It is an age-old struggle. Taxpayers try to keep more of their wealth and the IRS seeks to prevent it, especially the transfer of wealth from generation to generation.
Enter the generation-skipping transfer tax.
A recent article in The Motley Fool takes a shot at explaining this tension between taxpayers and tax takers in a recent article titled “Generation-Skipping Tax: What It Is and How to Avoid It.”
Basically, general estate tax principles work like this: first, folks want to leave their accumulated wealth money to their spouses, then to their children, then to grandchildren, and then to more distant descendants.
Thanks to Ronald Reagan's tax laws, the estate tax allows an unlimited deduction for any transfers between spouses.
However, that is the only tax-free transfer.
Typically, when an inheritance passes to the children's generation it is subject to an estate tax if it exceeds the estate tax exemption (currently $5.43 million per spouse).
And when the child passes away, the IRS takes another bite by taxing the grandchildren on the same inheritance.
The generation-skipping transfer tax (GSTT) levies this second tax on gifts made to grandchildren or those who are more than 37½ years younger than the person making the gift or bequest. Think an uncle leaving an inheritance to his favorite great-nephew.
This is to make sure those gifts are treated consistently with the policy behind the estate tax.
However, the GSTT applies the same 40% tax rate to gifts that the regular estate tax applies to direct inheritances.
In effect, the GSTT calculates tax liability so the grandchildren receive the same amount of assets as they would have inherited had it come straight from their parents instead of their grandparents.
The original article notes that outright gifts to grandchildren, so-called “direct skips,” are typically subject to GSTT.
Nevertheless, the GSTT can also apply in more complex scenarios.
These “indirect skips” occur when a interests in a trust created for multiple generations vests in grandchildren and distant relatives.
In such a cases, the GSTT can become due— not only when a trust is set up—but also years or even decades later when remote relatives find themselves the primary beneficiaries.
Lastly, there are also instances where a taxpayer can make what would otherwise be a generation-skipping gift without treating it as one for application of the GSTT.
The most common exception is the "deceased parent" rule, which makes sense in normal estate planning.
Most taxpayer will leave an equal amount to each of their children when they pass away.
But what if one of those children predeceases his or her parent?
The law usually assigns that the share of that deceased child to his or her children.
Fortunately, the GSTT doe not disrupt this logical inheritance transfer to the grandchildren when their parent has already passed away at the time of the transfer.
Because the generation-skipping tax is one of the most incidious aspects of the estate tax law, most taxpayers would do well to steer clear of it.
Contact an experienced estate planning attorney to find out more about the GSTT and other lesser know gotchas in the laws impacting wealth transfers.
Remember: “An ounce of prevention is worth a pound of cure.” When making your financial, tax and estate plans, do not go it alone. Be sure to engage competent professional counsel.
Reference: The Motley Fool (June 28, 2015) “Generation-Skipping Tax: What It Is and How to Avoid It”
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