The federal generation-skipping transfer (GST) tax is arguably one of the most complex and nuanced transfer tax regimes in existence. Even when practitioners have accounted for the federal estate and gift tax regime, the GST tax has a separate application and is often disregarded or forgotten. Because of the many ways that the GST tax can apply directly or indirectly to a transfer, it can surface unintentionally or unexpectedly in an existing or new estate plan. Without proper planning, the GST tax can derail intended planning results by unnecessarily depleting family wealth. The current GST tax rate is the same as the federal estate and gift tax rates; thus, it deserves careful attention and management in the estate planning process. With proper GST planning, families have a greater chance of preserving dynastic wealth for generations.
This Article assumes a basic understanding of the generation-skipping transfer (GST) tax rules. Its purpose is to combat the “GST tax anxiety” that many practitioners may experience by building on that basic understanding and raising awareness of ten common GST planning mistakes. The Authors hope that by avoiding these common mistakes practitioners might provide better planning advice to clients to meet their wealth, succession, and tax goals.
A threshold mistake is to disregard the GST tax altogether. Ignoring the GST tax may stem from the practitioner (1) determining that mentioning the GST tax to the client would derail progress with an already complicated tax planning discussion; (2) not being well versed in the GST tax rules; or (3) being unaware of the existence of the GST tax system, given it has only been around since 1986.
Congress enacted the original GST tax regime in 1976, but the modern estate tax dates back to 1916 and the gift tax to 1924. The original GST tax regime proved to be so complicated that it was retroactively repealed when Congress enacted the current GST tax on October 22, 1986. Although enacted in 1986, the tax applied retroactively to lifetime transfers made after September 25, 1985. This answers two possible reasons for the dearth of discussion on the GST tax: its complexity and its enactment as an afterthought to the estate and gift tax regime.
Although the GST tax is often overlooked, it can apply to a client’s estate plan in a variety of ways, and a plan’s exposure to the GST tax must be managed. Prior to the GST tax, multi-generational trusts could be used to avoid estate tax as the beneficial interest in trust assets passed from generation to generation. To address this form of tax avoidance, the GST tax generally applies to gratuitous transfers to individuals two or more generations younger than the donor and to trusts for the benefit of such individuals. The GST tax applies in addition to any applicable estate and gift taxes and is intended as a backstop to the estate tax to ensure that transfer tax is assessed on the transfer of assets at each generation. Good GST planning minimizes transfer taxes due and maximizes proceeds available to intended beneficiaries.
As a backbone to ensuring good GST planning, practitioners need to understand the terminology of the GST tax, some of which has unavoidably been used already in this Article. A “generation-skipping transfer” (GST) is, generally, a transfer to an individual who is assigned to a generation that is two or more generations below the generation of the transferor (a.k.a., a “skip person”) or to a trust for the benefit of only skip persons.
The first step in analyzing whether a GST has occurred is correctly identifying the transferor of the gift. This identification affects generational assignments of the beneficiaries and whose GST exemption can be allocated to a particular transfer. The “transferor” is the person disposing of the property, either directly or indirectly through a trust, by a transfer subject to the estate or gift tax. Many times, determining the identity of the transferor is straight forward, but there are a few rules that complicate the determination and warrant discussion.
a. QTIP Trusts. Generally, if an individual gifts property to a trust for the benefit of his or her spouse and a qualified terminable interest property (QTIP) election is made to qualify transfers to such a trust for the marital deduction, the beneficiary spouse (and not the donor spouse) becomes the transferor for GST tax purposes. As a result, the donor spouse may not allocate his or her GST exemption to the transfer. Rather, the beneficiary spouse may allocate his or her GST exemption to the property held in the trust upon his or her death. An exception to this general rule applies if the donor spouse makes a “reverse QTIP election.” If a reverse QTIP election is made, the donor spouse is treated as the transferor for both gift and GST tax purposes and, therefore, may allocate his or her GST exemption to the transfer.
b. Gift-Splitting. If spouses elect to split gifts for a particular year, both spouses are treated as the transferor with respect to 50% of the transferred property. Thus, even if all of the gifted property comes from one spouse’s separate property, 50% of such property is treated as being gifted by each spouse, and each spouse may allocate his or her GST exemption only to 50% of the transferred property.
c. Powers of Appointment. If someone has a taxable power of appointment over property, the exercise, release, or lapse (in excess of the greater of $5,000 or five percent of the value of the property subject to the power of appointment) of that power of appointment shifts the identity of the transferor to the holder of the power of appointment for GST tax purposes.
