Generation-Skipping Trusts and Dynasty Planning

Overview

A generation-skipping trust (GST) is one of the most effective tools for long-term wealth transfer and dynasty planning. Properly drafted and funded, a GST lets you move assets to grandchildren or later generations, protect those assets from beneficiaries’ creditors and divorces, and preserve estate tax-free growth for multiple generations. The federal generation-skipping transfer tax (GSTT) is a specialized tax that applies when property is transferred to a “skip person” — typically someone at least two generations younger than the transferor — but you can allocate GST exemption to shelter transfers from that tax. (See the IRS guidance on the generation-skipping transfer tax.)

In my practice advising families with multi-generational goals and complex estates, I see three consistent objectives: preserve capital, limit tax erosion, and impose disciplined distribution rules so wealth lasts. A properly structured GST addresses all three when combined with clear trustee instructions, state-law dynasty-trust options, and thoughtful funding.

How the GST tax works and the role of GST exemption

The GSTT is separate from federal gift and estate taxes. It applies to three basic transfer types: direct skips (a transfer that immediately goes to a skip person), taxable terminations (a termination of an interest in trust where the remaining interest goes to skip persons), and taxable distributions (distributions from a trust to a skip person). The GST tax rate is a flat 40% on taxable generation-skipping transfers that exceed the available GST exemption. The GST exemption amount is tied to the federal gift and estate tax unified credit and is adjusted for inflation; because rules and exemption amounts change periodically, confirm the current exemption with the IRS before planning. (IRS: Generation-Skipping Transfer Tax.)

Allocation of exemption. For lifetime gifts into a GST or for transfers at death, you must allocate GST exemption to the trust to shelter it from GSTT. For gifts, you typically report and elect allocation on Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return); for transfers at death, Form 706 (United States Estate (and Generation-Skipping Transfer) Tax Return) handles the reporting. If you do not timely allocate exemption, some transfers may be automatically covered by a retroactive allocation rule, but that is a technical area where you should consult an experienced estate planning attorney or CPA. (IRS: About Form 709; About Form 706.)

Note: portability between spouses applies to the estate tax exemption (via DSUE), but GST exemption is not portable between spouses in the same way—you must plan around that limitation.

Common GST/dynasty trust structures and choices

• Dynasty trust: A long-term irrevocable trust (often structured as a GST) that seeks to avoid state rule-against-perpetuities limits so assets can remain in trust for decades or indefinitely where permitted by state law. Many states now permit perpetual or near-perpetual trusts; selecting the right situs is a core planning choice.
• Direct-skip trust: Makes outright gifts or distributions to grandchildren; GSTT applies unless exemption is used.
• Trust with generation-skipping allocations: The grantor funds an irrevocable trust for children as income beneficiaries and grandchildren as remainder beneficiaries; proper allocation of GST exemption shelters future distributions.
• Grantor vs. non-grantor trust tax status: You can structure the trust so the grantor pays income tax (grantor trust) or the trust pays income tax (non-grantor). Grantor status can be an income-tax efficient technique for shifting future appreciation out of the grantor’s estate while leveraging the grantor’s lower income tax attributes.

Why families use GSTs in dynasty planning

• Tax efficiency: Shelter growth from future estate and GST taxes by using current GST exemption allocations.
• Asset protection: Spendthrift provisions and carefully chosen trustees can shield trust assets from beneficiaries’ creditors and divorcing spouses.
• Control and stewardship: Grantors set distribution standards (age-based, education, health, incentive clauses) that help heirs develop financial responsibility.
• Wealth compounding: Transferring appreciating assets out of your estate lets investments grow outside of future estate/GSTT exposure.

Practical steps to set up an effective GST for dynasty planning

1. Clarify objectives. Decide whether your goal is tax minimization, creditor protection, philanthropy, education funding, or combination strategies.
2. Choose the trust type and terms. Decide on perpetual vs. term-based, distribution standards, trustee powers, trust protector provisions, and successor trustee rules. Consider provisions that allow limited decanting or modification if circumstances change.
3. Allocate GST exemption. For lifetime gifts, prepare Form 709 and make an explicit election to allocate GST exemption to the trust. For testamentary transfers, prepare Form 706. Work with a CPA or estate attorney to get the timing and language right.
4. Fund the trust. Common assets used: marketable securities, interests in family businesses (sometimes with valuation discounts), private real estate, and life-insurance policies (particularly useful when created inside an irrevocable life insurance trust used in tandem with a GST structure).
5. Select trustees and protectors. Use institutional or individual co-trustees with experience in long-term trust administration; include a trust protector to retain flexibility.
6. Check state law. Dynasty-trust longevity depends on state law—select a favorable state if needed. Consider re-situs and decanting clauses where appropriate.

