Allocating GST Exemption to GRAT Property after the Annuity Term

Synopsis: This Article surveys questions regarding the allocation of GST exemption to GRAT property. Official guidance on these questions is at best unsatisfying, and there is little consensus, or in some cases even engagement, among commentators. Confi-dence in one’s answers can be atypically important because legal “finality” is often many years away. The Article concludes with tactical suggestions for increasing certainty.

I. Introduction

As is often said, grantor retained annuity trusts (GRATs) are not ideal vehicles for transferring wealth to grandchildren or more remote descend­ants. Although “zeroed-out” GRATs routinely enable transfers of post-gift appreciation without material gift tax consequences, it is at least doubtful that they also enable “leveraging” of the generation-skipping transfer tax exemption (GST exemption). Techniques attempting to work around that doubt have been proposed, but none are as mainstream as the zeroed-out GRAT itself.

However, even if it is assumed arguendo—as it is throughout this Article—that a GRAT does not enable “leveraging” of GST exemption, there are circumstances in which a donor may want to allocate GST exemption to GRAT property after the annuity term. For example, if the donor has more GST exemption than gift tax exemption remaining, a GRAT can enable the donor to fund a trust to which that “excess” GST exemption can be allocated during the donor’s life.

There are also circumstances in which GST exemption might be auto­matically, and inadvertently, allocated to GRAT property during the donor’s life unless the donor timely elects out, or is granted an extension of time to elect out, of that allocation.

In such circumstances, the questions discussed in this Article—regarding when and how GST exemption is or can be allocated to GRAT property—may be crucial. Yet there is at best unsatisfying official guid­ance on the answers to these questions. Clearer guidance has been requested over many years, but it is not a current priority. There is also little consensus on the answers, or in some cases even engagement with the questions, among commentators.

Confidence in one’s answers to these questions can be atypically important. For example, if GRAT property remains in trust after the annu­ity term, then the trustees might rely immediately on their understanding of the trust’s inclusion ratio even though—absent the time and expense of obtaining an Internal Revenue Service (Service) private letter ruling—that inclusion ratio may not become “final” until many years later, after the donor’s death. In such a scenario, the trustees, the donor, and their advisers must evaluate the trust’s GST tax posture based on the guidance that is available, however unsatisfying it may be. With this Article, the author attempts to assist in that effort—and to assist anyone drafting a GRAT that has “GST potential”—by first surveying some of the relevant questions and then offering tactical suggestions.

II. Is Every GRAT Subject To An ETIP?

The first question is whether every GRAT is subject to an estate tax inclusion period (ETIP). In general, an ETIP is any period beginning immediately after an inter vivos transfer of property during which the value of the property would be included in the gross estate of the transferor or the transferor’s spouse, other than by reason of Internal Revenue Code section 2035 (which is not relevant here), if that person were then to die. Any allocation of GST exemption to the property during an ETIP is effec­tive only as of the close of the ETIP. In addition, if there is an ETIP, the donor can still elect out of any automatic allocation of GST exemption that would otherwise occur, as of the close of the ETIP, through the due date of the donor’s gift tax return for the year of the close. So as relevant here, if a donor funds a multi-year GRAT and does not elect out of automatic allocation of GST exemption with respect to the GRAT on a timely-filed gift tax return for the year of the funding, then whether the donor can still elect out, without first obtaining an extension of time from the Service, depends on whether the GRAT is subject to an ETIP.

Immediately after a transfer to a GRAT, at least some portion of the GRAT property would be included in the transferor’s gross estate pursuant to section 2036 if the transferor were then to die. And the regulations provide that “[i]f any part of a trust is subject to an ETIP, the entire trust is subject to the ETIP.” All GRAT property is, consequently, subject to an ETIP unless an exception applies.

The only potentially relevant exception applies if “the possibility that the property will be included [in the transferor’s gross estate] is so remote as to be negligible.” The regulations deem this to be true “if it can be ascertained by actuarial standards that there is less than a 5 percent proba­bility that the property will be included in the gross estate.” Qualification for this “Remoteness Exception” is determined on a one-time basis as of the time of initial transfer.

