The federal generation-skipping tax aims to prevent wealthy families from dodging estate taxes by transferring assets directly to the wealth holders' grandchildren, thereby "skipping" the children. The generation-skipping tax inclusion ratio determines how much of that transferred wealth, if any, is subject to tax.
When a person dies, his estate will be subject to federal estate tax if it's larger than a certain amount -- at the time of publication, $5.34 million. What's left after tax goes to the person's heirs. When an heir dies, her estate becomes subject to tax in the same manner. People were once able to get around one or more rounds of estate tax by passing their assets directly to grandchildren, great-grandchildren or others by putting them into trusts.
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When a deceased person's assets skip generations through the use of a trust, the estate must pay generation-skipping tax. This tax is reported and paid along with any estate tax on Internal Revenue Service Form 706. The executor of the estate fills out this form. In doing so, the executor calculates the inclusion ratio, which is the percentage of the generation-skipping trust that is subject to tax. Schedule R of Form 706 guides the executor through the calculations.
Applying the Ratio
The inclusion ratio ranges from 0 to 1. A ratio of 0 means the trust is completely exempt from tax. A ratio of 1 means the trust is fully taxable. A ratio of, say, 0.65 means that 65 percent of the trust is taxable. The taxable portion of the trust is then taxed at the maximum estate tax rate, which as of 2014 was 40 percent.