P R O B A T E & P R O P E R T Y
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"Few issues are more complex than those associated with the decisions of whether, and when to allocate generation-skipping transfer (GST) exemption to transfers to such a trust"
Counsel must address a number of difficult issues when a client names grandchildren or more remote descendants as beneficiaries of an irrevocable life insurance trust. Few issues are more complex than those associated with the decisions of whether, and when, to allocate generation-skipping transfer (GST) exemption to transfers to such a trust. This article analyzes a particular type of trust to show that these issues may, in certain cases, be resolved rather efficiently by applying the rules set forth in the GST regulations.
Transfer Tax Treatment of Life Insurance
To understand the issue, one first must understand the transfer tax treatment of life insurance and the irrevocable trusts that individuals frequently use to shield life insurance proceeds from the estate tax. In general, Code §§ 2042 and 2035 require that life insurance proceeds be included in the gross estate if the insured decedent possessed any incidents of ownership in the policy during the three years ending on the date of the insured decedent's death. Estate planning lawyers commonly recommend that a client who owns life insurance on his or her life transfer all incidents of ownership in that life insurance to an irrevocable trust, so that the proceeds from the transferred policies will not be includable in the client's estate. Although such a transfer in trust can effectively shield the insurance proceeds from the estate tax, the client also must address the gift and GST tax implications of making transfers to the trust.
Transfers may be made to get an existing policy into the trust, to fund the trustee's purchase of a new policy or to make premium payments on a policy that the trust owns. The client will typically address gift taxes by granting the trust beneficiaries the right to withdraw assets from the trust. That way, transfers to the trust will qualify as present interest gifts that are eligible for the gift tax annual exclusion.
The GST tax may apply, even if the gift tax and the estate tax are avoided. For GST purposes,the relevant taxable transfers may occur when contributions are made to the trust or distributions are made from the trust. The fact that the proceeds are not taxable in the insured decedent's estate will not necessarily ensure that the proceeds are not taxable for GST purposes. There is an annual exclusion for GST purposes, but it applies to transfers in trust only in very limited circumstances, which are discussed below. If distributions from an irrevocable life insurance trust will be made to "skip persons," such as the grandchildren or more remote descendants of those who are making the transfers in trust, GST tax must be paid unless the trust itself is exempt from the GST tax as a result of an allocation of GST exemption.
For purposes of discussion, this article assumes an irrevocable life insurance trust naming grandchildren as the beneficiaries of a specific portion of the trust. The trust owns life insurance on a client's life and provides for the distribution of the trust assets at the client's death as follows: one-fifth in equal shares to the client's then-living grandchildren and four-fifths to the client's then-living descendants, per stirpes.
The particular portions (one-fifth/four-fifths) are not important, but the structure of the trust is. After the client's death, the trust agreement allows the trustee to hold any assets that would otherwise be distributed to a minor beneficiary in a vested trust for that beneficiary. The assets in any such "vested trust" would be distributable to the beneficiary's estate if the beneficiary were to die before reaching the client's chosen age of distribution. If none of the client's grandchildren survive the client, the grandchildren's portion of the trust would be distributed to the client's then living descendants, per stirpes.
Many clients intend for a life insurance trust to meet the single tax objective of excluding the life insurance proceeds from the client's gross estate for estate tax purposes. A client could meet this objective by transferring ownership of the policy to the intended beneficiaries. Practical concerns can arise, however, when multiple beneficiaries are involved, certain beneficiaries are minors or there is the prospect that one or more beneficiaries might not be responsible enough to maintain the policy. The hypothetical trust described above would resolve these concerns and divide the proceeds, as the client deemed proper, between grandchildren, as a class, and children, as a class, with the appropriate contingent beneficiaries in each case.
Contributions to a life insurance trust to pay premiums on a policy that the trust owns will be eligible for the gift tax annual exclusion by use of Crummey withdrawal rights. Nevertheless, the contributions will not be eligible for the GST tax annual exclusion, because the trust will not meet the requirements of Code § 2642(c)(2). Section 2642(c)(2) dictates that a transfer to a trust will not be eligible for the GST annual exclusion unless the trust has only one beneficiary and the trust assets will be includable in that beneficiary's gross estate if the beneficiary dies before the trust terminates. In effect, § 2642(c)(2) requires a separate trust for each grandchild beneficiary. This discussion assumes that the client prefers not to split the ownership of the policy among several trusts and that the client does not want to incur the costs and administrative burdens associated with the creation of one trust for children and separate trusts for each grandchild. Therefore, to shield distributions from the single trust to grandchildren or more remote descendants from the GST tax, GST exemption must be allocated to the trust.
