject to the federal estate tax, the assets could be passed on tax free.

The generation-skipping transfer tax would apply on three different types of transfers, as explained by Tisa Silver in Investopedia. One is a direct transfer in which, for example, a grandparent gives property directly to a grandchild. In this case, the grandparent would be responsible for paying the tax. The other two are indirect transfers.

One type of indirect transfer is a taxable termination. This would occur, for example, in a trust that is set up for a child. When the child dies, the property remaining in the trust would be transferred to his or her children '" the original donor's grandchildren. The generation-skipping transfer tax would be paid out of the property when it is passed to the grandchildren.

The other type of indirect transfer is a taxable distribution. When a grandparent sets up a trust for a grandchild, the grandchild would be responsible for paying the generation-skipping transfer tax when distributions from the trust are received.

According to the IRS, a generation-skipping transfer does not involve only descendents. The tax also applies on transfers to unrelated persons who are more than 37.5 years younger than the transferor.

Most property transfers that skip generations are not subject to tax. Gifts of up to $13,000 per person per year are not subject to gift tax and the same exclusion amount applies for the generation-skipping transfer tax. And the generation-skipping transfer tax is applied only to the extent that the exclusion amount is exceeded. As indicated by Gamble Parks in a tax alert for Mercer Advisors, for 2011 and 2012 the exclusion amount is $5,000,000 and the maximum tax rate is 35%. After that time, there could be changes, depending on the legislation that is passed.

Sources:
Dachary Carey, "Generation Skipping Tax" '" Life123
Form 709 '" United States Gift (and Generation-Skipping Transfer) Tax Return
Gamble Parks, "New 2011 Estate, Gift and Generation-Skipping Transfer Tax Law" '" Mercer Advisors
Instructions for Form 709 - IRS
Mark E. Powell, Esq., "The Generation-Skipping Transfer Tax: A Quick Guide" '" Journal of Accountancy
Publication 950 '" Introduction to Estate and Gift Taxes '" IRS
Tisa Silver, "A Look at the Generation-Skipping Transfer Tax" '" Investopedia