What is the generation-skipping transfer (GST) tax and why does it matter for trust planning?

The GST is a third layer of federal transfer tax (alongside gift tax and estate tax), designed to prevent ultra-wealthy families from skipping generations to avoid estate tax. Here's how it works.

The problem GST was created to solve:

Without GST, a wealthy grandparent could:

1. Give $13.6M directly to a grandchild (using the lifetime exclusion)
2. The grandchild inherits at no gift tax
3. The wealth bypasses the middle generation (the parent) entirely
4. The next-generation estate tax (on the parent) is avoided

The result: only one estate-tax event across two generations instead of two. The IRS lost half the revenue.

The GST tax:

GST tax is imposed at a flat 40% on transfers that "skip" a generation. A "skip person" is anyone two or more generations younger than the transferor (grandchildren, great-grandchildren, etc.). Each grantor has a GST lifetime exemption equal to the estate-tax exemption ($13.6M in 2025).

How trusts interact with GST:

A trust can be designed to be GST-exempt by:

1. Allocating the grantor's GST exemption to the trust at funding. Once exempt, the trust avoids GST tax even on distributions to skip-person beneficiaries indefinitely.

1. Choosing the right beneficiary class. A trust naming only grandchildren and great-grandchildren as beneficiaries triggers GST on funding. A trust with mixed-generation beneficiaries can layer distributions to manage GST exposure.

1. Using a dynasty-trust structure. In states with no rule against perpetuities (Florida, South Dakota, Alaska, Wyoming, Tennessee), a fully GST-exempt trust can last forever, moving wealth across many generations with each new generation getting a step-up in tax basis but no GST tax.

Numerical example:

A grandparent funds an irrevocable dynasty trust with $10M and allocates $10M of GST exemption. The trust grows to $100M over 50 years. When distributions are made to grandchildren, no GST tax. When distributions are made to great-grandchildren, still no GST tax. The trust is effectively a wealth-transfer machine that exempts $90M of growth from both estate tax and GST tax forever.

If instead the grandparent had not allocated GST exemption, the same trust would face 40% GST tax on distributions to grandchildren or further-down beneficiaries — destroying most of the planning advantage.

The unintentional-GST trap:

GST automatically applies if the grantor allocates exemption to the wrong assets, fails to allocate at all, or makes a "predeceased ancestor" mistake. Many trusts fail GST planning because of paperwork errors. Working with experienced trust counsel is non-negotiable.

Late allocation:

If the grantor forgets to allocate GST exemption at trust funding, they can sometimes do a "late allocation" via a Form 709 election. But late allocation uses the trust's FAIR VALUE at the late-allocation date — which is often much higher than the original funding amount. So you end up using more exemption than you would have at funding.

For the exam:

CFA L3 tests GST conceptually, not in numerical detail. You should know:

• GST applies to skip transfers ($\ge 2$ generations down)
• Flat 40% rate
• Each grantor has a lifetime GST exemption equal to estate-tax exemption
• Trusts can be GST-exempt if exemption is properly allocated
• Dynasty trusts are designed to be perpetually GST-exempt