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How a Generation-Skipping Trust Works

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A generation-skipping trust is an estate planning document that will distribute the assets one day to the grantor’s (person who set up the trust) grandchildren, passing over the grantor’s children. In other words, the assets in the trust skip the grantor’s children and go to the next generation, the grandchildren. People who set up generation-skipping trusts, usually do so to avoid estate taxes.

If there is significant wealth in the family, the “skipped” generation might prefer the assets go directly to the next generation, particularly if the assets are things that will likely stay in the family for multiple generations, like investments and business interests. If you are considering setting up one of these trusts, you need to understand how a generation-skipping trust works.

Why People Set Up Generation-Skipping Trusts

Let’s say that a grandparent (Generation 1) owns blue-chip stocks worth a sizeable fortune. Her child (Generation 2) is now in his sixties and quite wealthy in his own right. Grandma is in her mid-eighties. If she leaves the stock to her son, estate taxes will take a significant portion of the assets.

When the son (G2) passes away in 15 or 20 years, the estate will yet again have to pay estate taxes on the same assets. Since estate taxes can diminish the total value of the inheritance substantially, families who want to keep the assets in the family can avoid the estate-depleting taxes by skipping a generation. In this example, the family avoids double taxation.

The Rules of Generation-Skipping Trusts

The skipped generation (G2) can never own the assets in question. He cannot take title at any point.

A fun twist of generation-skipping trusts is the person who does receive the assets (G3) instead of the son (G2), does not have to be the grandchild of the person who set up the trust. The G3 does not even have to be a relative of the grandparent. The only restrictions on who can receive the assets (G3) in a generation-skipping trust is that:

  • The G3 cannot be a current or former spouse of the person who set up the trust (G1), and
  • The G3 must be at least 37 ½ years younger than the G1

While the assets must go to a G3, the grandparent’s child (G2) can still reap financial benefits from the assets. The G2 cannot own the assets, but the trust can provide that he receives the income from the assets, as long as the asset itself eventually goes to the G3.

Taxes on Generation-Skipping Trusts

Because these trusts were so effective at avoiding estate taxes, the federal government changed the rules in 1986 to create a transfer tax on generation-skipping trusts. In 2010 and 2012, tax law updates exempted the first $5 million from transfer taxes. The exemption adjusts every year for inflation. By 2017, the exemption grew to $5.49 million.

New tax laws doubled the exemption beginning in 2018, to $11.18 million for individuals and $22.4 million for couples. The exemption amount goes up every year because of inflation. The double exemption sunsets on December 31, 2025. If Congress does not extend this measure, the exemption will go back to its previous amount.

You should talk with a tax advisor about the tax issues of generation-skipping trusts. This article does not give tax advice. This article covers the general law, and your state might have different regulations. You should talk with an elder law attorney near you.

For more information about estate planning in Orlando, FL (and throughout the rest of Central Florida), visit our estate planning website and be sure to subscribe to our complimentary estate planning e-newsletter while you are there.

References:

Investopedia. “Generation-Skipping Trust.” (accessed December 19, 2019) https://www.investopedia.com/terms/g/generation-skippingtrust.asp

Suggested Key Terms: generation-skipping trusts, avoiding estate taxes with generation-skipping trusts