This type of trust takes advantage of the federal generation-skipping transfer tax exemption to minimize the tax burden on future generations.
The generation-skipping tax was instituted to address the occurrence of people avoiding gift and estate taxes by making outright gifts or transfers in trust to relatives more than one generation removed from the donor (as well as unrelated beneficiaries who are more than 37.5 years younger than the donor). Since trust assets that skipped the donor’s children were not subject to estate taxes, the generation-skipping tax was imposed on trust assets valued over a certain limit.
In a generation-skipping trust, assets such as cash or property valued under the current exemption amount are usually placed in trust for the grantor’s children and grandchildren for a particular term. (If the term is of unlimited duration, it is called a dynasty trust.) Trust income is distributed according to the grantor’s wishes, and then the principal is distributed outright to the grandchildren after the children die.
- When the grantor’s children die, trust assets pass tax-free to the grandchildren.
- Trust assets that would normally be subject to creditor claims are protected in a generation-skipping trust.
- Depending on the state in which the trust is created, trust assets inherited by the grandchildren are not subject to claims by former spouses.
While children may serve as trustees, caution is advised. If a child is appointed as sole trustee, that leaves the trust vulnerable to creditor claims and estate taxes upon the child’s death. The ability of a minor trustee to have discretionary control over how trust income is distributed can be limited by applying relevant ascertainable standards.