There are many kinds of trusts, and most are useful estate planning tools. Generation-skipping trusts are a way for grantors (those who establish trusts) to preserve family wealth for future generations by “skipping” over the next generation. This strategy may help reduce overall tax liability, as the trust is only taxed once. However, generation-skipping trusts cannot last forever.
So what happens when a generation-skipping trust terminates? Here’s a closer look.
How Do Generation-Skipping Trusts Work?
If a grantor leaves all of their assets to their children, those children can incur a significant estate tax liability. To bypass that liability, a grantor may establish a generation-skipping trust. These trusts are commonly used to pass assets down to grandchildren, but not always. To qualify to be the beneficiary of a generation-skipping trust, a person must meet the following requirements:
- Be at least 37.5 years younger than the grantor
- Not be a surviving spouse or an ex-spouse
There is a generation-skipping tax, but it generally only applies if the grantor is passing down a very significant amount of wealth. Current tax law treats the tax exemption for generation-skipping trusts the same as the lifetime gift or estate tax exemption, which is $13.99 million. Because of this high exemption, the generation-skipping transfer tax typically applies only when an ultra-high-net-worth individual creates the trust.
It might seem as though designing an inheritance to skip over a generation is profoundly unfair to the grantor’s children. After all, many who create generation-skipping trusts are people of considerable means, and their children may expect to receive the bulk of their parents’ estates.
However, that doesn’t mean that the grantor’s children cannot benefit financially. Because generation-skipping trusts tend to have substantial assets, these assets often earn significant interest. The grantor’s children may be given the interest generated by the trust, while the trust assets themselves are reserved for the grantor’s grandchildren (or other beneficiaries).
That’s not to say that a grantor’s children are always happy with the arrangement. Although they avoid significant tax liability by not inheriting assets directly, they may be frustrated that they do not have access to or control over trust assets.
Given the complexity of generation-skipping trust rules, the laws surrounding gift and estate taxes, and the strained family dynamics they may inspire, these trusts are not right for everyone. A financial advisor, tax professional, or estate planning lawyer can help you examine what it takes to launch a generation-skipping trust and decide whether it’s the right option to protect your legacy.
What Causes the Termination of Generation-Skipping Trusts?
Generation-skipping trusts can last for many years, but they don’t last forever. A generation-skipping trust will terminate when one of the following happens:
- The assets in the trust are depleted
- The last trust beneficiary dies
- The trust reaches an endpoint included in the original trust agreement
- The trust reaches a durational limit outlined by state law
Texas modified its rules for generation-skipping trusts in 2021. Previously, non-charitable trusts could not last more than 21 years after the death of the last beneficiary alive at the time the trust was created. This meant that, effectively, a generation-skipping trust could not last more than around 100 years.
Now, Texas allows so-called dynasty trusts. New laws limit the duration of non-charitable trusts (including generation-skipping trusts) to 300 years. However, there is an exception: Real estate may not remain in the trust for more than 100 years.
How Assets Are Distributed Upon Termination
When a generation-skipping trust terminates, what happens? Generally, its assets are distributed according to the provisions of the trust itself.
If you want to create a generation-skipping trust, it’s highly advisable to work with an experienced attorney to ensure the distribution of trust assets does not violate tax law. While you may outline how assets should be distributed upon termination, you must account for the possibility of a taxable termination.
Understanding Taxable Termination
The beneficiary of a generation-skipping trust is known as a “skip person.” For many of these trusts, the skip person is a grandchild, but it could be a great-grandchild, a grandniece or grandnephew, or even an unrelated person who is several decades younger than the grantor.
When a skip person receives a payout from the trust (a distribution), they are generally responsible for paying any generation-skipping transfer tax (should the trust assets exceed the GST exemption). This would be a taxable distribution.
Taxable termination is a similar concept, but instead of the beneficiary being responsible for the generation-skipping transfer tax, the trustee is responsible. A taxable termination happens when there are no longer any non–skip person beneficiaries, and only skip persons remain.
For example, imagine you are the grantor of a generation-skipping trust. You have one living child and two living grandchildren. Your child dies unexpectedly. Because the only remaining beneficiaries (your grandchildren) are skip-person beneficiaries, there is no remaining generation to “skip.” At this point, taxable termination occurs, which means that generation-skipping transfer taxes are immediately due.
There is one notable exception to this rule. If, immediately after the trust terminates, someone who is not a skip person has an interest in the property held in the trust, the generation-skipping tax may not be due.
An exception also applies if it would be impossible to transfer trust assets to a skip person. For example, imagine you create a generation-skipping trust to benefit your grandson (the skip person). If your grandson dies and the trust terminates, the termination isn’t taxable. This is because there is no way to transfer trust assets to a skip person — there are no remaining skip-person beneficiaries.
Legal and Administrative Steps in Trust Termination
Terminating a generation-skipping trust can be incredibly complex, and many of its complexities have to do with taxes. While the generation-skipping transfer tax comes with a generous exemption, the tax rate itself is significant: Any amount above the GST exemption of $13.99 million is subject to a tax of 40%.
It’s important to note that just as the GST exemption is separate from the exemption for gift and estate taxes, the generation-skipping transfer tax is calculated separately from — and in addition to — the federal estate tax.
Allocation vs. Automatic Allocation
If the value of the assets in a generation-skipping transfer exceeds the estate tax exemption, you must allocate that exemption to certain assets in the trust.
