Generation-Skipping Transfer Tax Design in Long-Term Trusts

Scope of the chapter. A trust meant to last for generations meets a federal tax built to reach exactly that kind of trust. Chapter 13 of the Internal Revenue Code imposes a tax on generation-skipping transfers, at the top estate tax rate, whenever property passes to a beneficiary two or more generations below the transferor without bearing an estate or gift tax at the intervening generation. A long-term trust that is not designed around chapter 13 will pay that tax, at forty percent, each time a generation of beneficiaries dies and the next takes its place. A trust that is designed around it can carry property through many generations with no transfer tax after the first. This chapter examines that design. It sets out the structure of the tax (see infra ¶ 2310), the rules that assign beneficiaries to generations and identify the transferor (see infra ¶ 2320), the exemption as it stands after the 2025 legislation (see infra ¶ 2330), the rules for allocating it (see infra ¶ 2340) and the inclusion ratio that results (see infra ¶ 2350). It then turns to the design of exempt and nonexempt trusts (see infra ¶ 2360), the funding of a long-term trust (see infra ¶ 2370), trusts protected by the 1985 grandfather rule and the use of powers of appointment (see infra ¶ 2380), and state taxes, governance and drafting (see infra ¶ 2390).

Relation to other chapters. Chapter 22 examines the state perpetuities law that permits a trust to last for centuries; this chapter examines the federal tax that follows such a trust each generation unless it is planned for (see supra ch. 22). The four safe harbors that preserve the grandfathered status of a trust irrevocable on September 25, 1985, when it is modified, decanted or settled, are examined in chapters 16 and 18 and summarized here (see supra ¶¶ 1680.05, 1870; see infra ¶ 2380.04). Division of a trust into exempt and nonexempt shares by qualified severance is examined in chapter 21 (see supra ¶ 2150). Sales to grantor trusts and the other leveraged techniques used to fund a dynasty trust are examined in chapter 40 (see infra ch. 40). The governance of a trust that will outlive everyone who knew the settlor is examined in chapter 29 (see infra ch. 29).

The idea of the tax. The estate and gift taxes reach property each time it passes from one owner to the next. A transfer in trust for the transferor's children for life, remainder to grandchildren, would escape the estate tax at the children's deaths, because the children own nothing that passes at death; their life interests end. Before 1976 a family could therefore pay estate or gift tax once and then hold property in trust for as many generations as the perpetuities rule allowed. Chapter 13 closes that gap. It treats the termination of the children's interests, a distribution to a grandchild, and an outright gift to a grandchild as taxable events in their own right. It taxes each at the highest estate tax rate, reduced only to the extent the transferor has allocated an exemption to the property. I.R.C. §§ 2601, 2611, 2641.

The planner's three objectives. Almost every design decision in this chapter serves one of three objectives:

1. Use the exemption on property that will grow. The exemption is fixed when it is allocated. Property that appreciates after allocation carries its exempt character with it, so exemption allocated to a trust that doubles in value protects twice the amount allocated.
2. Keep every trust either wholly exempt or wholly nonexempt. A trust with an inclusion ratio between zero and one pays a partial tax on every distribution and termination for as long as it lasts. A trust with a ratio of zero pays none, and a trust with a ratio of one can be designed so that its property is taxed in the estates of the children under the estate tax, which may cost less than chapter 13 (see infra ¶ 2360).
3. Keep flexibility for law and facts that will change. The exemption amount, the rates and the rules have changed repeatedly since 1986. A trust drafted to last a century must let a trustee, protector or beneficiary respond: by severing, by conferring a general power of appointment on a beneficiary whose estate can absorb the property, or by choosing which shares to distribute to which generation (see infra ¶¶ 2360, 2380.06, 2390).

A note on numbers. The exemption and the annual exclusion stated in this chapter are those in effect for 2026. Both are indexed for inflation in later years (see infra ¶ 2330). The examples use round numbers for clarity and ignore indexing unless they say otherwise.

Terminology. This chapter uses the statutory terms. The transferor is the person whose estate or gift tax transfer brought the property within chapter 13. A skip person is a beneficiary two or more generations below the transferor, or a trust whose interests are held only by such beneficiaries. A non-skip person is anyone else. The GST exemption is the amount each individual may allocate. The inclusion ratio is the fraction of a trust that remains exposed to the tax after allocation. Each is defined precisely in the paragraphs that follow.