Planning For Generation Skipping Transfer Tax Exemption
--------------------------------------------------------------------------------------------------------------------
This article addresses one of these "mysterious" areas of estate planning that is
often referred to as GST (Generation Skipping Transfer). Actually, this area
involves the concept of planning over several generations, and is based on the
reality that estate planning cannot focus on a single client or a single
generation. Estate planners always need to be aware of how actions of prior
generations will affect the current generation, and how the actions of the current
generation will affect future generations. The proper term for this kind of
planning is probably something like "multiple generation planning". However,
the terms generation skipping and GST are used quite often because of the
specific tax rules that operate to control multiple generation plans (and because
planners are always looking for shorter ways to refer to ideas).
The Federal Generation Skipping Tax
The current federal Generation Skipping Transfer Tax (GST Tax) came into
existence with the Tax Reform Act of 1986 (the original 1976 version was
repealed retroactively. Thank goodness it was an unbelievable mess.).
Basically, the federal "death" tax imposes a tax on the transfer of assets during life and at death in excess of the "unified credit". The credit was raised to $5.25 million under the 2012 American Taxpayer Relief Act, and is indexed to increase for inflation for every year. The credit during 2016 is $5.45 million. This federal tax (40%) is imposed on non-exempt gifts which taxpayers make in excess of the credit. Similarly, the federal GST Tax is designed to make sure that taxpayers do not avoid the estate and gift tax
through the use of long-term trusts, and to ensure there will be a tax paid at each generation. The GST credit amount is the same as the unified credit, $5.45 million, and is also indexed for inflation.
The primary target of the GST Tax is the typical generation skipping trust
(sometimes called a GST Trust or Dynasty Trust), which provides distributions
for the benefit of a child for life with the remainder continuing on for the
grandchildren (or more remote descendants). Under the current estate tax rules,
the trust assets would not be taxed at the child's death because the child does
not have sufficient powers over the trust to cause the assets to be included in
the child's estate. In this context, the reference to generation skipping does not
mean that the economic benefits of the trust "skip" the children, but simply that
the estate transfer tax is "skipped" at the death of the children. The GST Tax
was established to prevent this type of tax "skipping" (at least above certain
limits, as described below).
In the case of the typical GST Trust, the GST Tax would be imposed at the
death of the child, when the assets continue for the grandchildren (but only if
the assets of the trust are not otherwise subject to estate tax at the child's death).
The GST Tax also applies to direct transfers to grandchildren that would
otherwise avoid the GST Tax because no trust is involved.
Rate and Specific Application
When the GST Tax applies, the rate of tax is a flat rate equal to the maximum
estate tax rate (currently 40%). [IRC § 2641] However, unlike the estate and
gift tax, there are no lower rate brackets applicable to the GST Tax.
Specifically, the GST Tax is applied in each occurrence of a Direct Skip,
Taxable Termination, or Taxable Distribution.
Direct Skip: A direct skip occurs whenever a transfer is made to a "skip person"
with no intermediate benefit to a non-skip person. A skip person is anyone
assigned to a generation that is two or more generations below the
transferor's assigned generation (the most common example of a skip person
is a grandchild). A trust can also be a skip person if all the beneficiaries are skip
persons.
Taxable Termination: A taxable termination occurs through a trust when the
interest of a non-skip person terminates and there are no more non-skip
persons still holding an interest. For example, upon the death of a
child/beneficiary if, after the child's death, the only beneficiaries are grandchildren.
Taxable Distribution: A taxable distribution occurs whenever a distribution is made
from a trust to a skip person. However, a taxable distribution does not occur if the
event can be classified as a direct skip or a taxable termination.
To determine if a person is or is not a skip person for GST Tax purposes,
everyone is assigned to a specific generation on the basis of: 1) lineal descent
(if applicable); or 2) an implied generation assignment based on each 25-year
age group (for example, a person born more than 12 _ years but less than 37 _
years after the transferor will be deemed to be in the generation immediately
below the transferor). [IRC § 2651] In the case of lineal descendants, the
spouse of a descendant is deemed to be in the same generation as such
descendant. [IRC § 2651(c)]
There is also the "move up rule," which provides that at the time of any transfer
to a skip person, if the parent of the skip person (who is a descendant of the
donor) is not living, then the transfer will not be deemed a direct skip because
the skip person is "moved up" to the generation of his or her deceased parent.
[IRC § 2612(c)(2)] The move-up rule does not apply if the non-skip person is
only deemed to have predeceased the transferor as a result of a qualified
disclaimer.