For example, if the trust includes a $20 million home and another $20 million in stocks and bonds, you might decide you want to exempt $13.99 million of the value of the home from the generation-skipping transfer tax. This means that $13.99 million of the home’s value is GST-exempt, and the remaining assets in the trust will be taxed at the generation-skipping tax rate.
If you do not allocate which assets you want the lifetime GSTT exemption to apply to, automatic allocation applies. Leaving things up to automatic allocation could lead to unintended financial consequences. In some cases, however, automatic allocation may not be a bad thing. Your attorney can offer you advice on whether you should select specific assets to allocate when a taxable termination occurs.
Steps to Terminate the Trust
Just as every taxable distribution from a GST must be reported, the termination of generation-skipping trust must also be reported to the IRS. This process is not unlike filing an estate tax return, and somewhat counterintuitively, it’s more straightforward than reporting a taxable distribution.
The trustee needs one main tax form to complete this process: Form 706-GS (T), Generation-Skipping Transfer Tax Return for Terminations. On that form, the trustee must report the following:
- The fact that the trust has been terminated
- The value of the property held in the now-terminated trust
- The inclusion ratio of the trust
- The total tax due
With a taxable termination, the inclusion ratio is the amount of the trust that is subject to taxation. An inclusion ratio of 0 indicates that the generation-skipping transfer tax does not apply. For instance, if the trust’s total value is less than the total GST exemption, the ratio would be 0.
A ratio of 1 means that all trust assets are subject to taxation (although this inclusion ratio almost always appears on forms for taxable distributions, not for taxable terminations). If the trust’s total value is more than the $13.99 GST exemption, the inclusion ratio will likely be somewhere between 0 and 1.
After the termination of generation-skipping trusts, it is critically important that Form 706-GS (T) is filled out and filed correctly and on time. A mistake may result in unpaid tax liabilities and civil penalties. If the IRS suspects intentional tax evasion, the trustee could possibly face criminal penalties.
To reduce the risk of serious consequences down the line, the trustee can ask a tax professional to help them complete the form — or at the very least, ask a tax professional, an estate planning attorney, or both to look over the form before filing.
Challenges and Disputes That May Arise
The termination of generation-skipping trust can be logistically, financially, and even emotionally difficult. While trust beneficiaries or family members of the grantor can’t contest the existence of generation-skipping transfer taxes, they may contest the trust’s terms for the distribution of its remaining assets.
A potential heir can’t contest a trust’s terms just because they disagree with them. However, they might raise concerns or even pursue litigation if they allege any of the following to be true.
The Grantor Was Not of Sound Mind When the Trust Terms Were Created
As is the case with creating any legal document, the grantor of a generation-skipping trust must be of sound mind and not mentally incapacitated when drafting the terms of the trust. If someone with an interest (or potential interest) in trust property can convincingly argue that the grantor wasn’t of sound mind, a court may allow a change in terms.
For example, imagine that an aging grandfather creates a generation-skipping trust late in life after receiving a diagnosis of Alzheimer’s disease. The attorney who helped him create it does not have a prior relationship with him and does not know about the diagnosis.
The grandfather says that the trust’s remaining assets should be divided among his grandchildren upon termination. However, he forgets to include the name of one of his granddaughters.
When this omission is discovered, the excluded granddaughter goes to court and argues that the grantor forgot to include her because of his illness. If the court agrees, it might rule that she is entitled to some of the trust’s assets.
The Trust Was the Result of Fraud
Because creating a generating-skipping trust is so complex, fraud in the creation process is very unlikely. However, someone could trick a grantor into signing a trust that benefits them, and the trust might later be found to be fraudulent. Another example of fraud is if the trust’s documents (as well as the grantor’s signature) are all completely forged.
The Trust Was the Result of Undue Influence
Undue influence is also rare, but it occasionally becomes a concern during disputes about inheritances. For instance, suppose that the grantor lived with an extremely abusive adult child who threatened and coerced their parent into writing a trust that favored the adult child’s children. If this coercion is discovered, the court may allow changes to the trust.
Options for Continuing Asset Protection After Trust Termination
A generation-skipping trust can not only reduce tax liability but also shield assets from creditors and offer other protections. However, if that trust terminates, the assets within it can be vulnerable to seizure by creditors and may no longer be protected against lawsuits.
The best way to protect the assets in a trust depends on the types of assets it holds and your unique situation. An estate planning attorney can help you make the right decisions to protect future generations.
The tax and creditor protections of a GST come from the fact that it is an irrevocable trust. However, this isn’t the only type of irrevocable trust, and it’s worthwhile to consider other options.
For example, an asset protection trust (APT) is a type of irrevocable trust designed to keep your assets safe from seizure. Alternatively, if you want your assets to go to a loved one with a disability, you might create a special needs trust for their ongoing support. Another option is a spendthrift trust, which gives assets to support a beneficiary but controls distributions.
Considering Ways to Transfer Wealth?
Between new tax laws, different ways to allocate GST exemptions, changes to the Internal Revenue Code, and the general complexities of preserving wealth across multiple generations, it’s in your best interests (and the best interests of your heirs) to work with an experienced estate planning lawyer to create, maintain, or terminate a generation-skipping trust.
The Hunter Sargent, PLLC team has been helping Texas families grow and preserve their wealth for generations, and we take pride in drafting custom solutions to build and protect your legacy. We work collaboratively, striving to ensure that you make informed decisions about generation-skipping trusts and other estate planning tools.
Our firm values transparency and open communication, so we use a flat-fee structure — there are no surprise costs with us! If you want to learn more about our private client services or you’re ready to get started, contact us online or by phone to schedule your initial consultation.