How does generation-skipping transfer tax planning work?

What it is

The GST tax is designed to tax wealth that skips a generation. A skip person is generally an individual two or more generations below you, such as a grandchild, or a trust whose interests are all held by skip persons. The tax applies to direct skips, taxable distributions, and taxable terminations.

A dynasty trust is a long-term trust for several generations. If GST exemption is allocated to cover the full value, distributions to grandchildren and later generations are not subject to GST tax, no matter how much the trust grows, as long as nothing is added without more exemption.

The tax applies on top of gift or estate tax. Without planning, a large transfer to grandchildren could face both a 40% gift or estate tax and a 40% GST tax. The GST exemption exists so that transfers up to the exemption amount avoid the second tax.

What the law says

IRC §2601 imposes a tax on every generation-skipping transfer. Under §2641, the rate is the maximum federal estate tax rate (40%) times the inclusion ratio. Section 2631(a) gives each individual a GST exemption that can be allocated to property he or she transfers, and §2631(c) sets the exemption equal to the basic exclusion amount under §2010(c), which is $15,000,000 for 2026.

Section 2632(b)(1) automatically allocates unused exemption to lifetime direct skips, and §2632(c)(1) automatically allocates it to indirect skips to GST trusts, in each case to the extent needed to make the inclusion ratio zero. You can elect out. If an allocation is not made on a timely gift tax return and is not automatic, §2642(b)(3) values a late allocation as of the date it is made. Section 2642(g)(1) provides relief for late elections.

Section 2651(e) generally moves a grandchild up a generation if the grandchild's parent (the transferor's child) has died before the transfer.

Requirements and tests

• Identify each transfer as a direct skip, a transfer to a GST trust, or a transfer to a non-skip trust.
• Confirm how exemption was allocated: automatically, by affirmative election, or by electing out, on Form 709 or Form 706.
• Keep the inclusion ratio at zero by not adding property to an exempt trust without allocating more exemption, and by keeping exempt and non-exempt property in separate trusts.
• Draft the trust within state perpetuities limits; in Texas, §112.036 allows interests to vest up to 300 years after the effective date for trusts that became irrevocable on or after September 1, 2021.

How it works

You transfer assets to a dynasty trust and allocate GST exemption equal to the value transferred. The trust has an inclusion ratio of zero, so later distributions to grandchildren and taxable terminations are not subject to GST tax. The gift itself uses your basic exclusion amount for gift tax.

If a trust has an inclusion ratio above zero, GST tax applies when a taxable distribution or taxable termination occurs, based on the value at that time. Growth in a non-exempt trust therefore increases the eventual GST tax.

Direct skips during life, such as a gift outright to a grandchild above the annual exclusion, are tax-exclusive: the donor pays the GST tax on top of the gift, and that payment is itself treated as an additional gift. Taxable terminations and taxable distributions are tax-inclusive: the tax is computed on the whole amount, and the trust or recipient pays it.

Estates can also allocate GST exemption on Form 706 to property passing at death, including to trusts created under the will or a revocable trust. Any exemption not allocated by the executor is allocated automatically under §2632(e).

Risks and IRS scrutiny

Risks include unintended automatic allocation to trusts that are unlikely to benefit skip persons, electing out by mistake, mixed inclusion ratios, additions to exempt trusts, grandfathered trusts that lose protection when modified, and valuation disputes. Late allocations use current values, which can require more exemption.

Who it is not for

This is not for families giving only to children outright, for estates well under the exemption with no multigenerational goals, or for families unwilling to maintain a long-term trust and its records.

Families using annual-exclusion gifts to grandchildren outright generally do not need to allocate exemption to those gifts, because §2642(c) gives them a zero inclusion ratio.

How ebotCPA helps

We review your Forms 709 and 706 to trace every allocation, identify trusts with inclusion ratios above zero, and prepare allocations, elections out, or §2642(g) relief requests. We coordinate with your attorney, who drafts the legal documents.

Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.

Primary sources

1. 26 U.S.C. §2601. Tax imposed on generation-skipping transfers.

   “A tax is hereby imposed on every generation-skipping transfer (within the meaning of subchapter B).”

   Imposes the GST tax.

2. 26 U.S.C. §2631(c). GST exemption amount.

   “For purposes of subsection (a), the GST exemption amount for any calendar year shall be equal to the basic exclusion amount under section 2010(c) for such calendar year.”

   Sets the GST exemption equal to the basic exclusion amount.

3. 26 U.S.C. §2632(b)–(c). Deemed allocation of GST exemption.

   Allocates unused GST exemption automatically to direct skips and indirect skips to GST trusts unless you elect out.

4. 26 U.S.C. §2642(b)(3) and (g). Late allocations and relief.

   Values late allocations at the date made and authorizes relief for late elections.

5. Treas. Reg. §26.2632-1. Allocation of GST exemption.

   Explains automatic allocation, elections out, and late allocations.

6. Tex. Prop. Code §112.036. Rule against perpetuities for trusts.

   Allows interests in trusts effective on or after September 1, 2021 to vest up to 300 years later.

Frequently asked questions