For practical guidance on choosing fiduciaries and protecting trust flexibility, see FinHelp’s guides on selecting the right fiduciaries and using trust protectors.

• Selecting the Right Fiduciaries: Trustees, Agents, and Executors — https://finhelp.io/glossary/selecting-the-right-fiduciaries-trustees-agents-and-executors/
• Using Trust Protectors to Maintain Flexibility in Long-Term Trusts — https://finhelp.io/glossary/using-trust-protectors-to-maintain-flexibility-in-long-term-trusts/

Income tax and reporting considerations

Income taxation of trust income is separate from GSTT. If a trust is a grantor trust for income tax purposes, the grantor pays income taxes on the trust’s income; that may be advantageous because paying trust income tax reduces the trust’s assets available to beneficiaries without using up GST exemption. If the trust is a separate taxpayer, the trust pays income tax under the trust tax brackets, which reach high rates at low dollar levels—this can be inefficient for retained income. Discuss how to balance income tax and transfer-tax goals with your CPA or tax attorney.

Reporting: lifetime gifts require Form 709; estate and certain GST events require Form 706. For income tax filing, the trust’s Form 1041 or grantor’s tax return will handle income reporting depending on status.

Common mistakes and how to avoid them

• Waiting too long to act: Using current GST exemption while available may be critical; tax laws and exemption amounts change.
• Incorrect or incomplete exemption allocation: Failure to timely allocate GST exemption on Form 709 can leave sizeable transfers exposed to tax.
• Ignoring state dynasty rules: A trust that is perpetual in one state may be limited by another state’s rule against perpetuities—confirm situs and governing law.
• Poor trustee selection: Trustee capability matters for long-term stewardship—choose fiduciaries with investment, tax, and distribution experience.
• Overlooking income tax trade-offs: Focusing only on transfer taxes without addressing income tax can reduce the trust’s after-tax value.

Practical examples (illustrative)

• Education and health distributions: A grandparent funds a GST with $1 million for grandchildren, with annual discretionary distributions for education and medical costs. The trust’s growth is sheltered from the grandchildren’s future estate taxes if exemption is allocated.
• Business succession plus dynasty planning: A parent transfers minority interest in a family company to a GST. With proper valuation and GST exemption allocation, future appreciation occurs outside the founder’s estate while maintaining family control through voting arrangements.

When a GST may not be right

• Smaller estates or simple bequests often do not justify the complexity and costs of an irrevocable GST.
• If you require control and anticipate needing to change terms frequently, a revocable trust or other vehicles may be more appropriate.

Final checklist before you establish a GST

• Confirm current GST exemption and GSTT rules with IRS resources.
• Decide grantor vs non-grantor trust income-tax treatment.
• Prepare Form 709 and elect GST exemption where appropriate.
• Select experienced trustees and include a trust protector clause.
• Verify state trust law and consider selecting a dynasty-friendly situs.
• Coordinate the GST with other planning vehicles (life insurance, marital trusts, family limited partnerships).

Sources and further reading

• Internal Revenue Service, “Generation-Skipping Transfer Tax” — https://www.irs.gov/businesses/small-businesses-self-employed/generation-skipping-transfer-tax
• Internal Revenue Service, “About Form 709” — https://www.irs.gov/forms-pubs/about-form-709
• Internal Revenue Service, “About Form 706” — https://www.irs.gov/forms-pubs/about-form-706
• Investopedia, “Generation-Skipping Trust” — https://www.investopedia.com/terms/g/generation-skipping-trust.asp

Professional disclaimer: This article is for educational purposes only and does not constitute legal, tax, or investment advice. Laws and exemption amounts change; consult a qualified estate planning attorney and a CPA to tailor strategies to your situation.