By Robert L. Moshman
I n the estate planning universe of today, only a small percentage (perhaps 1%) of estates are taxable and still fewer trigger the generation-skipping transfer tax (GSTT). Yet the GSTT is a deceptive and deadly tax with which to reckon. It strikes without warning. Furthermore, its calculations are so inhumanely convoluted that the GSTT can send estates into a black hole of confusion from which no lawyer can extract them--or so it seems. Fortunately, lawyers and clients can manage the GSTT by observing a few basic principles. This article attempts to seek out the truth about the GSTT and arm estate planning lawyers with a collection of simple, practical strategies to address the GSTT effectively.
It's Out There
The GSTT is sneaky and applies in more scenarios than meet the eye. For example, assume a testamentary trust provides for a distribution when the grantor's son reaches age 45 but provides that, if the son dies before he reaches age 45, the trustee will distribute the remaining trust assets to the grantor's grandchildren. That event is a "taxable termination" subject to GSTT under Code § 2612(a). The drafting lawyer may not have anticipated that result.
The GSTT is also a powerful force. Once a client exhausts his or her GST exemption (currently $1,010,000, but subject to adjustment for inflation) elsewhere, the tax starts right off at its flat rate of 55% (subject to any applicable gift tax annual exclusions). Add this to the separate estate and gift tax at a top rate of 55%. After various calculations, the total transfer tax may have an effective rate that well exceeds 100%, making the tax larger than the gift.
The GSTT is also a nuisance for lawyers and tax return preparers. After contemplating such terms of art as the "inclusion ratio" and "estate tax inclusion period," the professional soon
realizes that calculating the GSTT is reason enough to handle potential GSTT exposure with extreme prejudice.
The pragmatic lawyer is a lonely outpost for GSTT awareness, watching the night skies and scanning the horizon for possible skip transfers. Like an asteroid that suddenly appears one second before impact, a surprise GSTT scenario can be an estate-terminating event. Yet it was not that long ago that multi-generational trusts, such as those used by the Kennedy family, were a basic part of an estate plan.
The Kennedys' Secret Weapon
At age 25, Joseph P. Kennedy was merely the president of a bank. Kennedy, however, soon established himself as a freewheeling investment banker, becoming a master of stock market manipulation and insider trading during the Roaring Twenties before the government regulated the securities market. Kennedy made another fortune in Hollywood, where he established RKO during the formative years of the movie industry.
After liquidating his stock holdings just before the October 1929 crash, Kennedy used short sales to make huge profits during the Depression. Ironically, his insight into exploiting the
system made him President Franklin D. Roosevelt's choice to become the first chairman of the brand new Secu-rities and Exchange Commission.
In his estate planning, Joseph Kennedy followed a simple strategy. Before the enactment of the Tax Reform Act of 1976, the estate tax greeted (and depleted) each successive generation like a gatekeeper. Having amassed a considerable fortune, Kennedy apparently saw the wisdom of avoiding a 77% tax. By passing wealth directly to his grandchildren and skipping a generation, he skipped an entire layer of estate taxation.
For example, trusts Joseph Kennedy established for John F. Kennedy provided JFK with income for life as well as the right to withdraw up to 5% of principal in any year. During the Kennedy administration, the President's trust funds were said to be paying him $500,000 of annual income. Because Joseph Kennedy gave his son only a life estate, the assets were not subject to estate tax at JFK's death. Thus, the government taxed the assets only once, in Joseph P. Kennedy's estate, before those assets reached Joseph's grandchildren, John F. Kennedy Jr. and Caroline Kennedy Schlossberg.
The Kennedy estate plan shows that when assets are unencumbered by transfer taxes or the need to benefit one particular generation, the family can productively invest those assets
in long-term pursuits. The Kennedy trusts held assets ranging from businesses to real estate. The family holding company, Joseph P. Kennedy Enterprises, recently sold the Merchandise Mart in Chicago--which Joseph Kennedy purchased in 1945 for $13 million--for $625 million.
Taking Kennedy's estate plan concept to its logical conclusion, a client could create a trust that is a perpetual source of revenues, will avoid transfer taxes forever and will serve as a family bank to finance his or her descendants. Although the common law rule against perpetuities imposes a time limit--a life in being plus 21 years can reach about 100 to 120 years--true dynasty trusts can be established, with various limitations, in a growing number of perpetuity havens: South Dakota, Wisconsin, possibly Idaho (ambiguities exist), Delaware (for personal property) and, most recently, Alaska, Arizona, Illinois and Maryland.
