Generation-Skipping Transfer Tax Basics

Generation-skipping transfer (“GST”) tax is the tax imposed on bequests that are made to an individual who is at least two generations younger than the donor (for example, a gift from a grandparent to a grandchild).  The purpose of the GST tax is to ensure that certain gifts, which could avoid either the estate and/or gift tax, are still subject to tax.  Certain states, such as Minnesota, do not apply a GST tax. Additionally, as it stands currently, there is no applicable federal GST tax for transfers made in 2010.  However, as is the case with the federal estate tax, without any action from Congress, the federal GST tax is set to return on January 1, 2011.

The return of the GST tax is significant. In 2011, there will be a GST exemption amount of $1 million (indexed for inflation), however, any amount over the exemption amount will be taxed at a rate of up to 55%.

Gift Tax vs. GST Tax

Currently, an individual can gift up to $13,000 to another person (other than a spouse since spouses can gift an unlimited amount to one another throughout their lifetimes and at death) per year without incurring any gift tax.  An individual has a lifetime gift exemption of $1 million meaning that if an individual gifts an amount over their allotted $13,000 per year to one individual, that excess amount will be deducted from the individual’s lifetime gift exemption.

Example: If Grandparent wants to give $13,000 one year to grandchild that gift will not incur a gift tax.  However, if Grandparent wants to give grandchild $20,000 one year, $7,000 of the gift will be deducted from Grandparent’s $1 million lifetime gift exemption.  As long as the donor stays under the annual gift exclusion limit, the donor does not have to worry about gift taxes.

Therefore, individuals should choose accordingly under what category a gift falls and the amount of the gift to ensure they maximize their annual gift exclusion limit rather than eat into their GST exemption.  In addition, if a donor wants to give a gift with the intent that it pays for an individual’s education and/or medical expenses, the donor should consider paying the tuition or medical expenses directly to an educational or medical institution on behalf of the donee so that payment will be exempt from gift taxes.

With careful planning, a donor can gift a significant amount of assets to others without being exposed to taxes.  By contrast, with poor planning, a donor can gift a significant amount of assets to others and be liable for taxes up to a rate of 55%.

Charitable Giving

Another option for individuals to avoid paying taxes on gifts is by making charitable contributions.  If an individual fears exceeding his or her GST exemption, they should consider making donations to charitable organizations.  Gifts to charities are never taxable, do not count against an individual’s annual gift exclusion, lifetime gift exemption or GST exemption, and are allowable deductions used in determining an individual’s taxable estate.

It is still uncertain what legislation will be in place as of January 1, 2011 with regards to federal estate, gift and GST tax.  Nevertheless, a conversation with one of your estate planning professionals (financial advisors, tax accountants and/or attorneys) could be useful in determining if there are steps that should be taken before the end of the year to maximize tax benefits.