How can you best preserve wealth for your heirs? If your children are well off and your estate is large enough that estate taxes are a concern, you may be inclined to bequeath more assets directly to your grandchildren as part of your estate plan. In effect, this gives Uncle Sam one less bite at the tax apple because those assets won’t be included in the taxable estates of your children, right?

Not exactly. Under the generation-skipping transfer (GST) tax, an additional tax (on top of estate tax) may be imposed on gifts and bequests that skip a generation. So, you can’t automatically avoid adverse tax consequences simply by bypassing your children. But with proper planning, you may be able to sidestep the GST tax — or at least minimize it. 

Generally, assets that are inherited by nonspouse beneficiaries are subject to federal estate tax. But estate tax liability is often reduced or eliminated through the lifetime gift and estate tax exemption. (Transfers to a U.S. citizen spouse are shielded by the unlimited marital deduction.)

Effective in 2018, the Tax Cuts and Jobs Act (TCJA) doubled the exemption from $5 million to $10 million, subject to inflation indexing. It is $12.06 million for 2022. But the exemption is scheduled to revert to $5 million, plus inflation indexing, in 2026. Of course, Congress could change the law again before then, but that’s where we stand now. 

At the same time, the TCJA preserved a top federal estate tax rate of 40%. For example, if the estate eventually is taxed on $5 million, the resulting estate tax is $2 million.

Therefore, wealthy individuals still may be searching for ways to minimize estate tax on transfers to heirs, including making gifts or bequests to grandchildren. Unfortunately, the GST tax stands in their way. 

Essentially, the GST tax applies to transfers to related individuals who are more than one generation away — such as grandchildren or great-grandchildren — and unrelated individuals, like family friends, who are more than 37½ years younger. All these designated beneficiaries are referred to as “skip persons.”

Furthermore, you can’t dodge this potential tax pitfall simply by transferring assets to a trust and naming your descendants as the ultimate trust beneficiaries. For these purposes, all of the trust beneficiaries are treated as skip persons — even the trust is considered a skip person in certain circumstances. 

Similarly, a trust termination generally results in imposition of the GST tax. This occurs when an interest in a trust terminates — unless only nonskip persons are receiving the trust assets and no skip persons have a right to receive the assets after the termination.

Special exception: In the event their parents have predeceased them, grandchildren effectively move up the line in the place of their parents. Because transfers to them technically are no longer skipping a generation, the GST tax doesn’t apply anymore. But such transfers are still exposed to regular federal estate tax.

Just as with regular estate tax, your family may benefit from a GST tax exemption. The exemption moves in lockstep with the estate tax exemption. Accordingly, the GST tax exemption for 2022 is $12.06 million. It’s also scheduled to drop to $5 million, plus inflation indexing, in 2026.

Note that these figures are effectively doubled for joint filers. So, a married couple can shield up to $24.12 million from the GST tax in 2022 — a hefty figure.

Also, be aware that you can currently gift up to $16,000 per person per year, including a grandchild or other descendant, under the annual exclusion without triggering any gift or GST tax liability. This exclusion is also indexed for inflation, but only in $1,000 increments. (For 2022, it was increased from the 2021 amount of $15,000.)

Gifts made to skip persons, directly or through a trust, are referred to as “direct skips.” If GST tax is paid rather than having the lifetime exemption applied, the direct skip is turned into an “indirect skip.” Generally, the tax must be paid on Form 709 for the year the gift is made.

The GST tax situation is complex — this brief article only provides an overview. In addition, you may face state tax complications, because many jurisdictions have their own version of a GST tax. Best approach: Seek guidance for your particular situation from an experienced professional. 

Even if your situation triggers the generation-skipping transfer (GST) tax, you can take steps to avoid or minimize it. For instance, you can: 

1. Maximize use of the GST tax exemption. The current $12.06 million exemption ($24.12 million for a married couple) provides a lot of protection from the GST tax. 
2. Use the annual gift tax exclusion to shield from GST tax gifts of up to $16,000. Employ this technique before tapping into the GST tax exemption.
3. Take advantage of the ability to use trusts within the rules. Also, rely on the exception for predeceased parents, when appropriate. 

Coordinate these three strategies as part of your overall estate plan.