What Is a Generation Skipping Trust?

How Do Generation Skipping Trusts Work?

Generation-Skipping Trusts (GSTs) are an estate planning tool designed to transfer wealth to grandchildren, great-grandchildren, or non-related individuals who are at least 37.5 years younger than the grantor¹, avoiding the taxes that would typically be applicable if the wealth were passed down through each generation. Here's an overview of how they work:

1. Creation of the Trust: The grantor (the person creating the trust) establishes a Generation-Skipping Trust. This is done by drafting a trust document with the help of an estate planning attorney who understands the generation-skipping trust rules. The trust document outlines the terms of the trust, the trustee's powers, the beneficiaries, and the circumstances under which distributions can be made.
2. Funding the Trust: The grantor transfers assets into the trust. These assets can be virtually anything of value, such as cash, stocks, bonds, real estate, or other investments.
3. Appointing a Trustee: The grantor appoints a trustee responsible for managing the trust's assets and overseeing distributions according to the trust's terms. This trustee can be an individual, a group of individuals, or a corporate entity, like a bank or a trust company.
4. Designating Beneficiaries and Terms for Distributions: The primary beneficiaries of a GST are typically the grantor's grandchildren or subsequent generations. The grantor sets terms for how and when the beneficiaries can access the trust's funds, often contingent on specific milestones (like reaching a certain age) or events (such as funding education, buying a home, or starting a business).
5. Generation-Skipping Transfer Tax (GSTT): The U.S. imposes a GSTT on assets passed down to individuals two or more generations below the grantor. However, a GST exemption allows a certain amount of assets to be transferred without incurring this tax burden. The exemption amount is periodically adjusted for inflation. Any transfers above this exemption may be subject to the GSTT, separate from the individual estate or gift taxes.
6. Distributions: Depending on the terms set by the grantor, the trust can make distributions to the beneficiaries for things like living expenses, education costs, emergencies, or even without a specific purpose, depending on the discretion granted to the trustee.
7. Duration of the Trust: The trust can last several generations, depending on state laws. Some states have rules against "perpetuities," which limit the lifespan of trusts, while others allow them to last indefinitely, creating what's often referred to as a "dynasty trust."
8. Termination: The trust terminates either when the last beneficiary dies, when the assets are fully depleted, after a certain period set out in the trust agreement, or as required by state law. Any remaining assets are distributed according to the trust's instructions upon termination.

What Is the Difference Between a Generation Skipping Trust vs. Dynasty Trust?

The key difference between a Generation-Skipping Trust (GST) and a dynasty trust is the duration of the trust. GSTs can be designed to terminate after a certain number of years or after the death of the last beneficiary. Dynasty trusts, on the other hand, are designed to last for multiple generations.

What Are the Benefits (Pros) Of a Generation Skipping Trust?

A Generation-Skipping Trust (GST) offers several benefits, primarily in estate planning and tax efficiency, but also in asset protection and control over the distribution of assets. Below are some of the key benefits:

• Estate Tax Reduction or Elimination: One of the primary advantages is the potential reduction or elimination of estate taxes. Usually, assets passed directly to children and then onto grandchildren are taxed at each transfer, which can significantly erode the estate's value. A GST can help preserve the estate's wealth by skipping generations because the assets are not subject to estate taxes at each generation.
• Generation-Skipping Transfer Tax (GSTT) Exemption: A GSTT is imposed on assets that skip a generation. However, a GSTT federal estate tax exemption also allows a substantial amount of assets to be transferred to the trust without incurring this generation skipping tax. This exemption is periodically adjusted for inflation and can be strategically utilized to transfer wealth.
• Protection of Assets: Assets held in a GST are generally not considered the property of the trust beneficiaries; therefore, these assets can be protected from creditors, legal judgments, or divorces of the beneficiaries. This is particularly important for individuals who want to ensure that family wealth remains within the family.
• Control Over Wealth Distribution: The grantor (creator) of the trust can set specific terms for how the trust's assets are managed and distributed. This level of control allows the grantor to ensure that beneficiaries meet certain requirements or achieve specific milestones (like graduating from college, reaching a certain age, etc.) before receiving distributions. It can also provide for special circumstances, like health emergencies or financial hardships.
• Long-term Wealth Management: Some states in the U.S. allow trusts to last indefinitely, while others have a set number of years. These "dynasty trusts" can provide a financial foundation for many generations, with assets managed professionally by a trustee or trust company.
• Privacy: Trusts can offer a degree of privacy, as the assets and terms typically aren't part of the public record. This can be important for families who wish to keep their financial affairs private.
• Flexibility: GSTs can be very flexible in their design and operation, accommodating various assets, beneficiary circumstances, and generational considerations.

