Multigenerational wealth transfer with IDGTs and GST tax planning

Editor: Jeffrey N. Bilsky, CPA

As the landscape of estate planning evolves, high–net–worth families and their advisers face increasing complexity in preserving wealth across generations. The interplay among federal transfer taxes, state–law developments, and sophisticated trust structures requires a nuanced approach. Among the most powerful tools available are intentionally defective grantor trusts (IDGTs), especially when paired with effective generation–skipping transfer (GST) tax planning through dynasty trust IDGTs. For accountants and advisers, understanding these strategies is essential to delivering favorable outcomes for taxpayers seeking to establish a lasting legacy.

The GST tax: A critical consideration

The GST tax, enacted to prevent the avoidance of estate taxes through transfers to grandchildren or more remote descendants, is a flat 40% federal tax imposed on certain transfers to “skip persons” — individuals two or more generations below the transferor, or trusts for their benefit. Importantly, the GST tax is imposed in addition to the federal estate tax, and when combined with potential state estate or inheritance taxes, can significantly erode family wealth over successive generations.

Every U.S. taxpayer is granted a unified exemption from gift and estate tax set at $15 million per person in 2026 (annually indexed for inflation) and a separate GST exemption, also set at $15 million per person in 2026 (annually indexed for inflation). While the gift and estate tax exemptions are portable between spouses, the GST exemption is not, making careful planning essential to make full use of both spouses’ exemptions. This distinction is critical: Any GST exemption unused during life or on the decedent’s estate tax return is lost.

A key nuance: Not all gifts draw equally from the GST exemption. Transfers to nonskip beneficiaries (such as children) may use gift and estate tax exemption without affecting the GST exemption, while certain trust contributions, such as those to irrevocable life insurance trusts, may require allocation of GST exemption to avoid future GST tax exposure. This creates a difference between the amount of gift and estate tax exemption a person may have and the amount of remaining GST exemption. For example, a taxpayer who has made substantial gifts to children may have more GST exemption remaining than gift tax exemption, or a taxpayer who has made substantial annual exclusion gifts to GST trusts, as defined in Sec. 2632(c)(3)(B) or as elected on a timely filed gift tax return, may have more gift tax exemption remaining due to the different requirements for annual gift exclusion and annual GST exclusion.

Why dynasty trusts matter

Historically, the rule against perpetuities (RAP) limited the duration of trusts, often forcing distributions and subjecting assets to estate taxation within a few generations. Most states recognized a RAP that would terminate a trust no later than 21 years after the death of the last life in being when the trust became irrevocable. Many states later incorporated a “wait and see” approach to avoid invalidating a trust from the outset if there was even a remote possibility that the RAP might be violated, allowing for a period to see if the trust assets were timely distributed.

Since the mid–1980s, however, numerous states have enacted legislation to allow the creation of dynasty trusts with extended perpetuities periods — from hundreds of years to 1,000 years. Some states have abolished the RAP altogether, allowing for perpetual trusts. Assets held in properly structured dynasty trusts with GST exemption allocated can grow and be distributed to beneficiaries for generations — free from estate and GST taxes. The effect of these tax savings is exponential for families with significant wealth.

The role of IDGTs in multigenerational planning

An IDGT is a powerful tool in the estate planner’s toolkit. It is an irrevocable trust intentionally structured so that the grantor is treated as the owner for income tax purposes but not for estate tax purposes. This allows the grantor to pay income taxes on trust earnings (further reducing the taxable estate without additional gift tax) while trust assets appreciate outside the estate.

The key benefits of IDGTs include:

Leveraging GST exemption: By allocating GST exemption to gifts to an IDGT, especially one that is established as a dynasty trust in a long–duration–trust state, assets and their future appreciation can escape transfer taxes for numerous generations.

Discounted transfers: Transferring interests in family entities subject to valuation discounts (e.g., for lack of marketability or minority interests) allows for more wealth to be moved using available exemptions. Be mindful that if transfers of interests are made close to the grantor’s death, the grantor retains too many powers over the business, or the business interest formalities are not followed, then the IRS may dispute the transfer. Also, significant discounts for nonoperating businesses may be subject to IRS audit.

Sales to trust: A grantor who has already funded an IDGT with a gift may subsequently sell additional assets to the trust in exchange for a promissory note bearing interest at the applicable federal rate (AFR), provided the gift and sale are independent transactions and the trust has adequate collateral. This structure enables significant wealth transfer with minimal gift tax exposure by moving asset growth in excess of the AFR outside the estate.

Income tax efficiency: Because the grantor pays the income tax on trust earnings, the trust grows undiminished by income tax payments, and the grantor’s estate is further reduced by the taxes paid. Income tax payments on trust assets are not considered gifts and immediately reduce the grantor’s estate. Some states and trust agreements allow for an independent trustee or protector to reimburse the grantor for income tax related to trust income. This provides flexibility but should be used cautiously.