The Next Generation
At the time of his assassination in 1963, JFK had not updated his 1954 will, which made no provision for his children. Had he lived, he might have adopted a multi-generational trust approach in the same manner as his father and, eventually, his widow. Alternatively, because Caroline Kennedy Schlossberg and John F. Kennedy Jr. were already set financially, the President might have turned his attention to his own grandchildren.
For the same reasons, it made sense for Jacqueline Kennedy Onassis to direct her wealth to her grandchildren. She coordinated her GSTT strategy with a charitable lead trust (CLT) that would have reduced taxes and maintained privacy. Ironically, the public identified the Onassis estate with the use of CLTs even though the estate's executors ultimately decided not to fund the trusts, demonstrating the flexibility of the Onassis estate plan. One reason for the change may have been the size of the estate, which fell short of the $100-$200 million amounts noted in the press, even with $34.4 million from a 1996 Sotheby's auction of the Kennedy family's personal property. On the other hand, the acclaimed CLT/GSTT arrangement may have resulted in too much GSTT after all.
Deep Impact: The First GSTT
An entire generation of estate planners has never known a time when the GSTT did not exist. Travel back 22 years to a pre-GSTT age of innocence when Congress first began to sow the seeds of change. The summer of 1976 was a bicentennial time of tall ships and fireworks. In North Carolina, 5'8" Larry Jordan was beating his little brother Michael in one-on-one in the backyard. On Wall Street, the formation of Kohlberg Kravis Roberts and Drexel Burnham Lambert presaged a future era of hostile takeovers and junk bond deals. Silicon Valley did not yet exist. Steven Jobs, a 21 year old college dropout, had just started Apple Computers in a garage, one year after 19 year old college dropout Bill Gates founded Microsoft.
A typical estate planning lawyer might have spent the summer of 1976 musing over the latest Clifford trust techniques and pecking out letters on an IBM Selectric typewriter. Suddenly, a screaming comes across the sky. It is October and the Tax Reform Act of 1976 has reached President Gerald Ford's desk. A meteor shower of tax changes unifies estate and gift taxes, increases the marital deduction, provides throwback rules for accumulation distributions from trusts and makes other profound changes in the transfer tax system and related income tax provisions. In the midst of this meteor storm of change, the public witnessed the birth of a new tax, the first GSTT.
A Fallible Authority
Congress makes mistakes. Tax experiments go awry. Lawyers take for granted the stepped up basis for assets held at death under Code § 1014. Nevertheless, in 1976, Congress attempted to impose carry-over basis at death, only to postpone it and ultimately retroactively repeal it (and with quite a low profile) in the Crude Oil Windfall Profit Tax Act of 1980.
Likewise, problems soon became apparent with the new GSTT. For example, instead of a flat tax rate of 55%, Congress imposed the tax at the tax rate of the deemed transferor--the grantor's child or some other member of the generation that was skipped. To calculate the tax rate, the tax return preparer needed to know the size of the deemed transferor's taxable estate, including prior adjusted taxable gifts. This proved to be highly infeasible.
Due to this and numerous other problems, Congress first postponed the 1976 GSTT, amended it three times and ultimately repealed it retroactively 10 years after the fact. It was as if Congress just erased the whole messy chapter. In 1986, Congress provided an entirely new GSTT law.
Code §§ 2601-2663 comprise the 1986 GSTT and speak for themselves. In summary, here are five key points about the GSTT:
1. The GSTT does not have a progressive rate schedule. Rather, Congress imposed the tax on nonexempt property at a flat 55% rate.
2. Each person has a GST exemption; the amount is currently $1,010,000, subject to adjustment for inflation.
3. A gift or bequest skips a generation when assets pass to an individual who is two or more generations below the transferor.
4. In the case of unrelated individuals, a transfer generation skips under Code § 2651(d)(2) if assets pass to an individual who is more than 37.5 years younger than the transferor.
5. Each generation is considered to be 25 years.
If only it were this simple.
The X Files
Just to keep things interesting, there are several distinct types of generation-skipping transfers subject to the GSTT, each with its own horrendous and paranormal tax implications. A transfer in trust may not result in immediate GSTT. As circumstances unfold, however, a taxable termination or distribution in the future may involve skip persons and may trigger GSTT without triggering additional gift or estate tax. By comparison, direct skips arise in a more straightforward fashion, i.e., when a direct transfer to a skip person triggers gift or estate tax as well as GSTT.
