Generational Skip Trust
With previous discussions of estate planning and grantor trust, let’s examine another common practice within financial planning: generation-skipping trust.
What is a Generation-Skipping Trust?
A generation-skipping trust is a trust where the settlor or grantor of the trust transfers assets to recipients who are two or more generations younger than them. Therefore, the settlor can bypass a generation when leaving assets to their heirs and eliminate one round of estate tax.
How a Generation-Skipping Trust Works
A generation-skipping trust allows the grantor to leave an inheritance (either in the form of money or assets) to his grandchild, great-niece, great-nephew, or any other natural person who is at least 37.5 years younger than the grantor. The trust’s beneficiaries cannot, however, be the spouse or ex-spouse of the grantor.
The trust created will also be regarded as irrevocable, meaning that the trust cannot be changed or revoked. The fact that the trust will be irrevocable does not mean that the grantor relinquishes all of their power and can still insert provisions that allow them to determine how the assets are distributed and how the estate is invested.
The tax on generation-skipping trusts is also separate from estate and gift tax.
No regulations prevent the grantor’s children (the skip person) from participating in the income earned on the assets held in the trust as long as the original assets are not distributed.
Who Needs a Generation-Skipping Trust?
A generation-skipping trust may only be suitable for some. It should be noted that it should last the lifetime federal GST exemption of $12.06 million per individual (this increases to $24.12 million for a couple). If this is possible, the grantor may be subject to GST and estate taxes.
As the skipped generation will only be able to benefit from the income earned and generated from the trust assets, it may not be suitable for smaller estates where the assets need to pass directly to the next generation (children/spouses).
Who Gets the Income from a Generation-Skipping Trust?
The income generated and earned from assets held in the trust can be paid to the children/spouse of the grantor as long as the assets are not physically distributed to them. The income will be taxed accordingly; however, the assets will be kept separate from their own estate.
Passing Assets to Grandchildren Through a Generation-Skipping Trust
A grandparent can ensure that assets and inheritance can be passed to grandchildren by forming a generation-skipping trust during the grantor’s lifetime or by transferring the assets directly to the grandchildren in the grandparent’s wills.
How to Create a Generation-Skipping Trust
Creating a generation-skipping trust is complicated, and the exact details of the trust will depend on the specific goals of the grantor. Two transferring strategies are available to grantors, and these are as follows:
Assets are placed in a trust using the GST exemption. The trust can then pay any income earned from the assets in the trust to the skip person and/or skipped generation (children/spouses), while the remaining assets in the trust pass outside of the grantor’s estate to future generations after the death of your child/spouse.
Direct Generation Skip
The grantor will bypass their own children and give the assets qualifying for the GST exemption amount directly to your grandchildren or place them in a trust for their benefit or the benefit of future generations.
Generation-Skipping Trusts & Taxes
Much like other financial trusts, a generation-skipping trust will often have taxes attached to it. Who, what, and how are listed as:
Who Has to Pay Estate Taxes?
Estate taxes are owed on any estate exceeding the federal estate tax exemption of $12.06 million. This lifetime exemption changes annually to adjust for inflation (it should be noted that should Congress not intervene, the exemption amount will revert to a $5 million baseline, adjusted for inflation, in 2026). In some states, the estate tax exemption is the same as the federal exemption; in others, this may be less than $1 million.
An individual is allowed to give gifts during their lifetime without paying taxes as long as the value of the gifts does not exceed your lifetime exclusion which is the same as your estate tax exemption.
There is an annual gift exclusion of $15,000.00. However, should you grant a gift worth more than the annual exclusion, your lifetime exclusion decreases by the excess value of the gift.
Generation-Skipping Transfer Tax
The GST tax applies when someone gives direct gifts of money or other assets to someone at least 37.5 years younger than them. A flat tax rate of 40% on the transfer value exceeds the GST exemption, and GST tax can also be referred to as GSTT or simply as a transfer tax.
Benefits of Generation Skipping Trusts
The following three most common benefits are:
- GST is a great planning tool for larger estates as you can ensure that your family legacy is maintained for at least two generations. It enables your own children to benefit and ensures that your grandchildren will also be supported.
