How Does a Generation-Skipping Trust Work?

Generation-skipping trusts allow assets to grow or be transferred tax-free

Generation-skipping trusts aren't just for the very wealthy -- they're a way to save any family's assets from excessive taxation, ex-spouses looking for money, and creditors. Plus, they protect assets such as stocks that are likely to grow in value over time.

What's the benefit to a generation-skipping trust?

Generation-skipping trusts are a good way for wealthy families to transfer assets from the senior generation to their grandchildren and great-grandchildren without exposing those assets to several levels of estate taxes. Typically, if the second generation in a family is already comfortable financially, the grandparents set up a generation-skipping trust providing for all of their descendants as possible beneficiaries. Ultimately, any remaining assets will be distributed to grandchildren or great-grandchildren many decades in the future. This way, all of the descendants (children, grandchildren, and great-grandchildren) can benefit from the trust assets, but the grandchildren or great-grandchildren eventually receive the remaining funds without the imposition of estate taxes when the children die, and again when the grandchildren die.

Not just for the wealthy

Let's say a child in the second generation goes through a nasty divorce. The divorcing spouse can't lay claim to a share of the assets in the trust, because they legally don't belong to the ex-spouse. They're for the benefit of the entire group of descendants of the grandparents. Likewise, if a child funds a start-up company and provides personal guaranties and the company drowns in debt, the trust assets can't be directly tapped to pay the debts, because the child doesn't own those assets.

The assets would also be protected in the event of other financial catastrophes, such as large gambling debts or an uninsured car accident. "A creditor could get a judgment against the child, but they can't go directly after the assets in the trust, because they wouldn't be his or her assets," attorney Philip Feldman says.

Likewise, if the grandparents fear that one of their children is a spendthrift and would waste his inheritance quickly, a generation-skipping trust allows the child to have access to the trust assets but not necessarily direct control over the amount or timing of distributions.

Asset Protection and Limits of Generation-Skipping Trusts

Use a generation-skipping trust to protect assets from creditors or spouses

Generation-skipping trusts can also be used to protect assets from creditors or a divorcing spouse, or to guard assets a trustee believes will grow substantially in value over time. That's why most families should at least consider this type of trust.

For example, a moderately wealthy older couple could put money in a generation-skipping trust, reserving the ultimate distribution for their grandchildren. But they could make the trust assets available to their children for their needs. If the couple transferred those assets outrigh t to the children, and then from them they went to the grandchildren, the assets could be taxed twice at a rate of 45 percent; once when the assets pass from the grandparents to their children, and then again when they pass from their children to their grandchildren. By establishing a generation-skipping trust, the couple makes sure the assets are taxed only once, at the time of the initial transfer to the trust.

Because the second generation never technically owns the assets (they only have a right to distributions for reasonable needs), the trust assets have some protection from the claims of creditors or divorcing spouses in the second generation. "This is not just a strategy for the wealthy. This is usable by anyone. In my practice, even clients with modest net worth might benefit from such a trust," says Philip Feldman, a trusts and estates partner with Coblentz Patch Duffy & Bass in San Francisco.

Limits to a generation-skipping trust

There's a limit on the amount that can be transferred into such a generation-skipping trust. Currently, there's a $2 million exemption; that is, each person may leave up to $2 million in a generation-skipping trust free of the generation-skipping transfer tax.

Coincidentally, you can also leave up to $2 million to your family free of estate tax, so if you plan carefully, you can leave up to $2 million in a generation-skipping trust without any transfer tax. Any transfers in excess of this limit will be subject to gift or estate tax when the senior generation passes along the assets, and an additional generation-skipping tax is imposed when the middle generation of beneficiaries die and the property is transferred to the third-generation beneficiaries. Every dollar over the $2 million exemption is subject to the highest existing estate tax rate, currently 45 percent. But with proper planning this exempt $2 million may grow to a sizable amount that gets transferred free of tax when the middle generations die.

