What it means
Estate tax is designed to take a slice of wealth as it moves from one generation to the next. A wealthy family could sidestep that by leaving everything straight to the grandchildren, so the assets pass down two rungs of the ladder while only being taxed once.
The generation-skipping tax closes that gap by charging a separate levy on transfers to what the rules call a skip person. A skip person is normally a grandchild or great-grandchild, or an unrelated individual more than 37.5 years younger than the person making the transfer.
Trusts can also be skip persons if every possible beneficiary is one. The tax applies to three kinds of event: a direct skip such as a straight gift to a grandchild, a taxable distribution out of a trust, and a taxable termination when an interest in a trust ends and only skip persons remain.
The rate is flat rather than banded, and it is set at the top estate tax rate, currently 40%. That flatness makes it unusually punishing, because there is no gentle entry band the way there is with income tax.
Crucially it stacks: a direct gift to a grandchild can attract gift tax and generation-skipping tax on the same dollars. Each person has a lifetime generation-skipping exemption, which broadly tracks the estate tax exemption and has run into the tens of millions of dollars in recent years.
Allocating that exemption to a transfer produces an inclusion ratio, a fraction between zero and one that determines how much of the transfer is actually exposed. A fully exempt trust has an inclusion ratio of zero and can grow for decades without ever paying the tax.
For business owners, this matters most when shares in a family company are moved down the family tree. Allocating exemption early, when the shares are worth less, shelters all the future growth, which is why succession planning tends to happen years before anyone expects a handover.
In practice
Real-world examples.
Example
A retired manufacturer gifts $500,000 of company stock directly to his two grandchildren. Because this is a direct skip, his adviser allocates generation-skipping exemption to the transfer so that the inclusion ratio is zero and no tax falls due.
Example
A family trust set up thirty years ago pays out $300,000 to a great-grandchild for a house deposit. That payment is a taxable distribution, and because the trust was never given exemption, the recipient bears generation-skipping tax on the full amount.
Example
A widow's will leaves her estate to her son for life and then to her grandchildren. When the son dies, the interest terminates and only skip persons remain, triggering a taxable termination that the trustees must fund from trust assets before distributing anything.
Think of it
“Generation-skipping tax applies when you skip a generation-grandchildren inheritance tax.
Formula
Calculation
Generation-skipping tax = (value transferred to skip persons - exemption allocated) x 40%. Equivalently, tax = value transferred x inclusion ratio x 40%, where the inclusion ratio is 1 minus the fraction of the transfer covered by exemption.
Suppose a grandmother leaves $20,000,000 in trust for her grandchildren and has $14,000,000 of generation-skipping exemption remaining. The exposed amount is $20,000,000 - $14,000,000 = $6,000,000, and the tax is $6,000,000 x 40% = $2,400,000.
Checking it the other way gives the same answer. The applicable fraction is $14,000,000 / $20,000,000 = 0.70, so the inclusion ratio is 1 - 0.70 = 0.30, and $20,000,000 x 0.30 x 40% = $2,400,000.Case study
Seen in the real world.
This is an illustrative and entirely fictional scenario. Harrowgate Cabinetry, an invented family joinery business, was owned by its founder, who wanted to pass shares straight to his three grandchildren because his own children were comfortably off. He signed the transfer without advice, moving shares then valued at $18,000,000.
Because no exemption had been allocated in advance, the fictional family faced both gift tax and generation-skipping tax on the same shares, and the combined bill forced the sale of a warehouse to raise cash. A later review showed that allocating exemption at the moment of transfer, or making the gift eight years earlier when the shares were worth a fraction as much, would have removed almost the entire charge.
The illustrative lesson the family drew was blunt: the tax was not caused by the size of the estate but by the timing and paperwork of the transfer.
Watch out
Common mistakes.
- Assuming the generation-skipping tax replaces estate or gift tax, when in reality it is charged in addition to whichever of those applies.
- Forgetting to allocate the exemption on the correct tax return, which leaves a trust with an inclusion ratio above zero for its entire life.
- Thinking the tax only affects grandchildren, when any unrelated person more than 37.5 years younger counts as a skip person too.
Questions
People also ask.
Does the tax apply if a grandchild's parent has already died?
Usually not, because the grandchild moves up a generation for these purposes under the predeceased parent rule.
Can small gifts to grandchildren trigger it?
Gifts that qualify for the annual gift tax exclusion and certain direct payments of school or medical fees are generally outside the charge.
Is the rate ever lower than 40%?
No, it is a single flat rate tied to the top estate tax rate, so there is no banding to soften a large transfer.
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