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One change affecting estate plans under the Tax Cuts and Jobs Act is that, for the estates of persons dying after December 31, 2017, and before January 1, 2026, the generation-skipping transfer (GST) tax exemption amount increases to an inflation-adjusted $10 million, or $20 million for married couples with proper planning ($11.18 million and $22.36 million, respectively, for 2018). However, without further congressional action, the exemptions will revert to an inflation-adjusted $5 million and $10 million, respectively, beginning January 1, 2026.

What is GST tax?

The GST tax is one of the harshest in the Internal Revenue Code. It’s a flat 40% tax on asset transfers to “skip persons” — that is, your grandchildren, other family members who are more than one generation below you or nonfamily members who are more than 37½ years younger than you. The GST tax is calculated independently from and is in addition to gift and estate taxes, so it can take a significant bite out of your hard-earned wealth.

Fortunately, the estate tax law provides a generous GST tax exemption. Careful planning is required, however, to make the most of the exemption. In some cases, for an exemption to apply, you must allocate it to particular assets via an affirmative election on a timely filed gift tax return. In other cases, the exemption is allocated automatically (unless you opt out), which can lead to unwanted results if you prefer to allocate your exemption elsewhere.

To avoid costly mistakes, it’s a good idea to review each transfer for potential GST tax liability. Also, take steps to ensure that your exemption is allocated in the most advantageous manner.

Keep accurate records

The GST tax applies to direct gifts to a skip person, as well as to two types of transfers involving trusts:

• Taxable terminations. Trust assets pass to your grandchildren when your child dies and the trust terminates.
• Taxable distributions. Trust income or principal is distributed to a skip person.

GST tax doesn’t apply to direct gifts that are covered by the annual gift tax exclusion (currently, $15,000 per recipient; $30,000 for “split” gifts by married couples).

What protection do automatic allocation rules provide?

The automatic allocation rules are intended to protect you against inadvertent loss of GST tax exemptions. For example, if you make a direct gift in excess of the annual gift tax exclusion to a grandchild or other skip person, your unused GST tax exemption is automatically applied to the gift without the need to make an allocation on a gift tax return. The exemption is also allocated automatically to “GST trusts.” The rules are complex, but in general, a trust is considered a GST trust if there’s a possibility it will benefit your grandchildren or other skip persons in the future.

In many cases, the automatic allocation rules work well, ensuring that the GST tax exemption is used where it’s needed most. But in some cases, the rules lead to unintended — and potentially costly — results. Here’s an example:

You set up a trust primarily for the benefit of your children, although your grandchildren are named as contingent beneficiaries. This may be enough to trigger the automatic allocation rules even if the possibility that your grandchildren will receive any trust assets is remote. Depending on the size of your estate, you may be better off opting out of automatic allocation and directing your exemption to gifts that are more likely to trigger GST taxes.

GST exemption not permanent

Fewer families will be affected by the GST tax going forward, thanks to a significantly higher exemption amount. But there are still reasons to plan for this tax. Contact your estate planning advisor for more information.