Exclusions from the GST Tax
The GST Tax does not apply to transfers made prior to September 25, 1985-so
that an irrevocable trust created before September 25, 1985 is considered
"grandfathered" for GST Tax purposes (distributions from the trust are
generally not subject to the GST Tax). In addition, the GST Tax does not apply
to any transfer under a will or revocable trust if the will or trust was executed
before October 22, 1986, and the decedent died before January 1, 1987. (This is
becoming less and less significant as the years roll on.) However, if additions
are made to a grandfathered trust, the trust becomes partially taxable in the
future except to the extent the GST Exemption (described below) is allocated to
the additional transfer.
In addition, if a transfer is not subject to gift tax because it is within the $10,000
annual exclusion amount, the GST Tax will not apply. [IRC § 2611(b)(2)]
However, as a result of the Technical Corrections and Miscellaneous Revenue
Act of 1988 (TAMRA), this exception for nontaxable transfers is limited to
transfers that are direct skips; and for this purpose, a gift to a trust will only be a
direct skip if: 1) the trust is for only one beneficiary who is a skip person; 2) no
one other than the beneficiary can receive distributions during the beneficiary's
lifetime; and 3) if the beneficiary dies before the trust terminates, the trust
estate must be included in the beneficiary's estate for tax purposes. What this
means is that transfers to trusts that qualify for the gift tax annual exclusion as a
result of withdrawal rights (sometimes known as Crummey Powers) will not
qualify for the GST annual exclusion unless the trust also meets the
requirements detailed above.
Finally, transfers made directly to education institutions (for tuition) or
healthcare providers on behalf of a donee, which are therefore exempt from gift
tax under IRC § 2503(e), are excluded from the GST Tax. [IRC § 2611(b)(2)]
$1,000,000 GST Exemption
One of the most important aspects of the GST Tax is the $1,000,000 GST
Exemption that is available to each individual. This is commonly called the
GST Exemption. (Note: As a result of recent changes in the tax laws, this
$1,000,000 is indexed for inflation, and is actually $1,010,000 in 1999, but is
still often referred to as the $1,000,000 GST Exemption.) Because of this GST
Exemption, each person has the ability to transfer up to $1,010,000 (determined
at the time the exemption is allocated) in a manner that would otherwise be
subject to the GST Tax. [IRC § 2631(a)] This amount can be used for lifetime
gifts, and any portion of the GST Exemption not used during lifetime will be
applied to assets passing at death.
The GST Exemption can be allocated in any manner chosen by the transferor
(or the decedent's personal representative). [IRC § 2632(a)] Normally, the GST
Exemption will not be allocated without affirmative action of the transferor.
However, the GST Exemption will be automatically applied to direct skips
unless the transferor elects not to use the GST Exemption. [IRC § 2632(b)]
Any portion of the GST Exemption unused at death, and not allocated by the
decedent's personal representative (sometimes called the executor), will be
automatically allocated to direct skips occurring at death, and then any
remaining GST Exemption will be allocated to trusts with respect to which the
decedent is the transferor, and as to which taxable distributions or taxable
terminations may occur.
Reverse QTIP Election. Married couples can make use of a special IRC §
2652(a)(3) election (reverse QTIP election) that allows the full use of the GST
Exemption for both spouses, even if the unlimited marital deduction is utilized.
Normally, assets in a Qualified Terminable Interest Property (QTIP) Marital
Trust are deemed to pass from the surviving spouse (and could only utilize the
GST Exemption of the surviving spouse). The IRC § 2652(a)(3) election
reverses this presumption so that, for GST Tax purposes only, the QTIP Trust
assets are deemed to pass from the first spouse (and therefore will utilize the
first spouse's GST Exemption).
ETIP Rules. No GST Exemption can be allocated to a transfer to which the
transferor has retained certain rights or interests that would cause the assets to
be included in the transferor's estate for estate tax purposes under IRC §§ 2036,
2037, 2038, 2041, and 2042 (but not IRC § 2035). This is known as the Estate
Tax Inclusion Period (ETIP), which continues until the assets of the trust would
no longer be included in the transferor's estate under the above Code sections.
Allocation to Lifetime Gifts . If an allocation of GST Exemption is made on a
timely filed gift tax return (including extensions), the allocation is effective
from the date of the gift (even if the value has since changed). An allocation of
GST Exemption made after the due date for the gift tax return must be based on
the current value of the asset (although the value at the beginning of the month
may be used instead, unless the grantor has died). The Treasury Regulations
also confirm that if an allocation of GST Exemption is made for an irrevocable
life insurance trust, the GST Tax status of the trust continues after the grantor's
death, even if the grantor dies within three years and the trust assets (the
insurance policy) are included in the Grantor's estate for federal estate tax
purposes.
Inclusion Ratios
Every trust has an inclusion ratio that determines the portion of each future
distribution or termination that will be subjected to the GST Tax. [IRC § 2642]
For example, an inclusion ratio of "zero" means that the trust is totally exempt
from the GST Tax; an inclusion ratio of "one" means that all taxable
distributions and taxable terminations will be fully subject to the GST Tax; and
an inclusion ratio of _ means that one-half of all taxable distributions and
taxable terminations will result in a GST Tax.