In the case of a transferor who is sufficiently young and healthy, it may be actuarially ascertainable that there is less than a five percent prob­ability of death during the period that the GRAT property would, consequently, be included in the transferor’s estate. For example, the Service’s mortality table, Table 2010CM, implies that if a transferor’s nearest age is no more than seventy-two, less than a five percent probabil­ity of death within two years exists. How does that bear on the existence of an ETIP when such a transferor funds a two-year, zeroed-out GRAT?

The author is aware of three responses to this question. The first is to ignore it, perhaps in the belief that the Remoteness Exception does not mean what it says, even though there is no official guidance on what it does mean. Although this response is technically unsatisfying, its advo­cates are perhaps encouraged by the fact that what little official guidance there is also appears to ignore the question. Examples in the regulations assume the existence of an ETIP without saying anything about the trans­feror’s life expectancy, and there are many private letter rulings relying on the requesting taxpayer’s representation that there is an ETIP, without further discussion, even in some circumstances where the representation is material. For some practitioners, that may be satisfaction enough.

The second response is to conclude that there is no ETIP if the actuar­ially ascertainable probability of death during the aforesaid period is less than five percent. This response is technically more satisfying but, per­haps, “does not seem to make sense because it excepts a subset of GRATs from the ETIP rules depending on the age of the grantor and the length of the term of the retained interest.”

The third response, although less common, has the virtue of support­ing technically what appears to be the intuition of many commentators and perhaps the Service: the Remoteness Exception practically never applies to a GRAT because, immediately after the initial transfer, there is a non-remote possibility that at least some of the transferred property (or its prod­uct) will be included in the transferor’s gross estate, either pursuant to section 2036 if the transferor dies during the relevant period, or pursuant to section 2033 (or otherwise) to the extent the property returns to the transferor in satisfaction of the GRAT’s annuity payment obligations. This response potentially covers practically every GRAT—specifically, every GRAT that is projected to return more than just trust accounting income to the transferor, even if it is not fully zeroed-out. The response relies on the observation that neither the ETIP rules generally, nor the Remoteness Exception specifically, excludes either section 2033 or any other provision from those to be taken into account for the purpose of determining whether property is “included” in the transferor’s or the trans­feror’s spouse’s) gross estate; both speak to inclusion of transferred “property,” without requiring that it then be held in trust or by someone other than the transferor.

In any event, it is assumed for the rest of this Article that each GRAT discussed is subject to an ETIP, and that any conditions necessary to sup­port that conclusion are satisfied.

III. If a GRAT is Subject to an ETIP, as of When is the “Indirect Skip” Determination Made?

Given the uncertainties discussed in this Article, one hopes that any donor who has transferred property to a GRAT has affirmatively elected out of automatic allocation of GST exemption with respect to that transfer, even if only protectively, as is widely recommended. But suppose the donor did not. Assuming the GRAT is subject to an ETIP, how precisely is it to be determined whether there was automatic allocation of GST exemption (to the extent the donor had any remaining) as of the close of the ETIP?

Absent an election out, GST exemption is automatically allocated to “direct skips” and “indirect skips.” A direct skip is a transfer, subject to gift or estate tax, to a “skip person” such as a grandchild or a trust exclu­sively for the current benefit of grandchildren. An indirect skip is a transfer, subject to gift tax and not a direct skip, to a “GST trust” within the meaning of section 2632(c)(3)(B). When there is an ETIP, applicable rules provide that any direct skip or indirect skip is deemed to occur only at the close of the ETIP. Perhaps in part for that reason, it has been sug­gested that the determination of whether there is a direct skip, an indirect skip, or neither, is made as of the close of the ETIP—for example, in the scenario discussed in this Article, by reference to the GRAT beneficiaries remaining at that time. That approach would perhaps better further the policy motivating these automatic allocation rules: they were intended to give effect to a donor’s presumed wishes, and perhaps those wishes are best given effect with the benefit of new information available only at the time that the allocation, if any, would become effective.

On the other hand, the better textual reading appears to be that the determination is made as of the time of the initial transfer to the GRAT. That is what the statutory and regulatory language implicitly indicates: it postpones until the close of the ETIP the deemed occurrence of any direct skip or indirect skip, suggesting that the direct skip or indirect skip deter­mination is made first. Austin W. Bramwell, moreover, has persuasively reasoned that the funding of a GRAT is never a direct skip. If that is all correct, the only relevant question is whether the GRAT itself is a GST trust at the time it is funded.

