Direct skip

What Is Direct Skip?

A direct skip is a specific type of transfer of property that is subject to the federal Generation-Skipping Transfer Tax (GSTT). Within the realm of estate planning and taxation, it occurs when assets are transferred directly to a "skip person," bypassing an intermediate generation that would typically be subject to estate tax or gift tax. This transfer can be made during the transferor's lifetime or at death. The direct skip is designed to capture wealth transfers that jump one or more generations, ensuring that a transfer tax is imposed at each generational level. The person making the transfer is known as the grantor, and the recipient is the beneficiary or "skip person."

History and Origin

The concept of a direct skip, as part of the broader Generation-Skipping Transfer Tax, originated from a legislative effort to prevent the avoidance of transfer taxes across multiple generations. Before the introduction of the GSTT, wealthy individuals could establish trusts or make direct bequests that would benefit grandchildren or later generations, effectively "skipping" the children's generation and avoiding an additional layer of estate tax. This loophole allowed for perpetual trusts that could hold assets for many generations without incurring transfer taxes at each generational shift.³⁸

Congress first addressed this issue with the Tax Reform Act of 1976, enacting an initial version of the generation-skipping transfer tax.³⁷,³⁶ However, this early iteration proved complex and difficult to administer, leading to widespread criticism.³⁵,³⁴ Consequently, Congress repealed the 1976 version and enacted a new GSTT law as part of the Tax Reform Act of 1986.,³³,³² This revised legislation, with an effective date of October 23, 1986, simplified the tax imposition by introducing specific taxable events, including the direct skip, taxable distribution, and taxable termination, to ensure that wealth transfers to younger generations did not bypass the federal transfer tax system.,³¹ The current version of the GSTT, including provisions for direct skips, has been reinstated and modified through subsequent acts, such as the Tax Relief, Unemployment, Insurance Reauthorization, and Job Creation Act of 2010.³⁰

Key Takeaways

• A direct skip is a transfer of property to a "skip person" that is immediately subject to federal estate or gift tax.
• A "skip person" is generally a relative two or more generations younger than the transferor (e.g., a grandchild), or an unrelated person more than 37.5 years younger.
• The transferor or their estate is responsible for paying the Generation-Skipping Transfer Tax on a direct skip.
• The GSTT is imposed at a flat rate, currently 40%, which is in addition to any applicable estate or gift taxes.,²⁹
• A lifetime exemption amount applies to generation-skipping transfers, allowing a significant amount of wealth to be transferred without incurring the GSTT.

Formula and Calculation

The Generation-Skipping Transfer Tax (GSTT) on a direct skip is calculated as a flat percentage of the net value of the transferred property, after accounting for any applicable exclusions or allocated exemption.

Where:

• Net Value of Transfer: The fair market value of the property transferred, minus any annual exclusions or applied lifetime GSTT unified credit.
• GSTT Rate: The flat tax rate, which is equal to the highest federal estate and gift tax rate (currently 40%).,²⁸

The application of the GSTT exemption amount is crucial in determining the net value. Each individual has a lifetime GSTT exemption that can be allocated to transfers. Once allocated, any subsequent growth on the assets covered by the exemption is also sheltered from future GSTT.²⁷

Interpreting the Direct Skip

A direct skip signifies an immediate taxable event under the Generation-Skipping Transfer Tax regime. When a direct skip occurs, it means the transferor has made a gift or bequest to a "skip person" (a beneficiary two or more generations below them, such as a grandchild), and that transfer is simultaneously subject to either the federal gift tax (for lifetime transfers) or the federal estate tax (for transfers at death).²⁶ The defining characteristic is the immediate imposition of the GSTT at the time of the transfer. This contrasts with other GSTT events, like a taxable distribution or taxable termination from a trust, where the tax liability arises later. Understanding whether a transfer constitutes a direct skip is critical for proper tax planning and ensuring that the transferor or their estate correctly calculates and remits the applicable taxes.