A Trust for Appreciating Assets

You don't have to be in your twilight years to take advantage of a generation-skipping trust. You can create such a trust any time during your life, and make lifetime transfers to that trust (you can use up to $1 million of the $2 million exemption during your lifetime). Any asset that might grow appreciably is a candidate for such a trust. "For families that are establishing a wealth transfer plan, my advice is to place appreciating assets in a generation-skipping trust and let these assets grow outside your taxable estate," attorney Philip Feldman says.

It works this way. Any appreciable asset -- a piece of real estate, stock in a private company that may go public, hedge fund assets -- is a candidate for a generation-skipping trust. Say an engineer who joins a start-up receives stock valued at a dime a share. If she's given 1 million shares, they're worth $100,000. If she places that stock in a generation-skipping tr ust, when the company goes public at $20 a share, the trust suddenly owns an asset worth not $100,000 but $20 million.

Because it's in a trust, that appreciation is not taxable, even when the engineer and her spouse die. "You can keep the money available to the family and use it when they need it," Feldman says. And none of this $20 million will be subject to gift or estate tax as the assets pass to the children and grandchildren. Had the engineer held the stock personally, the $20 million (and all of the investment growth on that $20 million) would have been taxed at $9 million or more as it passed to the kids, and another 45 percent tax would have been assessed at the death of the children.

Feldman also points out that life insurance policies are often excellent candidates for a generation-skipping trust, but it's critical to get expert professional advice to navigate some of the technical requirements.

Planning for an Inheritance

A generation-skipping trust can also be used when a client "looks upstream" at what he may inherit from his parents. For example, a surgeon who has a lot of liability risk may want the parents to put the funds he'll inherit into a generation-skipping trust. That way the inher ited assets are available to him, but the inheritance itself is protected from creditors and can be passed down to the grandchildren without gift or estate tax. "This is like putting the assets in a tax-free insurance wrapper," says Feldman. "Any clients who have even moderate wealth might consider having their parents transfer their inheritance into a generation-skipping trust."

So even a family with $1 million in home equity and a retirement plan might consider a generation-skipping trust. "This is very straightforward, vanilla-type estate planning," says attorney Philip Feldman. Consult your trusts and estates attorney on the details, as some drafting nuances must be addressed, and state laws vary on specific aspects of these trusts.

Susan Kostal

Susan Kostal, Senior Editor of the Legal channel, has covered legal affairs issues as a journalist for more than 20 years. See full bio

about 1 year, said...

So, I married my wife whose mother had a generation skipping trust set up in the amount of 5.4 million. My wife has two children and her brother has no children. My wife's mother died leaving the generation skipping trust in tact. So if wife wife would pre decease me, would I be entitled to any of the assets of the generation skipping trust.

over 1 year, said...

