Establishing a trust can be a crucial part of estate planning for very wealthy taxpayers. Federal estate taxes can take a significant chunk out of an inheritance each time the assets change hands. However, both the rate on estates and the threshold for imposition change according to the political environment. For example, the 2017 Tax Cuts and Jobs Act increased the minimum amount for an estate to trigger the tax and indexed the amount for inflation.
For 2023, the threshold is $12.92 million, which means that far less than one percent of estates pay any estate taxes. However, the TCJA provisions expire at the end of 2025, so unless Congress takes action, the threshold will revert to the previous level of $5.4 million (although that amount will also increase to reflect inflation). For estates valued over the threshold, the rate is 40 percent.
Generation-skipping is a tool used to manage estate taxes by skipping a generation in the transfer of wealth. While most trustors skipped their children in favor of grandchildren, the bequest could go to anyone over 37 ½ years younger than the grantor. This tactic avoids the imposition of estate taxes on the grantor's children while still allowing them access to the trust earnings. Before the 1986 legislation that added a generation-skipping tax, wealthy individuals could avoid estate taxes by leaving assets directly to their grandchildren.
When Congress enacted the 1986 Tax Reform Act, it closed the loophole by including a generation-skipping transfer tax and combining limits for estate exemptions, generation-skipping, and gift taxes. For example, taxpayers can give gifts to individuals of up to $17,000 annually (the amount is indexed for inflation), but those gifts count against the overall estate exemption of $12.92 million.
As a result, generation-skipping trust distributions that exceed the exemption threshold are subject to the same 40 percent tax that a bequest to the next generation would be. Still, the tool effectively eliminates one imposition of taxes by skipping over a transfer from a grantor to their children.
If a grantor establishes a generation-skipping trust to distribute assets to their grandchildren (or an even later generation), the "skipped" beneficiaries often receive distributions from the trust as income. However, the distributions must not be large enough to deplete the trust assets. Those distributions are income to the recipients and taxed as ordinary income.
Generation-skipping trusts are irrevocable, which makes them much harder to alter. Assets placed in an irrevocable trust are no longer the legal property of the grantor, and neither the grantor nor the trustee can change the terms.