Contributed by: Brian Sak CFP®, CLU®, ChFC®

Navigating the seemingly endless tax regulations can feel daunting, especially for high-net-worth families and business owners striving to preserve and protect generational wealth. According to the book "Preparing Heirs: Five Steps to a Successful Transition of Family Wealth and Values", 90% of family wealth is dissipated by the third generation. Ineffective tax strategy is one of several contributing factors to this phenomenon along several others that we will discuss in concurrent blogs.

One complex component of the tax strategy is the planning around Generation Skipping Tax (GST), a federal tax on wealth transfers that skip a generation. For many, it remains a highly misunderstood concept. This comprehensive guide will shed light on GST, highlight common pitfalls, and explore planning opportunities that can aid in minimizing its impact.

Understanding the Generation Skipping Tax

The Generation Skipping Tax (GST) is pivotal in discussions about wealth transfer, but what exactly is it? At its core, GST is a federal tax imposed on transfers of wealth to individuals at least two generations below the donor, such as grandchildren or even unrelated beneficiaries. This tax aims to limit wealthy families' ability to bypass their children with transfers to avoid estate inclusion at their generation.

The GST applies to both direct transfers and those made through trusts. It's comparable to the federal estate tax, but specifically targets these generational skips. In 2024, the GST exemption amount is set at $13.61 million, with transfer amounts exceeding this threshold taxed at 40%. Understanding these figures is crucial for effective estate planning.

GST Relationship with Other Taxes

It is important to recognize that the GST tax is a separate and distinct tax in addition to the federal estate and gift tax system. The exemption level is set at the same levels set for the estate and gift tax. As of 2024, estate, gift tax and GST exemptions are established at $13.61 million ($27.22 million for married couples) to be used either during lifetime (a gift) or at death (estate transfer). This alignment offers a streamlined understanding for estate planning, as individuals and their advisors can work within a consistent framework when considering transfers. The uniformity of these exemptions not only simplifies planning efforts but also enables strategic coordination across different types of wealth transfers. Utilizing these exemptions effectively can significantly impact the efficiency and outcomes of a comprehensive estate plan.

For many taxpayers, GST is just one piece of the larger tax puzzle, which includes income tax, capital gains tax, estate, and gift tax. GST's unique role as an additive tax to the gift and estate systems requires careful navigation to avoid compounding tax liabilities.

From a taxpayer's perspective, the interplay between these taxes can be challenging. For instance, while income and capital gains taxes focus on taxing earnings and appreciating assets; GST, gift and estate taxes focus on taxing the transfer of wealth. Overlooking this interconnectedness can lead to substantial unanticipated tax burdens, and significantly increase the effective tax rate of the family.

Without meticulous planning, wealth can be subjected to multiple layers of taxation before it reaches the intended recipients. Initially, capital gains tax may be levied on the appreciation of assets, reducing the overall estate value. Subsequently, transfers made during the donor's lifetime might incur gift tax, or at death, face estate tax implications. Moreover, if the transfer intentionally skips a generation, the Generation Skipping Tax comes into play, imposing an additional tax on the same wealth. Thus, the intricate combination of these taxes can significantly diminish the wealth passed down through generations if strategic estate planning isn't employed.

For business owners and high-net-worth families, understanding these dynamics is vital. It enables the creation of tax-efficient strategies that balance GST planning with broader financial goals.

Applicability of GST - What Transfers Are Affected?

Identifying which transfers are subject to GST is essential for effective planning. Primarily, GST affects individuals making significant wealth transfers to direct skip persons either directly or through trust —those two or more generations younger. This includes not only grandchildren but also unrelated individuals at least 37.5 years younger than the donor.

The specific figure of 37.5 years stems from the legal definition used to determine generational assignments for tax purposes under the Internal Revenue Code. In instances where direct familial relationships do not clearly define the generational gaps, the IRS employs this age-based calculation to ensure consistency.

GST isn't limited to individuals. Trusts with beneficiaries fitting this description are also subject to GST. Critically, the tax applies not just during lifetime transfers but at death and other events triggering wealth transfers, making it an all-encompassing consideration for estate planning.

For high-net-worth families, understanding who GST applies to can streamline estate planning, ensuring that wealth transfer strategies align with both personal goals and tax regulations.

Common Pitfalls in GST Planning

Despite its importance, GST planning is fraught with common pitfalls that can derail even the best-laid plans.

Commingling GST-Exempt and Non-GST-Exempt Assets

This mistake typically arises when individuals are unaware of the distinctions between GST-exempt and non-GST-exempt assets, leading to their improper mixing within a single trust structure. Without diligent recordkeeping and oversight, these commingled accounts result in complex allocations and unintended tax consequences.