Hypothetical Example

Consider Mrs. Eleanor Vance, a grandmother, who wishes to gift $15 million directly to her grandson, David, for his college education and future investments. David is a "skip person" because he is two generations younger than Mrs. Vance. Mrs. Vance has already used her annual gift tax exclusion for the year. The current lifetime Generation-Skipping Transfer Tax (GSTT) exemption is $13.99 million per individual (for 2025).²⁵,²⁴

1. Gift Value: Mrs. Vance's gift to David is $15,000,000.
2. GSTT Exemption Applied: Mrs. Vance can apply her $13,990,000 lifetime GSTT exemption to this direct skip.
3. Taxable Portion: The portion of the gift exceeding the exemption is $15,000,000 - $13,990,000 = $1,010,000. This is the amount subject to the GSTT.
4. GSTT Calculation: Assuming the current GSTT rate is 40%, the tax due on the direct skip would be $1,010,000 * 0.40 = $404,000.

In this scenario, Mrs. Vance, as the transferor, would be responsible for paying this $404,000 direct skip tax, in addition to any gift tax implications on the portion of the gift exceeding her combined gift tax and GSTT exemption. This example illustrates how the direct skip mechanism ensures that even when a generation is bypassed, a transfer tax is still applied to significant wealth transfers. Proper wealth transfer strategies are essential to minimize such liabilities.

Practical Applications

Direct skips are a key consideration in complex estate planning strategies, particularly for high-net-worth individuals aiming to transfer substantial assets to future generations. They primarily show up in situations where a donor or decedent intends to benefit beneficiaries who are two or more generations younger, often grandchildren or great-grandchildren.

One common application involves direct gifts from grandparents to grandchildren, either outright or into certain types of irrevocable trusts. For instance, a grandparent might make a direct skip gift to fund a grandchild's education or to establish a trust that directly benefits younger generations, thereby removing assets from the intermediate generation's estate. The specific rules for these transfers, including applicable exclusions and reporting requirements, are detailed in IRS publications, such as Publication 559, "Survivors, Executors, and Administrators."²³ This publication provides guidance on the tax duties for those managing the estate of a deceased individual, which can include accounting for generation-skipping transfers.²²

For direct skips, the transferor (or their estate) is typically responsible for paying the GSTT. Financial advisors often work with clients to strategically allocate their lifetime GSTT exemption to these transfers, maximizing the amount that can pass tax-free to skip persons.²¹ The current legislative landscape, particularly changes stemming from the Tax Cuts and Jobs Act, has significantly impacted the available exemption amounts, making it crucial for individuals to review and update their estate plans to leverage these thresholds effectively.²⁰

Limitations and Criticisms

While direct skips offer a mechanism for wealth transfer to younger generations, they come with certain limitations and criticisms. The most significant drawback is the immediate imposition of the Generation-Skipping Transfer Tax, which is levied at the highest federal estate and gift tax rate (currently 40%) in addition to any applicable gift or estate taxes.¹⁹ This "double tax" can lead to a substantial reduction in the transferred wealth if the lifetime GSTT exemption amount is not properly allocated or has been exhausted.

Another challenge is the complexity of the GSTT rules themselves. Understanding what constitutes a direct skip versus a taxable distribution or taxable termination requires careful analysis of the relationship between the transferor and beneficiary, and the structure of any intervening trusts. Misunderstanding these definitions or failing to properly allocate the GSTT exemption can lead to unintended tax liabilities.¹⁸

Critics of the Generation-Skipping Transfer Tax, including those who advocate for reform, point to several flaws. Some argue that the exemption amounts are too high, allowing significant fortunes to escape the tax system through "dynasty trusts" and undermining the tax's original goal of ensuring that extraordinary wealth bears its fair share of transfer tax burdens.¹⁷,¹⁶ Others highlight loopholes that permit taxpayers to "stuff" GST-exempt trusts with assets that grow to be worth far more than the initial exemption, effectively minimizing future tax exposure.¹⁵ Additionally, the lack of a uniform durational limit on these trusts in states that have abolished the rule against perpetuities allows wealth to remain outside the federal transfer tax base indefinitely, further exacerbating these concerns.¹⁴,¹³ These criticisms suggest that while the direct skip and GSTT aim to prevent tax avoidance, their current implementation may not fully achieve their intended purpose, leading to complex and sometimes inequitable outcomes in wealth management.