Generation-skipping trust tax free where applicable? Incredible. It is truly great. But "not just for the wealthy"?? I am not so sure about that. I'm not sure that computes. I mean... look -- what level of cash can you add to that magical generation-skipping trust is going to appreciate enough to make all this worthwhile, if you're not working with some pretty high numbers... If you're not adding some significant cash to that trust -- you're not going to yield super lucrative numbers 10 or 20 years later. So, really, even if we're not talking about wealthy per se -- we're talking about some serious number to make this thing work the way it's supposed to work! Like they always say -- you gotta have money to make money. If you're a regular Jane or Joe, working the night shift, adding $400 to that trust every month, say... How impressive is the eventual financial outcome going to be, further down the road....? Let's face facts friends -- you gotta add some significant cash to that trust, on a regular basis, to have something impressive down the line to retire with or re-invest with. Not only that, it's pretty complicated, so you have to hire an attorney to help you make the right moves, take the right steps -- if you're like me... shaky on the math and complex financial moves. And attorneys cost. They don't come for free. So if you're like a lot of people, and you don't have a ton of loose cash at your disposal... and let's say your credit cards are maxed out like so many people are -- and you don't have anyone around to borrow from. What do you do? I'd say coming into a healthy inheritance with a lot of liquid assets to work with, a good deal of cash let's say, is an ideal way to start up a generation-skipping trust. In fact -- if we're going to be brutally honest about this thing, I'd say that an unexpected windfall, or perhaps an expected inheritance (windfall), is probably just about the only way most of us will ever be able to kick off, and keep investing into, a super successful generation-skipping trust! Plus pay a CPA or better yet a high level tax attorney to keep a watchful eye on things so nothing can slide off the rails! And if you’re like many heirs and beneficiaries… you might take an extra plunge in advance of waiting a year or two, or more, for probate to close out – and take a good look at borrowing against inheritance funds… taking out a loan on your inheritance… from your inheritance. Banks won’t lend a dime based on inheritance assets, nor will credit unions. So you get a probate loan right now, with an eye on the future – and with an eye on probate loans, or inheritance loans, or estate loans…. Get some rock solid info on inheritance advance rates, or inheritance loan fees -- and take a good long look at your favorite kind of super fast 72 hour, maybe even 48 hour probate loans, inheritance advance loans, probate cash advance loans, or probate real estate loans… choose a probate loan or probate advance boutique firm like one of the established well known probate loan or inheritance advance firms, or or perhaps the new SoCal firm – and bank that windfall cash from a big fat estate loan, inheritance advance or probate advance cash assignment – call your expensive tax attorney on the golf course… and begin carefully shifting funds into that generation-skipping trust! With an eye towards the future… and a better life.

over 1 year, said...

Yes, but the truth is – only a small fraction of our society enjoy the type of million dollar inheritances you’re writing about. Maybe 1%, 2%. For the other 97% or 98%, the middle class and working classes, less and less can afford to leave a large inheritance these days because they are already doling out handouts to family members... Plus, the increasing layoffs we’re seeing are a factor, increasing medical costs and decreased assistance from medical insurance, weaker investment returns, higher day to day living expenses, less retirement benefits than ever before, and falling property values in most states. Things seem to be getting so tight for non wealthy families that the family members people that are waiting for their inheritance, waiting for probate to end, are frequently these days getting loans while waiting for inheritance – borrowing against their inheritance -- in the form of large probate loans, inheritance advances or inheritance advance loans, regular probate inheritance loans, or probate real estate loans, as soon as they can complete an inheritance advance or probate loan application from online probate loan or probate advance companies that have been around forever like the well known probate loan boutique firm, or or; rather waiting a year for probate to end. In my opinion this shows exactly how difficult it is for most working people, heirs, these days.

almost 3 years, said...

When was this article written? (Interested in how up-to-date tax rates are)

over 3 years, said...

What I need to know, we had a generation skipping trust in Iowa from our Grandparents, do we need to pay Capital Gain taxes to Iowa ? We have paid but we believe the Attorney who was handling this put the wrong information on the paperwork, nobody seems to have an answer for this and we really need help, after speaking to the State of Iowa they said well you paid the taxes, and we tried to explain what happened we were told. OH WELL!

over 3 years, said...

Any protection to the grandchildren's trust from someone suing a generation skipping trust?

about 6 years, said...

My wifes (second marriage for both of us) mother had a genration skipping insuancre policy set up by her fathers "money manager". Nether of us have or are going to have childern, she 58 I'm 63. The money sets in a trust in my wifes name in La. ,we live in Texas. The trust started with $100K , after 5 years it''s down to $80K. What are our options? Can we move the money to our money manager? I understand that we can use any income generated but can we use the base maney?

almost 7 years, said...

Learning how to avoid the gift tax.

about 7 years, said...

what about grand children not born at the time teh trust say (Gallo trust) was established. Are teyy still beneficiaries?

about 7 years, said...

great article. I have children benefiting a Generation My sisters do not. Where is thier benefit as second generation, if ever?

over 7 years, said...

Is the amount received by the grandchildren taxed as income or are no taxes paid on the amount by the receiver