Generation Skipping Trust - Explained
What is a Generation Skipping Trust?
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Table of ContentsGeneration-Skipping Trust DefinitionA Little More on What is a Generation-Skipping TrustHow Generation-skipping Trust WorksIs Generation-skipping Trust Subject to GSTT Taxation?How you can Avoid Generation-Skipping TrustAre there any GSTT Tax Exemptions that apply to Generation-skipping Trust?Benefits of Generation-Skipping TrustLimitations of Generation-Skipping TrustAcademic Research
Back to: INHERITANCE, ESTATES, & TRUSTS
What is a Generation-Skipping Trust?
Generation-skipping trust refers to a type of trust which is a legally binding agreement designed to enable a trustee to transfer assets to the next generation levels without it being taxed. The beneficiary of the trust (accumulated assets) can be the grandchildren, great-grandchildren or any other appointed person outside the trustees lineage, provided they are within the stated age as provided by law. Since generation-skipping trust is basically meant to transfer assets to the next generations, it can also be referred to as dynasty trust.
How Does a Generation-Skipping Trust Work?
Most trustees use assets that generate income as well as those assets that appreciate the value to fund their generation-skipping tax. For this reason, their children can directly benefit from the income being generated even though they can never own the assets. This is because the generation-skipping trust directly transfers the asset ownership to grandchildren. This denies the grantors children ownership rights to the assets. This transfer skipping is what enables the grantor to evade estate tax during asset transfer.
How Generation-skipping Trust Works
In a normal inheritance, a parent passes assets directly to his or her children. In this situation, the transferred property is subject to federal estate tax. This is only if the property exceeds the tax exemption amount. However, generation-skipping trust removes this kind tax by directly transferring assets from the grandparents to a younger generation such as grandchildren, great-grandchildren, or any other unrelated persons provided they are younger than the trustee by at least 37 years. Note that when generation-skipping trust is created, it is not an indication that individuals in between (trustees children) have been disinherited not unless the trustee specifies so. Note that there are other ways in which they can get their inheritance from the trustee. For example, they can benefit from direct gifts from the trustee which of course have a yearly tax exemption. They can also access income from the trust that has been passed over to their children by their parents. Generally, a generation-skipping trust that involves grandchildren only is considered the simplest. However, the more the generation levels of beneficiaries the better as it enables trustees to maximize the trust benefits through GSTT tax exemption.
Is Generation-skipping Trust Subject to GSTT Taxation?
There is a generation-skipping trust tax which is placed at a flat rate of 40% under GSTT. This applies to wealth that exceeds 11.8 million. This kind of tax is there to ensure that families that had evaded paying tax on the inheritance they had transferred to the younger generation are fully recovered. However, it is important to note that whether the trustee is to pay tax or not, is determined by the distribution of the trust income. For instance, where the trust amasses trust without distributing it, the trustees accumulated wealth is evaluated at the premier tax rate as an individual. On the other hand, if the trustee distributes the trust to beneficiaries, an evaluation is done where the beneficiaries will be obligated to declare their trust income nets share when filing income returns. In this case, the beneficiaries can also claim a tax credit which the trustee paid on their behalf. Generally, a trustee has a legal responsibility to operate the trust that goes to the beneficiaries. A trustee can be either a company or an individual.
How you can Avoid Generation-Skipping Trust
Note that when it comes to generation-skipping trust, they undergo a tax liability to a second level which happens to be beyond the estate and gift taxes. This usually has a tax rate of 40 percent which is additional taxation to the usual tax liability of the estate. The second level tax liability is usually for the purpose of ensuring that the property goes through double taxation so that it can be passed on to two or more generations. This is the same as if the grantor decided to pass the property to his or her child first before passing it on to the grandchildren following the death of his or her child. Nonetheless, there is a way generation-skipping trusts can be structured so as to avoid GSTT taxation on trust. This is can be possible when you decide to take advantage of the general-skipping transfer which has a lifetime tax exemption. For instance, generation-skipping trust can be funded up to a maximum of $5.45 million and then you assign it a lifetime exemption. This way, any appreciation in the future on the trust property is transferred directly to the beneficiary of the trust. In a case where trust happens to be irrevocable, then you will have no obligation of paying generation-skipping tax. This is regardless of whether the asset value increases and comes to completion.
Are there any GSTT Tax Exemptions that apply to Generation-skipping Trust?
Following a loophole that existed in the payment of federal estate taxes where wealthy families could easily evade paying estate tax down to several generations; generation-skipping transfer tax (GSTT), was introduced to seal that loophole. However, through the 2010 Tax Relief Act, exemptions on GSTT were given to ensure that families that transferred modest wealth to the future generation had a bearable tax burden. Therefore, the American Taxpayer Relief Act of 2012 created a permanent tax exemption on GST. With this, the federal tax would only apply on a sum of wealth that exceeded $5 million. However, the amount has since been adjusted to $5.49 million. Generally, there are two exemptions that apply to the generation-skipping trust. We have exemption related to the estate as well as that related to general-skipping transfer tax. Exemptions on the two taxes are as follows:
- There is an exemption amount of up to $5.49 million which applies to an individual.
- Also, we have an exemption of $11.2 million that apply to a married couple.
Note that the exemption on the estate tax applies to the assets value which the descendant transfers directly to the beneficiaries he or she has chosen.
Benefits of Generation-Skipping Trust
Although those with large estates may not have many advantages when it comes to generation-skipping trust, there are still several benefits. Below are some of the benefits: Trust remains out of the reach of the grantors child creditors should there be financial problems between the child and the creditors. In this case, the law protects the trust funds from being used to pay creditors.
- Trust is a protected asset and, therefore, the grantors children cannot lose the property in any given legal action such as divorce. Also, the asset is not vulnerable to any financial disasters such as medical bills, financial debt, unsuccessful business or any other financial calamity.
- Another advantage is that grantors children can sometimes access income generated from the generation-skipping trust.
- There is an element of saving on taxes. There is a way you can take advantage of lifetime GSTT tax exemptions.
Note that since this type of trust is under protection, the children of the grantor have no legal right of using the trust to salvage themselves from any financial crises. In other words, this kind of trust cannot be used by the grantors children as collateral.
Limitations of Generation-Skipping Trust
A generation-skipping trust generally affects those with large estates. Below are some of the limitations of this kind of trust:
- Trust is irrevocable. Meaning that it is a binding agreement and, therefore, under no circumstance can it be canceled or altered.
- Though children can access income from the generation-skipping trust, they cannot acquire the ownership because it is a protected asset.
- Declaration of Trust
- Uniform Gifts for Minors Act
- Acceptance of Office by Trustee
- Beneficial Interest
- Asset Protection Trust
- Bare Trust
- Blind Trust
- Charitable Lead Trust
- Charitable Remainder Trust
- Charitable Remainder Annuity Trust
- Charitable Gift Annuity
- Credit Shelter Trust
- Discretionary Trust
- Generation Skipping Trust
- Grantor Trust Rules
- Living Trust
- Inter Vivos Trust
- Revocable Trust
- Irrevocable Trust
- Irrevocable Income-Only Trust
- Qualified Domestic Trust (QDOT)
- Qualified Terminal Interest Protection Trust (QTIP)