Summary
- Review of transfer tax rules and exemption amounts.
- The benefits of a perpetual trust and the deferral or elimination of estate tax.
- Utilizing a grantor trust to maximize additional growth in the trust.
Probate & Property
Generation Skipping Tax: Use It or Lose It!
Carol Yepes/moment via Getty Images
Jump to:
The Tax Cuts and Jobs Act of 2017 (TCJA) has provided a historic opportunity for wealth transfer, with the doubling of the gift, estate, and generation-skipping transfer tax exemption to $10 million, adjusted for inflation. This doubling, coupled with record inflation in 2020 and 2021, has resulted in a generational opportunity to transfer wealth to future generations free of transfer tax. In 2024, individuals each had $13,610,000 in estate and generation-skipping transfer (GST) tax exemption to apply to transfers. Rev. Proc. 2023-34, 2023-48 I.R.B. 1287. The TCJA is set to expire on December 31, 2025, without further congressional action. The future of the exemption is uncertain, making 2025 crucial for maximizing the available estate and GST exemption.
The Transfer Tax Landscape
To take advantage of this window of opportunity, estate planners must be prepared to educate their clients on the advantages of leveraging the exemption, particularly the GST tax exemption, before the 2025 sunset.
First, an understanding of the transfer tax landscape is required. Gifts and bequests are subject to gift, estate, and GST taxes. Gift tax is applied to lifetime transfers made without adequate consideration. Estate tax is applied to transfers made at death. The rate for both gift and estate tax transfers is 40 percent. I.R.C. §§ 2502, 2001(c). The GST tax is tax applied to transfers made to individuals (or trusts for the benefit of individuals) more than one generation below the transferor. Id. § 2601. The rate applied to generation-skipping transfers is an additional 40 percent, on top of the gift or estate tax rate applied to the transfer. Id. § 2641(b).
The effective rate of transfers to grandchildren and more remote descendants is high. But Congress instituted both annual and lifetime exclusions from gift, estate, and GST taxes. The current exemption is historically high; for comparison, under Section 501 of the Taxpayer Relief Act of 1997 the estate, gift, and GST tax was as low as $1,000,000. Under I.R.C. §§ 2505 and 2010, the gift and estate tax exemptions are a unified credit; to the extent an individual does not use the exclusion during his or her lifetime, the balance of the exemption can be applied to transfers made at death. Because not every transfer is a generation-skipping transfer, an individual may exhaust his or her gift and estate tax exemption before using his or her GST tax exemption. For example, an individual may make a gift to a child that uses the gift tax exemption but that has no GST tax consequences. Therefore, the gift and estate tax exemption will be depleted, but the GST tax exemption is not affected.
The combination of congressional action and inflation adjustments has resulted in the ability to pass over $13 million completely transfer tax free. For individuals who will likely be subject to the estate tax, using the full estate and GST tax exemption is critical to get the full benefit of the exemption prior to the sunset. The IRS has made clear, through Treasury Regulation § 20.2010-1(c), that any taxpayer who uses the exemption for gifts will not be penalized with respect to the estate tax after the exemption amount is decreased in 2026. But the doubled exemption is essentially “use it or lose it.” After the exemption amount returns to its pre-TCJA levels in 2026, if the taxpayer has used less than $5 million, indexed for inflation, the taxpayer will have only an incremental exemption to the post-TCJA exemption amount.
| UTC TRUST VS. DYNASTY TRUST | |||||
| Year | Beginning-of-Year-Balance | Growth and Income | Annual Distributions | Expenses and Taxes | End-of-Year Balance |
| 1 | $10,000,000 | $708,000 | $0 | $0 | $10,708,000 |
| 31 | $77,848,606 | $5,511,681 | $3,334,411 | $209,513 | $79,816,363 |
| 51 | $126,527,153 | $8,958,122 | $5,419,411 | $458,919 | $129,606,945 |
| 81 | $260,220,650 | $18,423,622 | $11,145,771 | $948,218 | $266,550,283 |
| GRANTOR TRUST | |||||
| Year | Beginning-of-Year Balance | Growth and Income | Annual Distributions | Expenses and Taxes | End-of-Year Balance |
| 1 | $10,000,000 | $708,000 | $0 | $0 | $10,708,000 |
| 20 | $36,682,493 | $2,597,121 | $0 | $0 | $39,279,614 |
| 30 | $72,701,350 | $5,147,256 | $0 | $0 | $77,848,606 |
| 40 | $144,087,432 | $10,201,390 | $0 | $0 | $154,288,822 |
| NONGRANTOR TRUST | |||||
| Year | Beginning-of-Year Balance | Growth and Income | Annual Distributions | Expenses and Taxes | End-of-Year Balance |
| 1 | $10,000,000 | $708,000 | $0 | $0 | $10,708,000 |
| 20 | $29,857,225 | $2,113,892 | $0 | $399,575 | $31,571,542 |
| 30 | $52,133,636 | $3,691,061 | $0 | $706,430 | $55,118,267 |
| 40 | $90,947,800 | $6,439,104 | $0 | $1,236,667 | $96,150,237 |
Estate planners must be prepared for high pressure and time-constrained conversations in 2025 to fully maximize this “bonus” exemption.