- GST allows the grantor to skip a round of federal estate taxes, as the federal estate taxes will only be assessed when the property is distributed to the beneficiaries of the trust. Should the assets be passed to the children of the grantor, the family legacy would have been subjected to tax twice.
- GST assets are not included in your child’s estate, which effectively protects their estate. They can also retain complete control of their own trust during their lifetime.
Drawbacks of Generation-Skipping Trusts
When considering a GST, the following drawbacks need to be considered:
- GST was established to ensure that families cannot escape federal estate taxes over multiple generations. If the estate’s value exceeds the GST tax exemption, it will be subject to both GST and estate taxes at a rate of 40%.
- Trusts may be powerful estate planning tools that allow families to minimize their estate’s exposure to probate. However, there is a very high administrative burden of running a trust. As trusts require a lot of thought, resources, and energy, it is best to work with an estate planning professional to assist with setting up a trust that will best suit your family’s needs.
- With a large enough estate, your children may still benefit from the profits generated from the assets held in trust. Suppose there is a need to support your children financially. In that case, an evaluation needs to be done to ascertain that the income produced by the GST will be substantial enough to cover their expenses and lifestyle.
Can a Generation-Skipping Trust be Broken or Dissolved?
It may be possible to dissolve a generation-skipping trust as the trust is an irrevocable trust. This means the trust cannot be broken, modified, revoked, or dissolved; however, it may be possible to modify or terminate the trust judicially, depending on the State.
Can a Generation-Skipping Trust be Contested?
A GST can be contested; however, this cannot purely be done on the basis that an individual or family member does not agree to the terms. It will need to be proven that the trust is not legally valid for the contention to be valid. Here are some valid reasons for a GST to be contested:
The grantor needs to be ‘sound of mind’ when the trust is created, meaning the grantor needs mental awareness of what they are doing. The trust can be invalid if it is possible to prove that they were not.
If a third party coerced the grantor to create the trust or name a specific beneficiary/fiduciary, the validity of the trust can be challenged. The level of pressure the grantor faces must be so severe that their own free will must be overwhelmed.
Fraud or Forgery
If a trust document was obtained through fraud, it could be contested and thrown out. This can occur when the grantor is tricked into signing the trust when they are under the impression that they are signing another document.
Who can Contest a Generation-Skipping Trust?
A trust litigation attorney can be approached to contest the GST. The aggrieved party will submit a motion or oral application to a High Court.
Do I Need A Trust Litigation Attorney To Contest A Generation Skipping Trust?
Some states, such as California, do not require a trust litigation attorney to contest the validity of a GST. However, it would be most beneficial for the person challenging the trust to employ one. Other states do require a Trust litigation attorney to be appointed by the aggrieved party or family members to submit a motion or oral application to a High Court.
Is a GST Trust Revocable or Irrevocable?
A GST is an irrevocable trust; however, the grantor can still make decisions regarding the investments made in the trust and the distributions made from the trust.
Protect against the Generation-Skipping Transfer Tax
In order to protect against the GST Tax, it is crucial to consider the most tax-efficient planning tools. As the lifetime exemption applies to an individual, it is possible to put an estate plan in place which may allow each spouse to apply for their GST tax exemption either during their lifetime or at the time of their death when the trust is created.
Common Transfer Strategies for You to Discuss with Your Tax and Legal Advisors
Bring up options for GST as an irrevocable trust to your tax or legal advisor, as they will best recommend options that are unique to your case and circumstances. The same can be done for tools to protect against the GST tax discussed above.
How to Use a Lifetime Exemption from GST
Lifetime exemption from GST can be used during the grantor’s lifetime or at the time of their death when the assets are inherited outright by the next generation or transferred into the trust. During the lifetime of the grantor, all applicable transfers of wealth made are automatically applied to the lifetime GST exemption unless elected otherwise. Also taken into consideration is that it’s also possible to employ the annual gift tax exclusion to ensure that not too much of the GST exemption is used up during the course of the grantor’s lifetime. For transfers at death, the exemption may be allocated as directed in the will of the grantor or as directed by the executors if not explicitly mentioned in their wills.