* Taxable terminations. Assume that a testamentary trust provides a life interest for Son with the remainder to Grandchild. At Son's death, his intervening trust interest ends and
the only remaining trust beneficiary is a skip person, Grandchild. This results in GSTT liability to be paid by the trustee out of the transferred assets. Code § 2612(a)(1). See also
Code § 2603(a)(2). Considering the 55% estate tax that Grandparent's estate paid, the additional GSTT on the remaining assets brings the effective tax rate on the gift to Grandchild up to about 80%.
* Taxable distributions. A trustee's discretionary distribution from a spray trust to a skip person results in GSTT liability to be paid by the skip person and effectively reduces the transferred amount. Code § 2603(a)(1). Treas. Reg. § 26.2612-1(C)(1) treats the trustee's payment of GSTT as a taxable transfer subject to additional GSTT. What happens if the transferor pays that tax as well? Will there be tax on tax on tax--a closed loop? When a trustee continues to pay all GSTT on a $1 million transfer for which no exemptions apply, the total GSTT tax comes to $1.222 million--an effective tax rate of 122%. As with taxable terminations, the distribution of assets from the trust does not trigger estate or gift tax. The initial transfers that funded the trusts, however, were subject to estate tax at rates up to 55%.
* Direct skips. What could be simpler than Grandma's bequest to Grandson? Grandma pays the gift tax and the GSTT. Unlike taxable terminations or distributions, a direct-skip transfer is subject to current estate or gift tax. For example, assume Grandma makes an inter vivos direct skip gift of $1 million to Grandson. to exemptions apply. Grandma's payment of the $550,000 of GSTT is treated as an additional taxable gift, controlling document is silent, so long as state law permits the severance.
* Married grantor. When marital assets are highly lopsided, clients should divide the assets to the extent necessary so that each spouse may take advantage of his or her GST exemption regardless of which spouse dies first.
* Reverse QTIPs. Clients and their lawyers should not overlook the grantor's GST exemption by transferring all assets to a surviving spouse. If a "reverse" QTIP election is made under Code § 2652, those assets will remain in the deceased spouse's estate for purposes of claiming the $1,010,000 GST exemption. Because that election applies to an entire QTIP, a client should use two separate QTIP trusts to make the reverse QTIP election for one of the trusts and use the grantor's GST exemption, while the other QTIP remains in the surviving spouse's estate for GSTT purposes. That way, the surviving spouse's GST exemption can also be used. The resulting three trust alignment looks like this:
* Trust #1: A credit shelter trust to which the grantor's executor allocates GST exemption.
* Trust #2: A separate QTIP trust to which the grantor's executor allocates the grantor's GST exemption remaining after allocation of the exemption to the credit shelter trust and with respect to which the executor makes a reverse QTIP election.
* Trust #3: Remaining assets in a standard QTIP trust to which the surviving spouse's GST exemption will be allocated at his or her death.
* Anti-GSTT approaches. A client should use intervening generations when appropriate. If the client exhausts his or her GST exemption and plans to skip a generation by leaving assets to a grandchild, this will actually produce more tax. The client should consider the alternative of not skipping a generation and leaving assets to a child, in whose hands the assets will be taxed. This may result in a lower overall transfer tax rate. For future flexibility, clients should consider a power of appointment that will allow the child to treat a transfer to a skip person as a taxable gift rather than a distribution subject to the GSTT.
* Multiple skips. As long as a client skips one generation, why not skip more for the price of one? Skipping additional generations does not add to the GSTT bill for direct skips--that is, outright transfers--but see Code § 2653 for multiple skips held in trust. The client should also beware of the rule against perpetuities.
* Disclaimer trusts. When a client plans outright gifts to his or her children, the client can establish unfunded multi-generational trusts that will be activated only if the children, seeing an opportunity to take advantage of unused GST exemption, disclaim inherited assets or powers of appointment and thereby fund the trusts.
* Leveraging. The most effective estate planning is implemented long before death. This is especially true of multi-generational inter vivos living trusts. A client can apply his or her $1,010,000 GST exemption to assets that appreciate by 100% by the time of death, thereby being as valuable as two exemptions. When a client pursues a lifetime generation-skipping gift, he or she should use assets that are most likely to appreciate rapidly.
With care and planning, a lawyer can avoid a GSTT asteroid. Keep watching the night skies, and may the force be with you.
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