A generation-skipping trust is an estate planning tool designed to transfer assets in a way that avoids some estate taxes. This type of trust, through which assets skip a generation, is also called a GST trust or dynasty trust, because it is often used by affluent families to pass down wealth at a great estate tax savings.
How Generation-Skipping Trusts Work
In a typical inheritance, when Parent A leaves assets to Child B directly, these assets would be subject to federal estate tax (40 percent in 2018) if their value does not fall below the estate tax exemption amount ($11.18 million in 2018). In turn, when Child B leaves the same assets to his child, Parent A's grandchild, they are again subject to estate tax and taxed again.
A generation-skipping trust removes one step from the estate tax equation by transferring assets directly from grandparent to grandchild (or great-grandchildren, other younger descendants, or unrelated individuals who are at least 37-1/2 years younger than the grantor, collectively known as "skip persons"). While some generation-skipping trusts involve only grandchildren, many involve several generations to maximize the benefits of having the trust.
Notably, this does not mean that the person in between is being disinherited entirely—unless, of course, that is what the grantor wants. The generation in between may inherit in various other ways, such as direct gifts—always, of course, with an eye toward the yearly exemption amount for gifts ($15,000 per person in 2018) to be sure not to incur additional gift tax.
There are no generation-skipping trust rules that require distributions to be made immediately or even at the will of the beneficiary. The grantor may choose to limit the reasons to allow distributions, such as for education, or may name an independent trustee to manage the trust and follow its terms. For this reason, inheriting could be a long way off for some skip persons, depending on the terms of the trust.
Generation-Skipping Trust Tax
Technically, there are no generation-skipping trust limits, but you should be aware of the generation-skipping trust tax (also called the GST tax or generation-skipping transfer tax), which applies a flat tax of 40 percent on generation-skipping transfers that exceed the exemption amount ($11.18 million in 2018). By claiming the exemption, you can use a generation-skipping trust to transfer up to that amount before it would be subject to the GST tax.
Essentially, the generation-skipping trust tax is intended to catch and tax those inheritances that may otherwise have escaped taxation.
Disadvantages of a Generation-Skipping Trust
For those with large estates, there aren't many disadvantages to a generation-skipping trust, but one is that the trust is irrevocable, which means it cannot be changed or canceled. On the other hand, the trust's terms can be written with an eye toward the future and potential situations that could arise. Accordingly, while the terms themselves won't change, the trust still may have some flexibility within its own confines.
Because generation-skipping trusts and the taxes that could come with them are highly complex estate planning tools, you should consult experienced professionals, such as those available through an online service provider, for advice on whether you need such a trust, as well as how to set it up to provide the most benefit to your estate and beneficiaries.