The inclusion ratio for a trust is initially determined by calculating the portion
of the transfer that is not covered by the GST Exemption, or an exclusion, and
dividing this amount by the value of the entire transfer. For example, if a person
transfers $1,500,000 into a generation skipping trust and allocates $1,000,000
of GST Exemption, the inclusion ratio would be:
$500,000 / $1,500,000 = 1/3
Subsequent transfers to an existing trust may affect the trust's inclusion ratio. If
sufficient GST Exemption is allocated to the subsequent transfer, the trust will
retain its zero inclusion ratio. It is advisable not to make additions to an existing
trust in amounts that exceed the available GST Exemption. However, if there is
not sufficient GST Exemption remaining, the inclusion ratio is redetermined as
follows:
First, the nonexempt portion of the trust (prior to the new transfer) is
determined by multiplying the pretransfer value of the trust assets by the
existing inclusion ratio.
Second, the value of this nonexempt portion is added to the portion of the
new transfer that is not covered by a GST Exemption or exclusion.
Third, this total of the nonexempt amount is divided by the total value of the
trust estate immediately following the new transfer.
For example, if an existing trust with an inclusion ratio of 2/3 has trust assets
valued at $750,000 (meaning that $500,000 is currently not covered by GST
Exemption), and if an additional $500,000 is transferred to the trust, but only
$250,000 of GST Exemption is allocated to the transfer, then the new inclusion
ratio for the trust will be determined as follows:
($500,000 + $250,000) / $1,250,000 = 3/5
The Treasury Regulations include elaborate rules as to when trusts or shares
will be treated as separate for purposes of the inclusion ratio. Extreme caution
is needed when, following the Grantor's death, a trust is to be divided into
exempt and nonexempt trusts for GST Tax purposes. This is particularly true
when the division is created by means of a pecuniary amount passing to the
nonexempt trust with the remainder becoming the GST exempt trust. Generally,
when such a pecuniary amount is funded, it must be done within 15 months, or
carry with it appropriate interest to compensate for the delay in funding. It is
also important that a trust is divided before any GST Exemption is allocated.
For example, if there is a $500,000 trust that has an inclusion ratio of _, the
Regulations do not allow this trust to be divided into a $250,000 trust with a
"zero" inclusion ratio and a $250,000 trust with a "one" inclusion ratio (even
though such result sounds quite logical). According to the Regulations, a
division of this trust would result in two $250,000 trusts, each of which would
still have an inclusion ratio of _.
General Planning Strategies
If the total value of the combined estates of a husband and wife is not expected
to exceed $1,000,000, then the GST Tax will not be a direct concern. However,
if children have sizeable estates, it may be beneficial to have some or all of the
parents' estate put into GST Trusts, or be given to grandchildren outright, to
avoid unnecessarily increasing the children's taxable estates. To the extent
possible, an estate plan for the parents should consider the planning
opportunities for children that may be lost once assets are distributed outright to
the children.
If the total value of the combined estates of a husband and wife is over
$1,000,000, but is not expected to exceed $2,000,000, then the GST Tax can be
avoided, but special planning may be necessary (using the reverse QTIP
election) to ensure that both spouses can use the $1,000,000 GST Exemption.
If the total value of the combined estates of a husband and wife substantially
exceed $2,000,000, then more sophisticated GST planning should be discussed,
including the use of the GST Exemptions during life.
To the maximum extent possible, it is important to make sure that each trust is
either fully exempt or fully nonexempt; otherwise, it will be impossible to make
the most efficient use of the exempt trusts. If a trust has an inclusion ratio of
something other than one or zero, there is no efficient method to make
distributions, because either: 1) a distribution is made to a skip person that will
result in the payment of some GST Tax; or 2) a distribution will be made to a
non-skip person that will result in wasting a portion of the GST Exemption
previously allocated.
Generally speaking, trusts with inclusion ratios of one should be used for
Non-skip persons (or be included in the estates of non-skip persons) and trusts
with a zero inclusion ratio should be used for skip persons or accumulated for
future generations. Once the trusts have been carefully divided into exempt and
nonexempt, distributions should be made to non-skip persons out of nonexempt
trusts and distributions should be made to skip persons out of exempt trusts.
Conclusion
This article summarizes the basic concepts and considerations involved in
planning for and around the GST Tax, but there is much more that could be
said. This is one area where the inexperienced and/or untrained professional
should not venture without the guide of an expert who has been there many
times before. But, hopefully, you now have some general information that will
permit you to participate in the discussions and provide a roadmap to the
mysterious land of GST.
--------------------------------------------------------------------------------------------------------------------
