Legal Definitions - generation-skipping transfer tax

The generation-skipping transfer tax is a federal tax specifically designed to prevent individuals from avoiding estate and gift taxes by transferring substantial wealth directly to beneficiaries who are two or more generations younger than themselves. This tax applies when assets, often held within trusts, are passed down to "skip persons" – individuals such as grandchildren, great-grandchildren, or unrelated persons who are at least 37.5 years younger than the person making the transfer. Its primary purpose is to ensure that wealth transferred across multiple generations is subject to taxation at each generational level, similar to how it would be if the assets were passed directly from parent to child, and then from child to grandchild. The generation-skipping transfer tax applies to transfers exceeding a specific exemption amount and is typically levied at the highest federal estate tax rate.

Here are some examples of how the generation-skipping transfer tax might apply:

• Example 1: Direct Trust to Grandchild

  An elderly grandmother, Sarah, wishes to leave a significant portion of her estate directly to her granddaughter, Emily, rather than her own child, Mark. Sarah establishes a trust that will distribute $15 million directly to Emily upon Sarah's death, effectively bypassing Mark's generation entirely for the principal amount.

  How it illustrates the term: Since Emily is two generations younger than Sarah, and the amount transferred exceeds the generation-skipping transfer tax exemption, this transfer would be subject to the generation-skipping transfer tax. The tax aims to capture the revenue that would have been collected had the assets first passed to Mark (and potentially been subject to estate tax) before passing to Emily.

• Example 2: Gift to an Unrelated Younger Person

  A wealthy entrepreneur, Mr. Henderson (age 70), has no children but wants to provide substantial financial support for his brilliant young protégé, Alex (age 25), who is not related to him. Mr. Henderson establishes a trust that will provide Alex with $10 million for his future endeavors.

  How it illustrates the term: Even though Alex is not a family member, he is more than 37.5 years younger than Mr. Henderson, qualifying him as a "skip person." Therefore, this transfer, exceeding the exemption amount, would be subject to the generation-skipping transfer tax, as it effectively skips a generation of potential estate or gift taxation.

• Example 3: Complex Trust with Intermediate Beneficiary

  Mrs. Chen creates a trust for her son, David, stating that David will receive income from the trust during his lifetime. Upon David's death, any remaining assets in the trust (valued at $20 million) will then pass to her granddaughter, Lily. David has no power to direct the principal of the trust.

  How it illustrates the term: While David (Mrs. Chen's son) is an initial beneficiary receiving income, the ultimate transfer of the trust principal to Lily (Mrs. Chen's granddaughter) upon David's death constitutes a generation-skipping transfer. Even though David benefited from the trust, the principal "skipped" his generation for estate tax purposes as it passed directly from Mrs. Chen's original intent to Lily. The generation-skipping transfer tax would apply to the portion exceeding the exemption when the assets are distributed to Lily.