Consider a family trust established with the purpose of passing wealth to future generations. This trust holds a mix of assets, including $13 million in GST-exempt funds and an additional $7 million in non-GST-exempt assets. The trust administrator, unaware of the distinctions and consequences, inadvertently distributes income from both pools equally among the beneficiaries, some of whom qualify as direct skips under the GST guidelines.

As a result, when making distributions, the administrator fails to correctly segregate the funds based on their GST status, leading to the unintended application of GST tax on the entire distributed amount. This oversight not only subjects the non-exempt portion to the anticipated 40% GST tax but also places a disproportionate tax burden on the beneficiaries receiving these commingled distributions. Without proper guidance, such mistakes can deplete the trust's value and disrupt the intended generational wealth transfer, underscoring the necessity of meticulous planning and recordkeeping in estate management.

Incorrect or Outdated Beneficiary Designations

Another frequent oversight involves beneficiary designations. Incorrect designations can lead to unintended tax consequences, underscoring the need for precise estate planning.

Failing to Elect GST When Making Transfers

Additionally, failing to utilize available exemptions effectively can result in higher than necessary tax payments.

The process of placing assets into a trust, either with or without GST exemption, involves deliberate decisions based on donor intent and strategic planning objectives. To place assets into a trust with GST exemption, an individual can allocate a portion of their GST exemption amount when the trust is funded. This allocation effectively shields future distributions to all future skip persons from GST liability, potentially for multiple generations. For instance, when forming a trust intended to benefit grandchildren and beyond, setting aside a portion of the $13.61 million GST exemption can ensure that the transferred assets and any growth they experience remain protected from GST.

Conversely, to place assets into a trust without claiming the GST exemption, donors might do so either by choice or due to the depletion of their exemption amounts. This scenario is often strategic, particularly if the donor anticipates the trust predominantly benefiting non-skip persons (children) initially, with minimal immediate need for GST protection. In cases where GST exemption is not allocated, it allows for flexibility to benefit from potential future shifts in beneficiaries or strategies. It’s essential for donors and their advisors to document these decisions carefully and ensure thorough tax reporting is completed. Awareness of these pitfalls empowers families and business owners to take proactive steps, such as consulting tax advisors, to mitigate risks and optimize GST planning.

Planning Opportunities for High-Net-Worth Families

Despite its complexity, GST presents numerous planning opportunities for high-net-worth families. Lifetime gifting, installment sales, GRATs, SLATs, leveraging life insurance for liquidity, and irrevocable trusts, for instance, are all powerful tools for minimizing GST impact. By allocating GST exemptions efficiently, families can shield significant assets from unnecessary taxation.

The potential sunset of the Tax Cuts and Jobs Act (TCJA) also warrants consideration. This legislation temporarily increased GST exemptions, creating opportunities for strategic transfers before potential changes in tax laws. Families can leverage this window to maximize tax-efficient wealth transfers.

The sunset of the Tax Cuts and Jobs Act (TCJA), scheduled for the end of 2025, could significantly alter the estate planning landscape by reducing the elevated GST exemption levels to pre-TCJA amounts. Prior to the Tax Cuts and Jobs Act (TCJA), the GST exemption amount was set at $5 million, adjusted for inflation. If no changes to the current law are made, it would mean close to a $14 million exposure increase for married couples for estate, gift and GST exemption calculations taxed at a 40% rate. High-net-worth families are advised to act swiftly to leverage these temporary provisions, ensuring that transfers are made before the potential rollback to previous thresholds.

The Time to Act is NOW

Engaging experienced professionals in estate planning is paramount, particularly as the deadline for changes approaches. The transfer process, especially for complex assets like real estate and closely-held business interests, can be time-consuming and challenging due to their intricate valuation requirements. Delaying consultation can lead to rushed decisions and missed opportunities to optimize tax strategies. Given these circumstances, it's crucial for families and business owners to act now without hesitation. The limited availability of skilled advisors as deadlines near underscores the importance of early engagement. Proactive planning together with timely professional guidance can ensure that wealth transfer strategies are executed efficiently and aligned with both current regulations and long-term family objectives.

Conclusion

Generation Skipping Tax is more than a regulatory hurdle; it's a crucial consideration for preserving family wealth across generations. For high-net-worth families and business owners, understanding GST, avoiding common pitfalls, and exploring planning opportunities are essential steps toward achieving long-term financial goals.

By adopting a holistic approach to GST planning, families can align tax strategies with broader estate planning objectives, ensuring that wealth transfers are efficient and tax-advantaged. For those seeking tailored guidance, Granite Harbor Advisors offers expert advice to help you make informed decisions and safeguard your legacy.

Take the Next Step

Contact Granite Harbor Advisors today to schedule a complimentary estate planning consultation. Begin your journey toward safeguarding your family's financial legacy with expert insights and personalized strategies.

Vic Preisser and Roy O. Williams, Preparing Heirs: Five Steps to a Successful Transition of Family Wealth and Values (San Francisco: Robert D. Reed Publishers, 2003).