What Is a Generation-Skipping Trust?
Generation-skipping trusts (GSTs) are irrevocable trusts designed for beneficiaries who are, at least, 37.5 years younger than the grantor and may or may not be related to them. GSTs are used by high net worth individuals to pass on wealth to their grandchildren and avoid double taxation of their estate.
GSTs are subject to taxes known as generation-skipping transfer taxes (GSTTs). The tax rates can run as high as 40% of the total estate. The main advantage of GSTs is tax benefits. They help grantors avoid double taxation. They also offer other benefits of a trust: multiplication of income with tax deferrals and probate avoidance.
Basics of Generation Skipping Trusts
Generation-skipping trusts are used by individuals to pass on wealth to their grandchildren or grand nieces or nephews. It is not necessary for beneficiaries to be related to the grantor, however. Any person younger by more than 37.5 years of age than the grantor can be assigned as a beneficiary.
GSTs are useful to avoid double taxation of grantor estates. The federal estate tax exemption limit in 2021 is $11.7 million, meaning all estates below that amount are not required to pay taxes.
The estate tax can be a headache for the very wealthy because they end up paying it twice – once when wealth is passed on from beneficiaries to their progeny and again when the same estate is passed onto the beneficiary’s progeny.
To avoid double taxation, the grantor can fashion a GST that skips a generation to pass wealth directly to the grandchildren. The grantor will relinquish ownership of the assets contained in the trust. The intermediate beneficiary – the grantor’s children – is not liable for taxes from the estate because they do not own the assets. The final beneficiary owns the assets and pays taxes on it when they inherit it from the trust. Therefore, the estate tax is paid only once across three generations.
GST and Taxes
The U.S. Congress created the Generation Skipping Transfer Tax in 1986 with an exemption of $1 million in 1986. Estates that were above the exemption limit were liable for taxes. The exemption limit has increased and decreased with subsequent administrations. For example, under the Clinton administration, it was indexed to inflation for the first time and resulted in increments of $10,000. The 2021 federal tax exemption limit is $11.7 million, meaning all estates that are below this amount are not liable for taxes. Estates above that amount are taxed at the top rate of 40%.
GSTs and Dynasty Trusts
Generation skipping trusts are similar to dynasty trusts in that both are instruments to pass on wealth between generations. Both also provide significant tax benefits because they help grantors avoid estate taxes.
Generation skipping trusts, however, are limited in their tenure and allow for passage of wealth only a generation apart. For example, a grantor can only pass on wealth to a person or relative who is 37.5 years younger than her.
In contrast, dynasty trusts enable passage of wealth between multiple generations. For example, the grantor can pass on wealth to an immediate beneficiary who can, then, pass on wealth to their offspring.
How to Create a GST
Before you begin with the process to create a GST, it is important to note that it is a complicated one. It is a wise idea to seek out legal help to create a watertight trust.
The process to create a generation skipping trust is similar to that of a regular trust. First, you need to determine the assets that you will put into the trust. Next, you have to identify appropriate documentation for the assets and take them to a financial planner or lawyer to draw up a blind trust. Finally, assign a trustee and beneficiary to the trust.
While GSTs are designed to skip a generation, they can still provide benefits and regular income to the skipped generation through judicious use of special powers of appointment. You can also customize GSTs. For example, you can insert provisions that allow the intermediate beneficiary to control distribution of the trust’s income to themselves. You can also insert conditions to restrict spending in the case of profligate beneficiaries.
Advantages and Disadvantages of GSTs
The advantages of GSTs are as follows:
- They help grantors avoid double taxation of their estates and offer tax deferral benefits.
- Even though it skips a generation, the trust can still be designed to provide regular income or benefits such as rent-free stay on property to the intermediate generation, such as the grantor’s immediate kin or relatives.
- GSTs help grantors avoid court-mandated probate processes for estates.
- GSTs can be customized to benefit or restrict beneficiaries.
The disadvantages of GSTs are as follows: ‘
- They cannot be changed after creation because they are irrevocable trusts.
- They can be expensive to create and maintain.