Generation Skipping Trusts Explained

‍In this article, we’ll be defining a generation-skipping trust (GST) and explaining some other vital points to consider before making a decision. If you’re considering creating a generation-skipping trust, here’s a concise overview of everything you may need to know, including “what is a generation-skipping trust?”, “What are the Benefits of a Generation Skipping Trust?”, “Who Can be a Recipient of a Generation Skipping Trust?”, “Do I Have to Pay Taxes on a Generation Skipping Trust?”

What is a Generation-Skipping Trust?

A generation-skipping trust (GST), sometimes referred to as a “dynasty trust,” is precisely what it sounds like – a legally binding, focused, irrevocable trust agreement in which a grantor’s assets are passed down to the grantor’s grandchildren (not children) to avoid estate tax liability. GSTs are designed to eliminate estate taxes at each generational level for as many generations as tolerated by applicable Illinois law. The grantor’s children can never take title to the assets and receive the opportunity to avoid estate taxes (taxes on an individual’s right to transfer property upon their death) that would apply if the assets were transferred to them.

Generation-skipping trusts aren’t meant to punish or avoid a grantor’s children intentionally; instead, it is utilized to escape the cumbersome estate taxes, which are known to drown inheritances. If the grantor’s children inherited the grantor’s assets, they would be taxed a staggering 45% estate tax. Once those beneficiaries passed the inherited assets down to their children (the original grantor’s grandchildren), they would be taxed another 45%. This isn’t a scalable solution for families passionate about sharing valuable assets with future generations.

What are the Benefits of a Generation-Skipping Trust?

While simple GSTs typically only involve grandchildren as eligible beneficiaries, the most common GST involves multiple generations of beneficiaries, which can take years or even decades for grandchildren and great-grandchildren to receive distributions from the trust. While the children can sometimes access the income from generation-skipping trusts, they do not own the protected assets, so they cannot lose them in any legal action. This kind of trust also protects the grantor’s children from all types of financial calamities, including divorces, failed businesses, medical bills, and financial debt. A GST protects the family’s wealth from these scenarios because the grantor’s children will have no legal authority to use the trust assets as collateral.

Who Can be a Recipient of a Generation-Skipping Trust?

It may sound like GSTs cannot provide any financial advantages to a grantor’s children. Still, on the contrary, the grantor can give their children access to any income the trust’s assets generate without removing the assets from the GST.

Interestingly, the recipient of a generation-skipping transfer doesn’t necessarily have to be a family member. As long as an individual is at least 37.5 years younger than the grantor, anybody other than the grantor’s spouse or ex-spouse can become a beneficiary of the GST. For people who own a significant amount of assets and savings, GSTs are truly effective wealth-preservation tools. For more information on how to modify a trust read our article, Actions to Modify a Trust

Do I Have to Pay Taxes on a Generation-Skipping Trust?

Once families started taking advantage of the GSTs’ loophole for avoiding federal estate taxes, the government updated the tax code in 1986 to create a generation-skipping transfer tax. The American Taxpayer Relief Act of 2012 established a permanent $5 million tax exemption on generation-skipping transfers, meaning there’s only a federal tax on a generation-skipping transfer of wealth exceeding $5 million. This amount adjusts every year to account for inflation. Families who are affected by the generation-skipping transfer tax face a heavy burden.

Due to the complexities surrounding generation-skipping trusts, it’s wise to seek professional legal help to create a GST that takes full advantage of the generation-skipping transfer tax lifetime exemption. The more effort you put toward planning the details of a complicated, high-net-worth estate plan now, the closer you are too massive tax savings for future generations of your family. If your family already has a GST and you are the grantor’s child, you may want to create a GST for your grandchildren. This way, the trust chain minimizes your family’s tax liability in generations to come.