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The Generation skipping transfer tax seems complicated to understand and it absolutely should only be dealt with by a seasoned professional, but there are some hallmarks that are present in each such transaction so that individual taxpayers know when the tax will apply and can follow a general conversation about the topic. To begin with, the name may seem a bit confusing at first. The skipping that the name refers to is the tax that would (should according to some lawmakers and IRS officials no doubt) be incurred when a second generation passes on the inherited asset.
The generation skipping transfer tax was first introduced in 1976 to avoid what Congress saw as an avoidance of the estate tax by wealthy families that could afford to hire attorneys to create complicated, long term trusts that avoided the estate tax. The net result was that less wealthy, middle class families were paying a disproportionate share of the estate taxes; in other words, those who could least afford it were paying more of the tax. The generation skipping transfer tax in its current incarnation creates tax liability anytime a transfer of an asset or money is transferred more than one generation from the grantor or to someone who is at least 37.5 years younger.
It is important to keep in mind that federal law unified the gift tax, estate tax and generation skipping transfer tax as part of the Tax Relief Act of 2010. That means that any transfer made to someone that would otherwise qualify (gift to someone who is greater than two generations from the grantor or younger by 37.5 years or more) is exempted up to the permitted exemption amount.
For sake of example, let us assume that the grantor used up the entire amount of his/her exemption for purposes of generation skipping transfer tax. Grandfather passes $10 million into to his child via his will. This will trigger estate tax liability of the entire amount since grandfather used up the entirety of his exemption. To further the example, if grandfather did use up any of the exemption, he would be allowed to exclude $5.45 million if he passed away in 2016; therefore only $4.55 million would be taxed. If grandfather also left $10 million to grandchild and he used up the entirety of his exemptions, all $10 million would incur estate tax liability (gift tax liability if during the lifetime of the grantor) as well as the additional, generation skipping transfer tax. As such, one transfer creates tax liability for two separate taxes. If grandfather did not use up any of the exemption, only $4.55 million would incur estate tax liability and the generation skipping transfer tax.
There are some limited exceptions to this general rule. If the gift if to a spouse, it does not matter if the grantor is more than 37.5 years older than the recipient. It also does not apply to gifts for payments for tuition or medical care, paid directly to the school or medical care provider. These monies are excluded from calculation from the generation skipping transfer tax.