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What Are the Potential Drawbacks (Cons) of a Generation Skipping Trust?

• Complexity and Cost: Establishing and maintaining a GST can be complex and costly. The initial setup requires the assistance of experienced estate planning attorneys and financial advisors. Additionally, the ongoing administration of the trust, which may include accounting services, legal fees, and trustee fees, can be expensive over time.
• Irrevocability: Many GSTs are irrevocable, meaning the grantor cannot change their terms or retrieve the assets once they are established and funded. This lack of flexibility can be problematic if the family's circumstances or laws change.
• Generation-Skipping Transfer Tax (GSTT): While there is a significant exemption to the GSTT in the U.S., transfers that exceed the exemption limit are subject to a substantial tax rate. If not properly managed, this can negate some of the tax benefits a GST aims to achieve.
• Potential Family Conflict: GSTs might cause familial discord by skipping a generation. Children who see their inheritance passed directly to their children might feel slighted. Even if they benefit from trust income, the lack of control over the principal can cause tension.
• Beneficiary Preparedness: Younger beneficiaries might not be financially responsible or prepared to handle the wealth they receive. Even though the trust can dictate the terms of distributions, beneficiaries may rely on future expected assets and not develop their financial independence or professional skills.
• Changing Laws and Regulations: Estate and tax laws are subject to change, and what might be an advantageous setup now could become less so in the future. These changes might impact the trust's tax benefits or its operation.
• Duration Limits: Some jurisdictions have a "Rule Against Perpetuities," which prevents a trust from existing indefinitely. This rule might force the trust to terminate sooner than the grantor intended, potentially creating tax consequences and disrupting the grantor's long-term plans for the beneficiaries.

It's crucial to weigh the potential drawbacks against the benefits and consult with a financial professional, such as an estate planning attorney and financial advisor, to determine whether establishing a Generation-Skipping Trust is right based on individual needs and circumstances.

How Much Does a Generation Skipping Trust Cost?

Establishing a Generation Skipping Trust (GST) involves several costs, which can vary widely depending on the complexity of the estate, the attorney's fees, and the jurisdiction. While it's challenging to provide a precise cost without specific details, let's explore the general financial components:

• Attorney's Fees: Legal fees might range from a few thousand dollars to several thousand for a straightforward Generation Skipping Trust. Attorney's fees can escalate substantially if the estate has numerous assets, diverse investments, or complex family considerations.
• Trustee Fees: If a bank or a professional trustee manages the trust, fees are often a percentage of the trust's assets and can also vary depending on the complexity of the trust's assets and the services the trustee is expected to provide. Costs for individual trustees might be lower but could still involve compensation and expenses related to trust management.
• Administrative Costs: Costs associated with filing the trust documents with relevant authorities. Potential costs related to preparing and filing tax returns for the trust. Management of trust finances might involve accounting fees, especially if the estate is extensive or intricate.
• Asset Management Fees: Investment advisory fees will apply if the trust's assets are actively managed. Property management fees may be incurred if real estate is held within the trust.
• Ongoing Operational Costs: Managing and executing income distributions might have associated costs. Ensuring meticulous documentation and record-keeping might involve additional expenses, mainly if professional services are engaged.

Given the range and variability of costs involved in setting up and maintaining a GST, obtaining detailed estimates from attorneys, trustees, and other professionals is crucial before proceeding.

How Are Generation Skipping Trusts Taxed?

The taxation of Generation-Skipping Trusts (GSTs) can be complex, as it involves various tax rules and regulations from both federal and state jurisdictions. Here's an overview of the key aspects of how GSTs are taxed:

Generation-Skipping Transfer Tax (GSTT):

• The primary GST tax is the Generation-Skipping Transfer Tax. This is a federal tax on assets transferred to beneficiaries two or more generations below the grantor (for example, grandchildren or great-grandchildren).
• The GSTT is levied at a flat rate equal to the highest existing federal estate tax rate, though the actual numbers can change with new tax laws.
• Each individual has a lifetime GSTT exemption, which is the amount that can be transferred over their lifetime to these 'skip persons' without incurring the GSTT. This exemption is unified with the estate and gift tax exemption amount, and the exact figure can change annually due to inflation adjustments.
• Any transfers that exceed this exemption amount are subject to the GSTT.

