Non-US families establishing succession planning structures rarely think about the US generation-skipping transfer (GST) tax. Nevertheless, when a foreign trust becomes a US domestic trust so that distributions can be made in a tax-efficient manner to the settlor’s US grandchildren and more remote descendants, US trustees or tax return preparers may raise questions about whether those distributions are subject to the GST tax. Advisers to these families should become familiar with the application of the GST tax rules in order to bring clarity to the situation.
For details regarding US gift and estate taxes in general, please see “Overview (August 2022)”. In addition to these transfer taxes, the United States has a third type of tax known as the GST tax. As its name implies, the GST tax is aimed at transfers that skip a generation. There are three GST transfers on which GST tax may be imposed – namely, “direct skips, “taxable terminations” and “taxable distributions”:
When a US citizen or a non-US citizen who is resident in the United States for transfer tax purposes (a US person) makes a transfer to a skip person, whether such transfer is made during life or at death, a GST tax is imposed in addition to any gift or estate tax that may be due. The GST tax is calculated at a flat rate equal to the top transfer tax rate of 40%.
For tax year 2022, an exemption amount of $12,060,000 is available to shelter gifts or bequests from GST tax. If a US person does not affirmatively allocate this exemption amount to specific transfers, automatic allocation rules apply.
The reach of the GST tax for transfers made by a non-resident alien (NRA) matches the reach of the estate and gift tax on the underlying transfer. Thus, a transfer by an NRA of non-US situs property is not subject to the GST tax, since it is not subject to estate or gift tax, but the GST tax applies when an NRA transfers US property (other than intangibles transferred by gift) to a skip person. For further details on when property has a US situs for tax purposes, please see “Estate and gift tax situs of assets – basic rules” and “Estate and gift tax situs of assets – specific examples”.
The NRA transferor is entitled to the same $12,060,000 (for tax year 2022) exemption from GST tax as a US person. Schedules to the federal estate and gift tax returns (Forms 706 and 709) are used to report generation-skipping transfers.
The key principle to keep in mind is that GST tax is determined by applying estate and gift tax rules. Specifically:
The time for testing whether the tax applies is the same time as under the estate or gift tax rules, even though the “skip” transfer would often occur later. Specifically, the character of the property and the non-resident alien status of the transferor are tested only at the time of the initial transfer as determined for estate tax purposes (at death) or for gift tax purposes (when the gift is complete).
Thus, the GST tax generally does not apply to transfers by NRAs of property situated outside of the United States as of the time of the initial transfer.
However, the converse is also true. If US situs property is transferred by an NRA to a trust, and that property is later reinvested in non-US situs property, GST tax will still apply on a taxable distribution or termination.
As mentioned above, the NRA transferor is entitled to the same $12,060,000 (for tax year 2022) exemption from GST tax as a US citizen or resident. This is true even though the NRA’s estate tax exemption is limited to $60,000 and there is no exemption amount for gift tax purposes.
When the transfer by the NRA is fully subject to the GST tax or when a trust is being funded with US situs property and may in the future have taxable terminations or taxable distributions, the same principles apply as for US transferors, so the NRA transferor can allocate their exemption on a timely filed Form 709, gift tax return, or Form 706-NR, estate tax return. Similarly, if the NRA does not affirmatively allocate their exemption, the automatic allocation rules will apply to certain transfers. In the case of a trust to which the NRA transferor has allocated GST exemption, the trust will thereafter have a GST “inclusion ratio” as discussed further below.
When the transfer by the NRA is not subject to the GST tax at all, or will not be subject to GST tax in the future, the exemption is not allocated.
As discussed further below, when an NRA funds a trust with US situs property, during life or at death, consideration should be given to allocating GST exemption to that trust if the transfer is a direct skip or if there could be a taxable termination or taxable distributions subject to GST tax in the future.
It is important to keep in mind that when an NRA transfers US corporation stock (an intangible) by gift during life, that transfer is not subject to US gift tax. But when an NRA dies owning US corporation stock the value of that stock is subject to US estate tax (absent an applicable treaty provision). If the NRA has bequeathed the stock to a grandchild whose parent survives the NRA decedent, GST tax will be due in addition to US estate tax.
Thus, NRAs need not consider the GST tax implications of their transfers unless the transfer otherwise requires the filing of a US gift or estate tax return. For example:
In the domestic context, a US settlor can give property to a trust to be held for the benefit of the settlor’s child and then to the settlor’s grandchildren. When the child dies and the trust property is distributed to the grandchildren, this triggers a taxable termination subject to GST tax. However, the settlor can allocate GST exemption to the trust, which will reduce or eliminate the GST tax. The amount of GST tax imposed will be determined by reference to a formula known as the “inclusion ratio”. An inclusion ratio of zero means none of the termination distribution will be subject to GST tax. An inclusion ratio of one means the entire distribution will be subject to GST tax. An inclusion ratio between zero and one means the distribution will be partially subject to GST tax.
Suppose that prior to her death, the NRA grandmother establishes a Bermuda trust and retains the right to revoke the trust. On her death, the trust holds US stock, the value of which is subject to US estate tax. Following her death, the trust will be moved to the United States and continue for the benefit of her US daughter and US granddaughter. The NRA grandmother’s estate files a US estate tax return and allocates her remaining GST exemption amount. The successor US trustee will need to know the trust’s GST inclusion ratio in order to determine whether distributions to the US granddaughter will be subject to GST tax.
If NRA grandmother’s trust was only partially subject to the US estate tax, a special rule for non-resident aliens applies to calculate the GST inclusion ratio of the transfer so that the GST tax can be calculated in the future. The effect of this rule, as in the domestic context, is to encourage the creation of a separate trust in the amount of the allocated exemption, easing administration and minimising taxes.
Suppose that, as is more often the case, the NRA grandmother transfers non-US situs assets to her Bermuda trust and at her death the trust owns only the shares of a foreign corporation which has invested in US stock, so that no US estate tax is due (see “Tax planning for US equities owned in a non-US trust structure”). In that case, no US estate tax return need be filed and the trust is exempt from GST tax. The successor US trustee can be provided with an explanation of the tax analysis so that when distributions are made in the future to skip persons there is no question as to whether GST tax is due.
The purpose of the GST tax is to discourage multi-generational tax planning so that the Internal Revenue Service collects estate tax from every generation. The goal of GST trust planning is to allocate, to the extent possible, the transferor’s GST exemption so that trusts have an inclusion ratio of zero. A trust established by an NRA settlor will not be subject to GST tax so long as property transferred to the trust during lifetime or held in the trust at death is not subject to US gift or estate tax. Where the NRA settlor’s children and grandchildren are US persons, ensuring that distributions from a trust lasting in perpetuity will never be subject to GST tax is an important consideration.
