Families with several generations may have a number of choices available to them when it comes to transferring assets to the following generation and lowering their exposure to capital gains, gift, and estate taxes. However, in order to carry out a wealth-transfer plan efficiently, you must be fully aware of the potential impact on your family of the laws controlling the transfer and taxation of assets between generations.

There are 2 primary methods of transferring wealth, either gifting during lifetime or leaving an inheritance at death.

Individuals may transfer up to $12.92 million (as of 2023) during their lifetime or at death without incurring any federal gift or estate taxes. This is referred to as your lifetime exemption. In addition, individuals may gift up to $17,000 annually to any individual without incurring any federal gift tax liability or using the lifetime exemption. This annual gift exclusion must be used within the year and does not carry over or accumulate. For example, if you gifted your child $20,000 in 2023, the first $17,000 would be applied to your annual exclusion and the remaining $3,000 would use up part of your lifetime exemption amount.

Gifts made during your lifetime in excess of the annual exclusion reduce the amount that can be excluded from the value of your estate at death. For example, if you gave $3 million in gifts during your life on top of any annual exclusion gifts you may have made, you would only be able to exclude $9.92 million from the value of your taxable estate at death in 2023. Any amount of assets above that number would be subject to a 40% federal estate tax, unless transferred to a spouse or charity.

Transfers to spouses in life or at death are subject to an unlimited marital deduction and assets transferred to a qualified charity are subtracted from the value of the estate when calculating the estate tax liability. In other words, the value of assets transferred to a spouse or a charity do not count against the lifetime exemption.

Careful planning is necessary, as the wealth transfer process is subject to various federal taxes that aim to regulate the transfer of assets, such as cash and non-cash gifts, real estate, stocks, and ownership interests in closely held businesses. The three significant taxes that impact this process are the gift, estate, and generation-skipping transfer (GST) taxes.

Three Types of Wealth Transfer Taxes

The three federal taxes we’ve mentioned impact the wealth transfer process and apply to different situations: The gift tax applies to transfers during your lifetime; the estate tax applies to transfers at the time of your death; and the GST tax can apply to transfers made during your lifetime and at or after your death.

Gift and estate taxes, known as “unified” taxes, share a single rate schedule and have a unified exemption amount, which means that you can transfer a certain value of assets during your lifetime or upon your death without paying gift or estate taxes. The GST tax is an additional tax imposed on specific transfers made to individuals more than one generation younger than you.

It’s important to mention that the IRS permits tax-free gifts up to a specific annual limit for each beneficiary, known as the gift tax exclusion. This exclusion does not affect the unified lifetime exemption. Additionally, there are exemptions and exclusions applicable to the GST tax.

Read Also: Real Estate Investment as a Vehicle for Building Generational Wealth

Each tax has its unique application and rules, targeting different scenarios of wealth transfer. Understanding these taxes and their implications is essential for individuals and families involved in estate planning and wealth preservation. It’s important to note that certain states have their own estate or inheritance tax laws, which may have different exemption amounts and tax rates. These state-level laws are unaffected by federal changes and may vary from state to state.

Here’s a breakdown of each federal tax and their properties:

• The estate tax, also known as the inheritance tax or death tax, is a tax imposed on the transfer of assets from a deceased person’s estate to their heirs or beneficiaries. The tax is based on the total value of the deceased person’s estate and is typically paid by the estate before the assets are distributed to the heirs. Estate tax laws and exemptions may vary between states. 
• The gift tax is a tax imposed on transfers of property or assets from one person to another during their lifetime. The purpose of the gift tax is to prevent individuals from avoiding the estate tax by giving away their assets before death. The person making the gift (the donor) is responsible for paying the gift tax, although certain exemptions and exclusions may apply, allowing for tax-free gifts up to a certain limit.
• The GST tax is a federal tax that applies when a person transfers assets to a “skip person,” typically a beneficiary at least two generations younger than the donor, such as grandchildren or great-grandchildren. The tax is imposed in addition to any estate or gift tax that may already apply to the transfer.

Not all transfers of wealth are subject to gift tax, estate tax, and GST tax. The GST tax exemption serves as a critical component of the tax code, allowing you to transfer a certain amount of wealth to subsequent generations without incurring additional taxes. In addition, valuation discounts can also mitigate GST tax liability. In certain instances, valuation discounts could be applied to reduce the taxable value of assets subject to the GST tax.

GST Tax Exemption

The primary purpose of the GST tax exemption is to strike a balance between wealth preservation and tax revenue generation. It recognizes the importance of intergenerational wealth transfer while ensuring that the tax system remains fair and equitable. By providing an exemption, the law allows families to transfer a certain amount of wealth to subsequent generations, thereby enabling them to preserve their financial legacy.