Estate and Gift Taxes:

• Assets placed into a GST may also be subject to federal estate and gift taxes, separate from the GSTT.
• If you transfer assets into a trust while you're alive, it's considered a gift, and it might be subject to the gift tax if it exceeds the annual gift tax exclusion amount.
• If the transfer occurs at death, it might be subject to the estate tax, depending on the value of your estate, compared to the applicable estate tax exemption amount.

Income Tax:

• The trust itself may be subject to income tax. Any income the trust generates and does not distribute in a given tax year is taxed to the trust at the trust's income tax rates, which tend to be higher and reach their maximum rate at much lower income levels than individuals.
• Distributions that the trust makes to beneficiaries may be subject to income tax for the recipients, depending on the nature of the distribution and the trust's income.

State Taxes:

• Estate, inheritance, and income tax at the state level can also apply, depending on where the grantor and the beneficiaries live and where the trust is administered. State taxes vary widely, so it's essential to consult with a tax professional who understands the specific laws of the relevant states.

Due to the complexities and potential for significant tax liability, it's crucial for individuals considering a Generation Skipping Trust to work closely with estate planning attorneys, tax professionals, and financial advisors. These professionals can help design the trust to maximize tax efficiency while meeting the grantor's family and philanthropic legacy objectives.

Is a Generation Skipping Trust Right for You?

Whether or not a Generation Skipping Trust (GST) is "worth it" depends on your specific goals and situation. Here are some factors to consider when deciding if a GST aligns with your needs:

Circumstances Where a Generation Skipping Trust May Be Beneficial:

• Large Estates and Tax Benefits: A GST can benefit individuals with estates significantly exceeding the tax exemption limits. By skipping generations, the GST can avoid the estate taxes that would typically apply to each generational transfer, potentially saving substantial money.
• Long-term Wealth Preservation: If your goal is to preserve wealth within your family for multiple generations, a GST can be structured as a "dynasty trust," which lasts for a prolonged period, providing financial benefits to your descendants for many generations.
• Control Over Future Use of Assets: A GST allows you to control how future generations use your assets. You can set specific terms for disbursement, such as releasing funds when beneficiaries reach a certain age, achieving particular milestones (like graduating from college), or stipulating that funds be used only for specific purposes, like education or buying a home.
• Protection from Creditors and Legal Judgments: Assets held within a GST are generally not considered the property of the beneficiaries, which means they are typically protected from creditors, lawsuits, or divorce settlements. If you're concerned about your descendants' ability to manage money or want to shield assets from potential loss, a GST can provide this level of protection.
• Special Family Circumstances: In families where the immediate heirs may not need or be able to responsibly manage a large inheritance (due to disability, financial irresponsibility, addiction issues, etc.), a GST can ensure that the wealth is preserved for grandchildren or future generations who may be more capable or in need of the funds.

Circumstances Where a Generation Skipping Trust May Be Less Beneficial:

• Smaller Estates: For individuals with estates that fall below the estate tax exemption threshold, the cost and complexity of setting up and maintaining a GST might not be justified, as there would be little to no tax benefit.
• Families with Immediate Financial Needs: If your children or the immediate generation have significant financial needs, skipping over them to benefit the grandchildren might not be practical or fair. In such cases, a different type of trust that provides for children first might be more appropriate.
• Uncertainty Among Potential Beneficiaries: If you're unsure about the reliability or responsibility of future generations, a GST might not be ideal. Since these trusts often benefit individuals who are not yet adults, predicting their future behavior or needs is challenging.
• Potential for Family Conflict: If there's a likelihood that skipping one generation in favor of another could sow discord within the family, the emotional cost might outweigh the financial benefits. It's important to consider the interpersonal dynamics of your family when setting up any estate planning tool.
• Jurisdictions with Unfavorable Trust Laws: The laws governing trusts vary by jurisdiction. If your jurisdiction has regulations unfavorable to the lasting nature of GSTs (like the Rule Against Perpetuities), or if it imposes high taxes on trust income, a GST might not be advantageous.

The worth of a Generation Skipping Trust is unique to each family. Consulting with an estate planning attorney and a financial advisor to fully understand the implications, costs, and benefits is crucial before deciding whether a Generation-Skipping Trust is the right choice for managing your assets.

Remember, depending on your needs and financial situation, you can use different types of trusts. It is important to take the time to research setting up a trust within your estate plan thoroughly. Consider all available options, considering your financial objectives, family, and personal preferences.

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Sources

1. Internal Revenue Service Form 706. https://www.irs.gov/instructions/i706