When the determination is made may matter in common scenarios. For example, suppose a GRAT subject to an ETIP requires that, upon the close of the ETIP, the property remaining after the final annuity payment be divided into two “separate shares.” As discussed in Part VI below, those shares should be treated as separate trusts for GST tax purposes as of that time. Suppose that as of that time, one share is a GST trust and the other is not. If an indirect skip determination is made as of that time, there will be automatic allocation to the former but not the latter. If the indirect skip determination is instead made as of the initial transfer to the GRAT, additional analysis will be required. That analysis may be difficult because of ambiguities in the GST trust definition. Relevant questions may include: whether for this purpose annuity payments to the donor are treated as mandatory distributions of “trust corpus”; and the scope of the “trust” and “trust instrument” to be considered, especially if the GRAT provides for distribution to a separate trust after the final annuity amount is paid (and especially if that trust exists under a different written instru­ment). In any event, one hopes that any automatic allocation of GST exemption that would otherwise be made to a trust then having no “GST potential” will instead be void, as it clearly would be in the case of an affirmative allocation.

IV. If A GRAT Is Subject To An ETIP, When Does The ETIP Close?

Assume again that a GRAT is subject to an ETIP (solely because of the transferor’s retained annuity interest). If so, then that ETIP closes when “no portion of the property is includible in the transferor’s gross estate (other than by reason of section 2035),” assuming the transferor survives until then. When for this purpose is “no portion” of the GRAT property includible in the transferor’s gross estate?

The common understanding—apparently at least assumed in a regulatory example and various Service private letter rulings—is that that state is reached upon the expiration of the GRAT annuity term, not­withstanding that payment of the final annuity amount may be delayed. That annuity amount is clearly includible in the transferor’s gross estate (pursuant to section 2033) after the expiration of the annuity term and until it is paid; therefore, the common understanding depends on the premise that, after the final annuity amount comes due, it is no longer for this pur­pose a “portion” of the GRAT.

That premise has at least intuitive appeal. The final annuity amount is a fixed dollar obligation, due immediately. The obligation does not depend on the value of the GRAT going forward, and the donor’s entitle­ment thereto is not subject to any remaining condition—not even the making of a demand. Perhaps for reasons including these, the Service and Treasury have treated it as a “receivable” separate from the GRAT in the rules that govern estate tax inclusion in the event that the donor dies after the amount comes due but before it is paid. The premise, if true, also supports a neat result: in the case of a typical GRAT subject to an ETIP, the ETIP closes upon the expiration of the annuity term, and delay in payment by the GRAT trustee does not extend the ETIP.

On the other hand, the final annuity amount will in the ordinary course be paid only from GRAT property, if sufficient, so in that respect the value of the donor’s entitlement does depend on the value of the GRAT. In addition, the annuity amount will be paid pursuant to the satisfaction of a fiduciary obligation; it is not an arm’s-length debt owed to the donor by an unrelated party. For these reasons, it is arguably still a “portion” of the GRAT until it is paid. There is, furthermore, no official guidance indicat­ing that the possibility of estate tax inclusion is disregarded for this purpose merely because it would be pursuant to section 2033 rather than some other provision, or merely because the entitlement would typically be valued at a fixed-dollar amount rather than by reference to the value of other GRAT property. The ETIP, therefore, arguably continues until the final annuity amount is fully paid. Although this argument is apparently uncommon and would allow a GRAT trustee to extend the ETIP by delay­ing that final payment, it is not without support.

V. If GST Exemption Is Allocated To A GRAT As Of The Close Of The ETIP, Is That Allocation Deemed To Precede Any Simultaneous Generation-Skipping Transfer?