Utilizing the GST tax exemption requires careful planning and understanding of the rules governing its application.  There are several key considerations to bear in mind:

• Allocation of the Exemption: The GST tax exemption can be allocated to various transfers, including trusts, outright gifts, and bequests. Understanding how to allocate the exemption optimally is crucial to minimizing tax liability and maximizing the preservation of wealth. The GST tax comes into effect when you transfer assets to a skip person. This type of transfer skips one or more younger generations and involves individuals related to you through blood, marriage, or adoption. Typically, grandchildren and great-grandchildren are considered common skip persons. However, there is an exception known as the deceased parent rule (IRC § 2651(e)), where descendants are elevated to their parent’s level if the parent passes away before the transfer occurs. Consequently, a grandchild who would have been considered a skip person to you will no longer be classified as such if the grandchild’s parent dies before you and the grandchild die. On the other hand, an unrelated person becomes a skip person if they are more than 37½ years younger than you.
• Generation-Skipping Trusts: Generation-skipping trusts are effective for utilizing the GST tax exemption. These trusts allow assets to be held for the benefit of multiple generations, providing income and support while minimizing tax consequences. Proper drafting and administration of these trusts are vital to ensure compliance with applicable regulations. A trust can be categorized as a skip person under two circumstances: (a) when all the beneficial interests in the trust are held by skip persons, or (b) when no current beneficial interests are held by skip persons (but note: distributions cannot be made to individuals who are not skip persons, commonly referred to as “non-skip persons”). An individual holds a beneficial interest in a trust when (a) they have a present entitlement to income or principal, or (b) they are a potential recipient of income or principal (for instance, when there are no mandatory income or principal beneficiaries presently, and the trustee has the authority to distribute income or principal to a group that includes the individual in question).

Several types of trusts can be used to address the GST tax. It’s important to note that each trust has its own unique features and considerations, and consulting with a qualified estate planning attorney or financial advisor is crucial to determine the most suitable trust structure for your specific circumstances and objectives. Here are a few common examples:

• Dynasty Trust: A dynasty trust is specifically structured to last for multiple generations. By transferring assets into this irrevocable trust, individuals can bypass the GST tax and preserve wealth for their descendants. The key feature of a dynasty trust is its perpetuity; keeping the assets within the trust so the trust can continue to grow and provide ongoing financial benefits to future beneficiaries without triggering additional GST taxes with each generational transfer.
• Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust specifically designed to hold life insurance policies outside of the estate of the insured individual. By using an ILIT, individuals can avoid estate taxes and potentially reduce the impact of the GST tax on the proceeds paid out to the trust beneficiaries.
• Qualified Personal Residence Trust (QPRT): A QPRT allows individuals to transfer their primary residence or vacation home to the trust while retaining the right to use it for a specified period. This type of trust can reduce the property’s taxable value and mitigate GST tax implications when passing it on to future generations.
• Grantor Retained Annuity Trust (GRAT): A GRAT allows individuals to transfer assets to an irrevocable trust while retaining an annuity payment for a predetermined period. Any remaining assets pass to the trust beneficiaries at the end of the term. Utilizing a GRAT can minimize the GST tax impact on the transferred assets.
• Charitable Lead Trust (CLT): A CLT allows you to provide income to a charitable organization for a set period while passing the remaining assets to non-charitable beneficiaries, such as your family members. By incorporating a CLT, you can reduce the value of your assets subject to the GST tax.

Considering the interaction between the GST tax exemption and the annual gift tax exclusion is essential. The annual exclusion allows you to gift a certain amount per year to each recipient without incurring gift tax. However, transfers utilizing the GST tax exemption will consume a portion of your lifetime gift tax exemption. 

When the GST tax exemption is utilized, you’ll need to file a generation-skipping transfer tax return with the IRS. Failure to file the return may result in penalties and interest. Complying with the reporting requirements is crucial to avoid unnecessary complications.

Conclusion

Navigating the complex landscape of wealth transfer taxes requires careful planning, knowledge of the available exemptions and strategies, and consultation with qualified professionals to ensure wealth preservation for future generations. Proper planning and understanding of these tax rules are crucial to preserving wealth. Utilizing the GST tax exemption, employing valuation discounts, and utilizing various types of trusts, such as dynasty trusts, irrevocable life insurance trusts, qualified personal residence trusts, grantor retained annuity trusts, and charitable lead trusts can be effective strategies for maximizing your tax savings.

Staying informed and working with qualified professionals is essential to ensure compliance and effectiveness of wealth transfer strategies. It’s important to note that valuation discounts and changes to the estate and gift tax laws, including a reduction in the exemption amount, an increase in tax rates, modifications to the generation-skipping tax, and potential elimination or modification of the step-up in basis at death, may occur. Monitoring these developments and adjusting wealth transfer plans accordingly will be crucial in the future.