Although the analysis is complex, the net result of applying the rules contained in the regulations is simple. A portion of any transfer to the trust (equal to the portion of the trust assets that will be set aside on the client's death for the grandchildren) will be treated as a direct skip to which GST exemption will be automatically allocated. In the case of the hypothetical trust, one-fifth of any contribution to the trust will be treated as a direct skip to which GST exemption is automatically allocated. The analysis proceeds as follows.
Separate Share Rules
Under the separate share rules, the trust may be considered as two separate trusts: one for grandchildren, as a class, and the other for descendants, as a class. Treas. Reg. § 26.2632-1(a) provides: "If property s held in trust, the allocation of GST exemption is made to the entire trust rather than to specific trust assets." This provision appears to prohibit the allocation of GST exemption to part of a contribution to an irrevocable insurance trust. GST exemption, however, may be allocated to part of a contribution to this hypothetical trust if the trust can be treated as two separate trusts and if any single contribution to the trust can be treated as a pair of separate contributions to two separate trusts.
Treas. Reg. § 26.2654-1(a)(1)(i) provides: "If a single trust consists solely of substantially separate and independent shares for different beneficiaries, the share attributable to each beneficiary (or group of beneficiaries) is treated as a separate trust for purposes of chapter 13." Treas. Reg. § 26.2654-1(a)(5), Example 1 then provides:
T transfers $100,000 to a trust under which income is to be paid in equal shares for ten years to T's child, C and T's grandchild, GC (or their respective estates). The trust does not permit distributions of principal during the term of the trust. At the end of the 10-year term, the trust principal is to be distributed to C and GC in equal shares. The shares of C and GC in the trust are separate and independent and, therefore, are treated as separate trusts.
The example in the regulations is very similar to the hypothetical trust considered here. Therefore, it is proper to treat the life insurance trust as two separate trusts for purposes of allocating GST exemption: one for the grandchildren, which consists of one-fifth of the trust assets, and one for the children (or the descendants, per stirpes), which consists of four-fifths of the trust assets. Note that the regulations provide that "the share attributable to each beneficiary . . . is treated as a separate trust for purposes of chapter 13." No election need be made to treat a separate share as a separate trust.
The example in the regulations assumes that each beneficiary will receive a fractional portion of the trust income, which is the same as that beneficiary's fractional portion of the remainder interest. Both the child and the grandchild received one-half of the trust income, and each will receive one-half of the trust assets remaining at the end of the 10 year term. Under a typical life insurance trust agreement, a beneficiary will have no right to distributions from the trust during the client's lifetime, except to the extent that the beneficiary exercises the Crummey withdrawal right that might be granted to him or her to ensure that transfers to the trust qualify for the gift tax annual exclusion. Based on the example in the regulations, the IRS could argue that the grandchildren's portion of the trust is not a separate share, because the beneficiaries of one share might invade the other beneficiaries' share by exercising their withdrawal rights. Counsel may address this problem by carefully drafting the withdrawal provisions, so that a child with a withdrawal right cannot invade the grandchildren's portion of the trust, and a grandchild cannot invade the children's portion.
The part of the trust that is treated as a separate trust for the grandchildren is a "skip person." Therefore, any contribution to the trust is, in part, a direct skip. Treas. Reg. § 26.2612-1(a)(1) provides: "If property is transferred to a trust, the transfer is a direct skip only if the trust is a skip person." Treas. Reg. § 26.2612-1(d)(2) then provides that a trust is a skip person if:
(ii) No person holds an interest in the trust and no distributions, other than a distribution the probability of which occurring is so remote as to be negligible (including distributions at the termination of the trust), may be made after the transfer to a person other than a skip person. For this purpose, the probability that a distribution will occur is so remote as to be negligible only if it can be ascertained by actuarial standards that there is less than a 5 percent probability that the distribution will occur.
Treas. Reg. § 26.2612-1(e)(1) provides that an interest in a trust exists if a person:
(i) Has a present right to receive trust principal or income;
(ii) Is a permissible current recipient of trust principal or income and is not described in Section 2055(a); or
(iii) Is described in Section 2055(a) and the trust is a charitable remainder annuity trust or unitrust. . . .