If there is an ETIP, it is clear that GST exemption can be allocated to the property subject to the ETIP, either automatically or affirmatively, as of the close of the ETIP. It also seems clear that any allocation as of the close of the ETIP is deemed to precede any generation-skipping transfer that occurs simultaneously. That is the express rule with respect to any generation-skipping transfer, such as a taxable distribution, that occurs during the ETIP. More precisely: the ETIP closes with respect to the prop­erty involved in the taxable distribution, and any allocation of GST exemption effective as of that close is deemed to be effective immediately prior thereto. By implication, when the ETIP closes with respect to all of the remaining trust property, any allocation effective as of that close should be deemed effective immediately prior to any simultaneous gener­ation-skipping transfer. If it were otherwise, the automatic allocation rules would, also by implication, be rendered absurdly ineffective whenever there is an ETIP: they would fail to apply in basic scenarios at which they were presumably aimed.

VI. If GST Exemption Is Allocated To A GRAT As Of The Close Of Its ETIP, Can The Exemption Be Allocated To Only A Portion Of The GRAT Property?

Assume a GRAT is subject to an ETIP that closes upon the expiration of the annuity term. Assume further that, at that time, the property held by the GRAT trustee in effect consists of both an amount payable to the donor and also other property to be held in continuing trusts for the donor’s descendants. If GST exemption is allocated to the GRAT as of the close of the ETIP, can it be allocated to only some of that property?

One subsidiary question is whether any GST exemption will be “wasted” on the property used to fund the final annuity payment to the donor. Conventional wisdom is that it will not be, and that seems clearly correct: such property remains includible in the donor’s gross estate, which means it is no longer part of the “trust” to which GST exemption will be allocated, by the definition of an ETIP and the assumption that the ETIP has closed. If the ETIP does not close until the final annuity payment is made, the result is the same, for the same reason.

A second subsidiary question is whether GST exemption can be allo­cated, as of the close of the ETIP, to only some of the continuing trusts. That result might be facilitated in at least two ways. First, if otherwise consistent with the donor’s wishes, the GRAT might be drafted to mandate a severance into “separate shares,” within the meaning of the applicable rules, as of the close of the ETIP. In that case, the separate shares will be treated as separate trusts for GST tax purposes as of that date, and it should be possible to allocate GST exemption to only some of them.

Instead or in addition, the continuing trusts might be established, as of the close of the ETIP, by a process satisfying the definition of a “qualified severance.” Either way, even if one or more of the continuing trusts is a skip person with respect to the donor, the allocation of GST exemption thereto should be deemed to precede the generation-skipping transfer thereto, as explained in Part V above. It would be most cautious, however, for all such trusts to be drafted with the intention that they will then be non-skip persons, to avoid any argument about the deemed order of events.

VII. If A GRAT Terminates In Favor Of A Separate Trust, When And How Should GST Exemption Be Allocated To The Subject Property?

If it is desired that GST exemption be affirmatively allocated to any GRAT property remaining (net of any final annuity payment) as of the close of an ETIP, and if that property is then to be distributed to a separate trust, should the exemption be allocated to the GRAT or to the separate trust? One hopes that this detail will be treated as irrelevant if the donor’s intention is made clear and is also consistent with some permissible approach. No specific form is required to make the allocation, so, if pos­sible, the notice of allocation might be worded to have the desired effect regardless. But as a general matter, however, GST exemption appears to be most properly allocated to the trust or deemed separate trust(s), which, as of the effective date of the allocation, holds the property previously transferred by the transferor (or the product of such property)—that is, to the GRAT if it still holds the property in question as of the close of the ETIP, notwithstanding that the separate trust might also then be considered to have an indirect interest in such property for some other purpose(s).

It has sometimes been suggested that if the remaining GRAT property (net of any final annuity payment) is to be distributed to a separate trust, then GST exemption can be affirmatively allocated to that trust after the ETIP closes but in the same year, or a GST trust election can be made with respect to that trust so that GST exemption is automatically allocated to it at the time of the distribution. For example, in private letter ruling 2002‑27‑022, the Service ruled that where GRAT property was to be divided between separate trusts upon the expiration of the annuity term, the donor could “commencing at that time” allocate part or all of the donor’s remaining GST exemption exclusively to one of those trusts based on the fair market value of its assets as of the date it was funded. As a technical matter, however, it is not clear that an allocation made within the time for filing a gift tax return for the year in which the ETIP closes can be made as of any date other than the date of that close—even if the property in question is distributed to a separate trust before the allocation is reported. It is also not clear that a GST-trust election can be made with respect to a trust to which the donor has never made a direct “transfer.” In any event, one again hopes that if the donor’s intention is timely com­municated and sufficiently clear, the Service will give it effect to the extent it is lawfully able.