GST tax planning strategies

Outright gifts and trust funding: Grantors may use GST exemption by making lifetime gifts to skip persons or to trusts for multiple generations. Lifetime gifts may be more efficient than testamentary transfers because post–transfer appreciation escapes estate taxation or the need to allocate GST exemption to the appreciated value. If the grantor has more GST exemption than remaining gift exemption, the grantor may use the remaining GST exemption and pay gift tax on the transfer amount above the amount of the remaining gift exemption. Then, if the grantor survives three years, the gift tax paid is also excluded from the estate. This is generally more tax–efficient because the tax paid may reduce the grantor’s taxable estate (and remove additional asset appreciation from their estate). Note that while gift tax may be paid for lifetime gifts, GST tax is paid only on direct, or outright, transfers to skip persons in excess of their remaining GST exemption. GST tax paid by the grantor may be considered a gift that would require additional calculations to determine the total amount due.

The amount of the GST exemption that a donor can allocate to an indirect gift is limited to the available GST exemption remaining; if the gift exceeds the remaining GST exemption amount, it will have an inclusion ratio of more than zero and less than one and will be only partially exempt from the GST tax. In that case, the trust is often severed into a GST–exempt trust and a non–GST–exempt trust for tax and administrative purposes. GST tax will also be assessed to distributions from a GST trust that has an inclusion ratio above zero when distributions are made to skip persons or on the value of the trust assets times the inclusion ratio when there are no remaining nonskip beneficiaries alive (a taxable termination).

Late allocation of GST exemption: Taxpayers may make a late allocation of unused GST exemption to an existing trust that is not fully GST–exempt, thereby shielding future growth from GST tax. This strategy may be particularly useful when the value of trust assets has declined, using less of the grantor’s GST exemption. This is normally done when there was a missed GST allocation, the grantor did not have sufficient GST exemption remaining at the time of the gift, or if the value of the assets has depreciated from the date of the transfer to the gift tax return due date; then, the grantor may elect out of GST allocation and do a late allocation on a late gift tax return.

GST planning with nonexempt trusts: Assets in nonexempt trusts are often included in the taxable estate of nonskip beneficiaries (e.g., children) due to general powers of appointment. Distributing these assets to nonskip beneficiaries, who then fund new GST–exempt trusts using their own exemptions, can perpetuate GST planning benefits. This “recycling” of trust assets facilitates each generation taking advantage of its own GST exemption.

QTIP trusts and reverse QTIP elections: Allocating GST exemption to a qualified terminable interest property (QTIP) trust (qualifying for the marital deduction) using a reverse QTIP election on a grantor’s gift or estate tax return may be an effective way to preserve GST exemption for future generations. This technique allows assets to qualify for the marital deduction while also being exempt from GST tax when ultimately distributed to skip persons. These assets are included in the surviving spouse’s estate, so this strategy may be beneficial in certain circumstances but is not widely used for lifetime transfers.

Practical considerations and pitfalls

Exemption management: Because the GST exemption is not portable, planners must strive to fully use both spouses’ exemptions during life or at death. Failure to do so can result in unnecessary gift, estate, and/or GST tax exposure for future generations.

Mixed inclusion ratio trusts: Gifts to trusts with both skip and nonskip beneficiaries, when GST exemption is insufficient, can create complex inclusion ratio calculations and potential tax exposure. Careful drafting and allocation of exemption are required to avoid unintended consequences, including the need to complete a qualified severance of the trust or pay GST tax.

State law variations: The choice of trust situs is critical. States with extended or abolished RAP provisions offer greater flexibility for dynasty trust planning. Advisers should consider the laws of potential trust jurisdictions and the impact on trust administration, taxation (including income tax), and asset protection.

Coordination with other professionals: GST tax planning and the use of IDGTs require coordination among attorneys, accountants, and financial advisers. The complexity of the rules and the high stakes involved demand a multidisciplinary approach that prioritizes ensuring the client’s objectives are met and risks are mitigated.

Case study: Multigenerational planning in action

Consider a family business owner who wishes to transfer significant wealth to grandchildren and future generations. By establishing an IDGT in a state with no RAP, the owner gifts discounted interests in the business to the trust, allocating GST exemption to shelter the transfer. The trust is structured as a grantor trust, so the owner pays income tax on trust earnings, allowing the trust to grow tax–free. Over time, the trust can make distributions to grandchildren and great–grandchildren, with assets remaining outside the transfer tax system for centuries. This strategy, when properly executed, can preserve and grow family wealth far beyond what would be possible with outright gifts or testamentary transfers.

A coordinated approach

Thoughtful integration of IDGTs and GST tax planning strategies can yield exponential benefits for families seeking to preserve wealth across generations. The complexity of the rules — and the potential amount of tax or savings involved — demands a coordinated approach among tax, legal, and financial advisers. By leveraging the tools available and staying abreast of legislative developments, advisers can help clients achieve their multigenerational legacy goals while minimizing transfer tax exposure.

As state laws continue to evolve and the federal exemption amounts face potential changes, proactive planning is more important than ever. Accountants and advisers who master these techniques will be well positioned to guide clients through the challenges and opportunities of multigenerational wealth transfer.

Editor

Jeffrey N. Bilsky, CPA, is managing principal, Washington National Tax, with BDO USA, P.C. in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA, P.C.