Under the separate share rules, it is proper to treat one-fifth of the trust as a separate trust for purposes of the GST tax. That portion of the trust is a skip person, because no individual or entity has any interest in that portion of the trust (except to the extent that a Crummey withdrawal right is exercised) during the client's lifetime, and after the client's death, all assets in that portion of the trust will be distributed to the client's grandchildren, who are all skip persons. If all of the client's grandchildren are dead at the time of the client's death, the assets in this portion of the trust will be distributed to the client's descendants, per stirpes. This may result in a distribution to non-skip persons. If the client has several grandchildren, however, the probability that all grandchildren will predecease the client will, in most cases, be "so remote as to be negligible."
Just as a child's ability to invade the grandchildren's portion by exercising a Crummey withdrawal right could jeopardize separate share treatment, that right could also jeopardize the status of the grandchildren's portion of the trust as a "skip person." The child's Crummey withdrawal right may grant the child an interest in the trust that would make the trust a non-skip person. Counsel may eliminate this problem by carefully drafting the withdrawal right provisions to ensure that a child may not invade the grandchildren's portion of the trust by exercising a withdrawal right.
Allocation of GST Exemption
Because a part of each contribution to the trust is a direct skip, the client's GST exemption will be automatically allocated to a part of each contribution to the trust. Treas. Reg. § 26.2632-1(b)(1)(i) provides:
If a direct skip occurs during the transferor's lifetime, the transferor's GST exemption not previously allocated (unused GST exemption) is automatically allocated to the transferred property. . . . The transferor may prevent the automatic allocation of GST exemption by describing on a timely-filed [gift tax return] the transfer and the extent to which the automatic allocation is not to apply.
Thus, unless the client "undoes" any automatic allocations of GST exemption by filing gift tax returns, all transfers to the separate trust for the grandchildren will have GST exemption allocated to them, and the separate trust for the grandchildren will have an inclusion ratio of zero unless the client's exemption has been exhausted before a transfer is made.
Some clients may not desire the result that the regulations impose, which is mandatory for the hypothetical trust described here. In some cases, it may be desirable intentionally to allocate GST exemption late (after the gift tax return is due for the year in which the transfer is made), to minimize the GST exemption that is used. In those cases, when a late allocation is permissibly made, GST exemption is allocated based on the value of the property in the trust at the time of the allocation rather than the value of any prior transfer in trust. A permissibly late allocation of GST exemption would be useful if the value of the life insurance policy that the trust owns on the date of the late allocation is less than the value of the contribution to the trust to make the premium payment. The opportunity, available to trusts that own term life insurance, to leverage the GST exemption by making a late allocation, however, is not available to the direct skip grandchildren's trust described here.
For direct skip trusts, the regulations eliminate entirely the opportunity to allocate late. If a client fails to take any action, the allocation is automatic. To the extent that the allocation is "undone" by the client's timely filing of a gift tax return, the grandchildren's portion of the trust will have an inclusion ratio other than zero for GST purposes. In either case, Treas. Reg. § 26.2632-1(b)(1)(ii) provides that "the automatic allocation of GST exemption (or the election to prevent the allocation, if made) is irrevocable after the due date [for the gift tax return that would otherwise report the transfer in trust]."
It is also important to note that the efficient result described in this article will not protect distributions to grandchildren or more remote descendants that might be made from the four-fifths of the trust that will pass to the client's descendants, per stirpes. Such a distribution would occur if a child predeceased the client. As to the portion of the trust that is set aside for the client's descendants, the estate planner must advise the client of the benefits (GST exempt distributions) and burdens (possibly wasting GST exemption) of affirmatively making an allocation on a timely or late gift tax return. GST exemption will not be allocated automatically to this portion of the trust, because this portion of the trust is not a skip person and transfers to it are not direct skips. A complete discussion of the decisions that must be made in allocating GST exemption to life insurance trusts that are not skip persons is beyond the scope of this article, but it is included in Jon J. Gallo, The Use of Life Insurance in Estate Planning: A Guide to Planning and Drafting--Part II, 34 Real Prop. Prob. & Tr. J. 55 (1999).
The GST regulations contain rules relating to the automatic allocation of GST exemption. Counsel should consider the application of those rules to transfers in trust when drafting life insurance trusts for the benefit of grandchildren or more remote descendants. With a properly designed trust, a client may eliminate the need to file gift tax returns to allocate GST exemption to transfers to such a trust.
Timothy H. Guare is a partner with Mezzullo & McCandlish in Richmond, Virginia.