The Right Tools to Prepare for Sunset
The most powerful tool at an estate planner’s disposal for leveraging this exemption is a grantor, dynasty trust for the benefit of multiple generations. Although any transfer using the exemptions is beneficial, a thoughtful structure can leverage the effect of the gift significantly over multiple generations.
The Power of a Perpetual Trust
Dynasty trusts are trusts that have no limit on their duration. For example, Tennessee Code § 66-1-202 has expanded the Rule Against Perpetuities to allow a trust to last up to 360 years. Florida’s Stat. § 689.225 permits trusts to have a term of up to 1,000 years. Furthermore, Delaware, South Dakota, and Rhode Island are examples of states that have abolished the Rule Against Perpetuities in its entirety, thereby allowing trusts to last in perpetuity. S.D. Codified Laws § 43-5-8; R.I. Gen. Laws § 34-11-38; Del. Code Ann. 25, § 503. Even if individuals do not reside in a state that permits perpetual trusts, they may generally avail themselves of the expanded term by appointing a trustee with situs in a state that has abolished the rule against perpetuities. S.D. Codified Laws § 21-22-2; Del. Code Ann. tit. 12, § 3340.
Under the Uniform Trust Code (UTC), adopted by most states, some version of the common law rule against perpetuities has been adopted. The rule was first seen in the United States in 1886: The classic common law language written by lawyer John Chipman Gray states, “No interest is good unless it must vest, if at all, not later than twenty-one years after some life in being at the creation of the interest.” Rule Against Perpetuities § 201.
Using the current maximized exemption will be favorable to future generations regardless of whether the trust is subject to the rule against perpetuities. The power of a dynasty trust is inarguable, however, when modeled out over multiple generations.
Depicted above is a “UTC Trust,” subject to the rule against perpetuities and a classic dynasty trust.
The UTC Trust assumes no grandchildren are living at the funding of the trust and the last life in being dies 60 years after the trust’s creation, allowing for an 81-year trust lifespan.
The chart assumes that the first (grantor) generation is using his or her remaining gift tax exemption ($10 million in this example) to fund the trust. Each generation is assumed to last 30 years (short time frame for simulation purposes only), with trust assets growing at a compounded rate of 7 percent. The illustration assumes no income tax was paid during the life of the grantor. After the death of the grantor, a 40 percent effective tax rate is assumed. The illustration assumes the trusts are outside of each generation’s taxable estate. It further assumes a 40 percent gift and estate tax rate applicable to future generations. The calculations assume a modest 4% annual withdrawal rate after the death of the grantor.
With a UTC Trust, at the end of the perpetuities period, $266,550,283 would be forced out into the hands of the grantor’s descendants, to be taxed upon their respective deaths. In the hands of a dynasty trust, the $266 million would continue to grow free of transfer tax, allowing additional generations to use and enjoy the funds.
From the above numbers, it is easy to see the vast difference in wealth accumulation when the assets remain free of estate and GST tax in trust for multiple generations. This chart demonstrates how funding irrevocable trusts designed to last at least three generations using the GST exemption is beneficial in all states but also that the compounding power of a dynasty trust will result in significant wealth preservation for future generations.
The Gift of Grantor Trust Status
Structuring the dynasty trust as a grantor trust will further turbocharge the applied exemption. An intentionally defective grantor trust is designed to allow all items of income and deduction to flow through to the grantor, yet still be outside of the grantor’s taxable estate for transfer tax purposes. I.R.C. § 671. Each year the grantor is living, he or she pays the income tax on the trust’s income, allowing the trust to continue to grow income-tax-free. This has a double benefit of also depleting the grantor’s taxable estate. Grantor trusts also permit incredible flexibility for the grantor to transact with the trust without income tax consequences, allowing sales of assets or purchases of assets without any gain recognition. This can be a very powerful tax deferral and planning strategy.
Conclusion
The math behind the funding of a grantor dynasty trust is clear. The question of whether to maximize the full exemption before sunset and how much of the exemption to use is personal to each individual’s financial goals, for the rest of that individual’s lifetime and for his or her descendants.
For a gift in trust to be complete and outside the grantor’s estate, the grantor cannot continue to benefit from the trust property and generally cannot have access to the funds. See id. §§ 2036, 2037, 2038. As much as the TCJA is an opportunity for powerful estate planning, it should not come at the expense of a comfortable lifestyle for the grantor.
Working with a multidisciplinary team of tax and financial advisors will allow advisors to calibrate the exemption planning that will benefit future generations while maintaining the individual’s financial security.
Helping individuals understand the outsized benefits of thoughtful planning, in situs selection, tax structure, and full use of the exemption will allow individuals to make the most of this moment and plan for generations to come.
This article is provided solely for informational purposes and is not intended to provide financial, investment, tax, legal, or other advice. It contains information and opinions that may change after the date of publication. The authors take sole responsibility for the views expressed herein, and these views do not necessarily reflect the views of the authors’ employers or any other organization, group, or individual. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Readers should consult with their own financial, tax, legal, or other advisors to seek advice on their individual circumstances.