Passing Assets to Grandchildren Through a Generation-Skipping Trust

Passing assets to your grandchildren can be a great way to ensure their future is provided for, and a generation-skipping trust can help you accomplish this goal while reducing estate taxes and also providing for your children.  

A generation-skipping trust allows you to “skip” over the generation directly below you and pass your assets to the succeeding generation. While this type of trust is most commonly used for family, you can designate anyone who is at least 37.5 younger than you as the beneficiary (except a spouse or ex-spouse).  

One purpose of a generation-skipping trust is to minimize estate taxes. Estates worth more than $12.06 (in 2022) have to pay a federal estate tax. Twelve states also impose their own estate tax, which in some states applies to smaller estates. When someone passes on an estate to their child and the child then passes the estate to their children, the estate taxes would be assessed twice—each time the estate is passed down. The generation-skipping trust avoids one of these transfers and estate tax assessments. 

While your children cannot touch the assets in the trust, they can receive any income generated by the trust. The trust can also be set up to allow them to have some say in the rights and interests of future beneficiaries. Once your children pass on, the beneficiaries will have access to the assets. 

Note however, that a generation-skipping trust is subject to the generation-skipping transfer (GST) tax. This tax applies to transfers from grandparents to grandchildren, even in a trust. The GST tax has tracked the estate tax rate and exemption amounts, so the current GST exemption amount is $12.06 million (in 2022). If you transfer more than that, the tax rate is 40 percent.  

The trust can be structured to take advantage of the GST tax exemption by transferring assets to the trust that fall under the exemption amount. If the assets increase in value, the proceeds can be allocated to the beneficiaries of the trust. And because the trust is irrevocable, your estate won’t have to pay the GST tax even if the value of the assets increases over the exemption amount. 

Generation-skipping trusts are complicated documents. Consult with your attorney to determine if one would be right for your family. To find an attorney near you, click here. 

Is a Grantor Retained Annuity Trust Right For You?

What is a GRAT?

Grantor Retained Annuity Trusts (GRATs) ­are a mechanism by which wealthier individuals and couples can transfer appreciating assets to their heirs and minimize gift or estate taxes. High-net-worth individuals and couples can use GRATs to freeze the value of their estates and transfer any increase in the value of their assets to their heirs, with minimal tax consequences.

Understanding the Basics

GRATs are irrevocable trusts permitted by the Internal Revenue Code. A client (grantor) transfers an asset or assets to the trust. The grantor (and only the grantor) retains a right to receive an annuity income from the GRAT over a certain period of time. The GRAT is required to pay this annuity stream no less than annually, and it must be a dollar amount or percentage of the value of the asset put into the trust. Any annuity income received is not subject to income tax due to special tax rules.

The asset that is transferred is considered a gift equal to its value reduced by how much of an annuity the grantor receives, along with any interest, as set forth in IRS guidance. Once the trust terminates, the assets transfer to beneficiaries such as a client’s children or a trust for their children.

A GRAT can be designed to result in no taxable gift and, therefore, no gift tax. However, if a GRAT cannot be set up this way, then the grantor can use any of his or her lifetime gifting exclusion to offset any gift tax.

If the grantor does not pass away during the GRAT’s term, then any assets or appreciation that pass to beneficiaries are not subject to gift tax or estate tax upon the grantor’s death. If the grantor dies during the term, then the value of the assets needed to pay the remaining annuity payments to the grantor would be included in his or her estate for tax purposes. The rest of the assets would pass without being included in the grantor’s estate.

Let’s Look at An Example

Let us say you have a stock account worth $1 million and transfer it to a GRAT. The terms of the GRAT provide that you receive 10 annual payments of $100,000, plus interest, at a rate set by the IRS from the income of the trust. If designed to be a zeroed-out GRAT, the total payments should equal the asset's present value at the date of transfer. If the stock account is appreciating, this works out very well. The trust can pay you the annuity without invading the principal, and any appreciation in value transfers to the beneficiaries of the trust, with no gift or estate tax consequences, once its term ends.

Why Consider a GRAT?

A GRAT may be especially prudent for clients that gift money regularly and may use up their federal estate and gift tax exemption. The total lifetime exclusion as of 2022 is $12.06 million ($24.12 million for married couples). A GRAT is also a helpful planning device for clients with high-value estates who may suffer serious tax consequences when the federal exemption reduces by half in 2026.

Furthermore, many states have less favorable estate tax exclusion amounts and gifting rules. New York, for example, has an exclusion of $6.11 million as of 2022. In New York, the consequences of exceeding this threshold can be harsh. If an estate is more than 5% over the exemption, the estate loses the exemption entirely, and the total value of the estate’s assets is subject to estate tax. New York also has a three-year clawback rule for gifts. So, when a person passes away, the state includes the last three years of gifts that person made in calculating the total value of their estate for tax purposes.

GRATs can help avoid many of these issues. So why not plan ahead now? Contact your attorney to determine whether a GRAT is a good fit for you.