An Explanation of the GSTT, But That Actually Makes Sense
I consider myself a pretty intelligent person. I'm well-read, arguably over-educated, and an eager lifelong learner. I'm the person who tries to get an A in Toddler Music Class. So you'd think that a bedrock concept of estate planning - the Generation Skipping Transfer Tax ("GSTT") - would be something I could get my head around.
However, I got to the "e" in a Google search without a firm grasp on the tax and the exemption from it. Every explanation I read left me with more questions than answers. And, thus, it became a mission of mine to not only understand the concept, but to find a way to distill it into a simple explanation that I could share with my dedicated reader(s).
The stakes are low here - I could literally throw poetry magnets at the fridge and come up with a clearer explanation than I've found so far - but here is my attempt nonetheless:
Step 1: There are two separate taxes that could be applied to assets passed to loved ones after someone's death. The first is the Estate Tax, which is 40%. The second is the Generation Skipping Transfer Tax, which is also 40%.
Step 2: The Estate Tax applies to any assets passed to any person*. The GSTT only applies to assets* passed (1) to someone who is related to the dead person and is more than one generation separated (i.e., grandparent to grandchild) or (2) to someone who is not related to the dead person but is more than 37.5 years younger than the dead person. The reason for the GSTT is pretty clearly explained on other websites and was essentially to stop rich people from avoiding all taxes by making gifts directly to grandchildren and great grandchildren.
*Step 2a: There are "exemptions" for both of these taxes, i.e., amounts of assets that can be passed to a loved one before the tax is imposed.
Step 3: As of 2017, the exemption amount for both of these taxes is $5.49 million per person. This amount is indexed to inflation and reset each year. This means that, in 2017, $5.49 million in assets can be passed on at your death tax-free.
Step 4: Admittedly, that is not much clearer than what else is on the internet - the game changer here is going to be an example.
Step 5: Example! Dead Person ("DP") dies in 2017 with an estate worth $12.98 million. Based on a very poorly planned estate plan (DP was obviously not a client of mine), DP gives his assets away in the following order: (1) $5.49 million to his favorite daughter, (2) $5.49 million to his only grandson, (3) $1 million to his less favorite son, and (4) $1 million to his only granddaughter.
The daughter's $5.49 million (#1) is exempt from the Estate Tax (and uses up the entire exemption) and not subject to the GSTT (because she is only one generation removed from DP). Yay for daughter! She gets all that money, nothing to Uncle Sam.
The grandson's $5.49 million (#2) is not exempt from the Estate Tax because the daughter used the whole Estate Tax exemption. The grandson is more than one generation removed from DP; however, this bequest is exempt from the GSTT, since the GSTT exemption of $5.49 million has not yet been used. Yay-ish for grandson, he gets $3.294 million, which is the $5.49 million minus the 40% Estate Tax levied by the government.
The son's $1 million (#3) is subject to the Estate Tax, since the exemption has already been used. Boo for son! He only gets $600 thousand, since 40% is paid in tax.
The granddaughter's $1 million (#4) is subject to the Estate Tax and is paid to a relative who is more than one generation separated from DP. Since the daughter used up the whole Estate Tax exemption and the grandson used up the whole GSTT exemption, the granddaughter owes 40% in the Estate Tax and 40% in the GSTT. Double boo for granddaughter! She only gets $200 thousand, since she has to pay a 40% Estate Tax and a 40% GSTT.
Step 6: Hopefully those were all the steps that were needed and now this makes perfect sense! Keep in mind that DP could have structured the estate plan in a way so that the grandchildren gifts were given first, thus avoiding the double taxation issue for granddaughter. But that wouldn't have been as good of an example.
Let me know if that still doesn't make sense or if you have a better way of providing an example. We can play our own little game of "how many lawyers does it take to adequately explain what should be a pretty basic concept?" Ok, "teamwork" on 3...