What is a Generation-Skipping Transfer Tax (GSTT)?

Generation-skipping transfer tax (GSTT) refers to a federal tax that comes up when there is property transfer in the form of an inheritance or a gift to a beneficiary who should be younger than the donor by at least 37.5 years. Note that the receiver of the gift or inheritance does not have to be a family member. It can be anybody provided that person is at least 371/2 years younger than the person transferring the property. Another term used to refer to generation-skipping tax is generation-skipping tax. 

• A generation-skipping transfer is where transferor transfers his or her possessions (property or money) either as an inheritance or gift to an individual who is below the donors generation by two or more generations.
• Generation-skip transfer related tax is highly dependent on whether the transfer is a direct skip or indirect skip.
• GSTT happens when grandparents transfer their possessions directly to their grandchildren skipping their parents so as to evade inheritance taxation.
• Generation-skipping transfer tax was introduced to seal the loophole on inheritance tax evasion.

How Does the Generation-Skipping Transfer Tax Work?

Generally, transfer taxes are taxes imposed on the transfer of property at death, by gift or during life. GSTT happens when grandparents transfer their possessions directly to their grandchildren skipping the grandchildren's parents. The generation of the parents is skipped for the purpose of evading inheritance taxes. Note that generation-skipping tax applies only where the transfer evades incurring tax related to an estate or a gift at each level of generation.

The History behind Generation-skipping Transfer Tax

The GSTT is a tax version that was introduced in 1976 to remedy the abuse of trust where several generations were benefiting from it while they avoid Federal Estate Tax payment throughout the trust period. Wealthy families who had established wealth went to estate planners to create a life estate in their property for their children. Another life estate property followed for their grandchildren, and then for their great-grandchildren and so forth. Note that under federal estate tax, life estates are not subject to taxation. With this trend, the families who were less wealthy found themselves giving out more estate tax than what the wealthy families were paying. Generation-skipping transfer tax was then created to seal this loophole on inheritance tax evasion. In other words, GSTT was introduced so that transfer taxes would apply to every generation and this time at higher rates.

General-Skipping Transfer Tax Exemption

When it comes to GSTT, there are exceptions that apply. Exemptions refer to the amount that has to be transferred to grandchildren without being subjected to federal generation-skipping tax.

• Grandchildren who have lost their parents are allowed to take the place of their parents. In this case, their gift is not subjected to GST because it has not skipped any generation.
• Also, couples that are married can double the exemption amounts. This enables the couple to transfer a substantial amount of money and property without it being taxed.

Direct versus Indirect Skips

Generation-skip transfer related tax is highly dependent on whether the transfer is a direct skip or indirect skip. 

Direct skip - This is where property transfer like estate or gift which is subject to taxation. An example of a direct skip is where a grandfather transfers property to his grandchild in the form of a gift. The estate, in this case, is subject to GST taxation because of the direct skip. 

Indirect skip-This is a transfer where intermediate steps are involved. In indirect skip, there are various steps that apply before the transfer reaches the skip person. Direct skip is of two types: 

Taxable Termination - Under taxable termination, we have a skip and non-skip person. A non-skip person refers to the prime beneficiary. This is basically a beneficiary entitled to receive the property before it is passed on to the skip person. A good example of taxable termination is a transferor (the person giving out the gift) who owns an income-producing trust for his or her son. By bad luck, the son passes on, and the transferor has to pass the remainder of the possessions to the grandchild. During this process of transfer, the property passed on is usually subject to GST taxation. 

Taxable distribution - This type of indirect taxation refers to any income or property's distribution directed to a skip person from the trust which does not undergo estate or gift taxation. For instance, if a grandfather started a trust where payments are made to the grandchild, the recipient of such funds has an obligation of paying GST tax because such funds are taxable.

Predeceased Ancestor Rule

The predeceased ancestor rule refers to where a person skips one generation in that if the generation that has been moved up is within the transferors one generation, then GST tax does not apply to any transfer made to the person. Below are provisions under the predeceased ancestor rule:

• The child and his or her two deceased parents must be descendants from the donors lineage or from the current or previous donors spouse.
• In a case where the donor has no descendants from his or her lineage, then the child and the deceased parent must be descendants from the lineage of the donors grandparents. A good example is where a great aunt who is childless gives a gift to her late brothers daughter or son. Such a gift is exempted from GST tax.
• Another provision is that at the time of awarding the gift, the child's parents must have been dead. This is regardless of whether the child gets the gift later either a trust distribution or a taxable termination.