VIII. Navigating This Uncertainty

In light of the questions discussed in this Article, the author offers the following tactics for increasing the probability that any allocation of GST exemption to GRAT property after the annuity term will be effective as intended (of course, in appropriate cases it may be worthwhile to request a Service private letter ruling).

First, the donor should elect out of automatic allocation of GST exemption with respect to the initial transfer to the GRAT. Unless the donor is confident that the transfer is subject to an ETIP, the election should be made on a timely return for the year of the transfer. It does not seem necessary to clarify that the election is also intended to be effective as of the close of the ETIP, if any, or with respect to any separate trust that stands to receive the GRAT property after the close of any ETIP, but there appears to be no harm in clarifying.

Second, if the remaining GRAT property is expected to benefit both skip persons and non-skip persons after the final annuity payment is made, then all else being equal, the GRAT should be drafted so that such property will be held in further trust (and most cautiously, not any trust then expected to be a skip person), at least for a while, to more clearly preserve options for segregating property to which the donor does, and does not, intend to allocate GST exemption.

Third, any affirmative allocation of GST exemption should be made thoughtfully. Three careful options, not meant to be exhaustive, are dis­cussed here. The first is for the donor to simply wait until the year after any ETIP would have closed and then make a late allocation to any one or more trusts that received property from the GRAT. This allocation should be made on a return postmarked after the due date (including extensions) of the return for the year in which the ETIP closed or would have closed; otherwise the allocation might be effective, if at all, only as of the close of the ETIP. If this option is being considered, advance planning might be undertaken to minimize the amount of time between the end of the annuity term and the late allocation, while also maximally avoiding the uncertain­ties discussed in this Article. For example, the terms of the GRAT could require that the final annuity payment be made close to the end of the cal­endar year; the payment could actually be made before the end of the calendar year; the donor could decline to request an automatic six-month extension of the deadline for filing either the donor’s gift tax return or the donor’s income tax return for that calendar year; and the allocation could be made on a return postmarked as soon as the day after that deadline passes. If the allocated-to trust would consequently have a mixed inclusion ratio, a qualified severance could also be commenced as soon as that day.

The second option is to attempt to make an allocation as of the close of the ETIP, if any, while side-stepping all of the questions discussed in this Article. This requires precise timing—specifically, that all of the following occur on the same day. First, the final annuity payment is made on the day it comes due, so that there is no question about when the ETIP (if any) closes. Second, if GST exemption is to be allocated to only some of the remaining GRAT property, then either the trust instrument requires a severance into separate shares on that day and/or a qualified severance is commenced on that day and completed within a “reasonable time” and in no event more than ninety days after. Third, GST exemption is allo­cated to the desired separate shares or trusts on a gift tax return postmarked that same day, so that the allocation is effective as of that day whether or not there was an ETIP. If this option is being considered, it may be desirable for the GRAT annuity term to expire on or before the due date (including extensions) of the return for the year preceding its expiration—but not too early in the year—so that the allocation can be made on the same return, if any, that the donor files for that preceding year. For exam­ple, if the term expires on October 15, the allocation will be more easily made on the donor’s gift tax return for the prior year, assuming it is filed “on extension.”

The third option is to attempt to make an allocation as of the close of the ETIP, based on what appears to be the conventional wisdom, as reinforced by applicable arguments summarized and perhaps further developed in this Article. That wisdom includes the view that if a GRAT is subject to an ETIP, the ETIP closes upon the expiration of the annuity term, and that as of that date GST exemption can be allocated to the remaining GRAT property, net of any final annuity amount to be paid to the donor.

IX. Conclusion

With this Article, the author has attempted to survey some of the ques­tions presented by any attempt to allocate GST exemption to GRAT property after the annuity term, with the hope of assisting practitioners who face those questions. The author does not mean to suggest that the GST tax law currently compels any particular answer to any given ques­tion. Diligent practitioners acting in good faith could reasonably disagree about the answer to many of these questions. To the extent the Service is lawfully able, it should perhaps take this uncertainty into account in future attempts to enforce the GST tax law, at least until clearer official guid­ance is issued.