Direct Skip vs. Taxable Distribution

Both a direct skip and a taxable distribution are events that trigger the federal Generation-Skipping Transfer Tax (GSTT), but they differ significantly in their nature and timing of taxation. The primary distinction lies in when the transfer is subject to the GSTT and whether it is also simultaneously subject to federal estate or gift tax.

A direct skip is a transfer of property to a skip person that is immediately subject to federal estate or gift tax at the time of the transfer.¹² This means the GSTT is imposed concurrently with either the gift tax (for lifetime transfers) or the estate tax (for transfers at death). For example, a direct gift from a grandparent to a grandchild is a direct skip. In such cases, the grantor or their estate is responsible for paying the direct skip tax.,¹¹

In contrast, a taxable distribution occurs when a distribution of income or principal is made from a trust to a skip person, but the distribution is not a direct skip or a taxable termination.¹⁰,⁹ This implies that the initial transfer into the trust was not a direct skip. The GSTT on a taxable distribution is generally paid by the beneficiary receiving the distribution, and it is imposed at the time the distribution occurs, which could be years after the trust was initially funded.,⁸ For instance, if a trust was set up for both a child and a grandchild, and the trustee makes a distribution directly to the grandchild during the child's lifetime, this would typically be a taxable distribution.

The key difference, therefore, is the direct and immediate nature of the taxation for a direct skip, which occurs at the initial transfer and concurrently with estate or gift tax, versus the deferred nature of the taxable distribution, which occurs when funds are distributed from a trust and the tax is borne by the recipient.

FAQs

What is a "skip person" in the context of a direct skip?

A "skip person" is a beneficiary who is at least two generations younger than the transferor. This generally includes grandchildren, great-grandchildren, or more remote lineal descendants. It can also refer to an unrelated individual who is more than 37.5 years younger than the transferor.,⁷

Who pays the Generation-Skipping Transfer Tax on a direct skip?

For a direct skip, the transferor (the person making the gift or bequest) or their estate is responsible for paying the Generation-Skipping Transfer Tax (GSTT).,⁶ This is different from a taxable distribution from a trust, where the recipient beneficiary typically pays the tax.

Can a direct skip occur through a trust?

Yes, a direct skip can occur through a trust if the trust itself is considered a "skip person." This happens when all present interests in the trust are held by skip persons. For example, if a trust is established solely for the benefit of a grandchild (a skip person) and no non-skip persons have an interest, the initial funding of that trust would be a direct skip.⁵

Is there an exemption for direct skips?

Yes, there is a substantial lifetime exemption amount for the Generation-Skipping Transfer Tax (GSTT) that can be allocated to direct skips. For 2025, this exemption is $13.99 million per individual.⁴,³ Transfers up to this amount can generally pass to skip persons without incurring the GSTT. This exemption is distinct from, but often coordinated with, the federal estate tax and gift tax exemptions.

How does the annual gift tax exclusion relate to direct skips?

The annual gift tax exclusion allows an individual to give a certain amount (e.g., $18,000 in 2024) to any number of individuals each year without incurring gift tax.² This exclusion also applies for GSTT purposes to direct skip gifts, meaning these amounts generally do not count against the lifetime GSTT exemption amount or incur the tax. Additionally, payments made directly to educational institutions for tuition or to medical providers for medical expenses on behalf of a skip person are also excluded from both gift and GST taxes, regardless of amount.¹