Once the identity of the transferor has been determined, the analysis turns to the identity of the recipient of the gifted property. A GST will occur only if the recipient is a “skip person.” As previously discussed, both a natural person and a trust can be a “skip person.” A natural person is a skip person if he or she is assigned to a generation that is two or more generations below the generation assigned to the transferor. A trust is a skip person if (1) only skip persons hold an interest in the trust or (2) no distribution from the trust will be made to a non-skip person. A person has an “interest” in a trust only if he or she has a right, other than a future right, to receive income or principal or he or she is a permissible current recipient of income or principal (except charities) for GST tax purposes. A “non-skip person” is anyone who is not a skip person.
To determine whether an individual is a skip person, one needs to know the generation assignments of the individuals involved in the transfer. An individual’s generation assignment depends on (1) the individual’s relationship to the transferor and (2) the individual’s age compared to that of the transferor.
Most of the generation assignments are intuitive. The transferor, his or her spouse, siblings (whole, half, or adopted) and their spouses, first cousins and their spouses, and those with a similar relation to the transferor are assigned to the transferor’s generation. Children of the transferor and their spouses, the transferor’s nephews and nieces and their spouses, and the transferor’s first cousins once removed and their spouses are assigned to the generation that is one generation below the transferor. Grandchildren of the transferor and their spouses, grandnephews and grandnieces of the transferor and their spouses, and grandchildren of first cousins and their spouses, are assigned to the generation that is two generations below the transferor.
Some of the generation assignments, however, are not as intuitive and require further knowledge of the rules. For those not related to the transferor by blood, marriage, or adoption, a generation is considered to be 25 years. As a result, anyone who is no more than 12½ years older or younger than the transferor is assigned to the same generation as the transferor. Anyone more than 12½, but no more than 37½, years younger than the transferor is assigned to the generation that is one generation below the transferor. Anyone more than 37½, but no more than 62½, years younger than the transferor is assigned to the generation that is two generations below the transferor.
Several additional rules, such as the “predeceased parent rule” and the “generation move down rule,” alter the generation assignments discussed above. These rules make sense when keeping in mind that the GST tax is designed to collect transfer tax at each generational level as wealth passes from one generation to the next.
The “predeceased parent rule” changes the generation assignment when there is an unnatural order of deaths within a family line, such as a child’s predeceasing his or her parent. When a lineal descendant of the transferor’s parent, or a lineal descendant of the parent of the transferor’s spouse or former spouse, is deceased at the time that the transfer subject to estate or gift tax occurs, the decedent’s children may be reassigned to the generation of the decedent. As a result, those children will no longer be skip persons and transfers to them will not be GSTs. For example, if client’s daughter dies being survived by her son, a gift from client to that grandson would not be subject to GST tax because of the predeceased parent rule.
The “generation move down rule” changes the generation assignment when a GST occurs (whether or not the GST tax actually applies) and, immediately after such transfer, the property is held in a trust. Immediately after a GST takes place with respect to property within a trust, the generation assignment of the beneficiaries of the trust is adjusted so that the generation of the transferor is assigned to the first generation above the highest generation of any person who has an interest in that trust. For example, assume that client creates a trust for a grandson, who is the sole beneficiary. The transfer to the trust is subject to both gift and GST tax, as the trust is a skip person. When the trustee makes a distribution out of the trust to the grandson, there is no GST because the generation of client, the transferor, has moved down to the generation that is one generation above the grandson’s generation.
Once the above rules are mastered, the determination of who is and is not a “non-skip person” becomes easy.
Knowing the generation assignment rules enables one to return to the definition of a “generation-skipping transfer.” Three different types of generation-skipping transfers may occur: a direct skip, a taxable termination, and a taxable distribution. A “direct skip” is a gift or bequest to a skip person. A taxable termination occurs when (1) a person’s interest in a trust terminates; (2) no non-skip person has an interest in the trust; and (3) a skip person could benefit from the trust. A taxable distribution is any distribution from a trust to a skip person (other than a direct skip or a taxable termination).
Some transfers, although otherwise satisfying the definition of GSTs, are excluded from the GST tax regime. Payments for a skip person’s educational or medical expenses directly paid to the institution providing the educational or medical services are not subject to GST tax. Similarly, distributions of property previously subject to GST tax when the transferee of a prior transfer is of the same generation as, or a lower generation than, a current transferee are not subject to GST tax. Other exclusions from GST tax concern the predeceased parent and generation move down rules, discussed above. Finally, the so-called “GST-tax annual exclusion,” which is similar to the gift-tax annual exclusion, may apply; however, as will be discussed later in this Article, several specific requirements must be satisfied in order for transfers to trusts to qualify for the GST annual exclusion.
Even if a transfer is not excluded from GST tax, many clients will not be subject to the tax because of the historically high GST-exemption amount. Currently, an $11.7 million exemption is available to each transferor to exempt transfers from the GST tax. If the GST tax is payable, a maximum tax rate of 40% applies to the transfer.
While disregarding the GST tax may be an issue, even practitioners who routinely engage in GST tax planning for clients may make the common mistake of assuming the GST tax will never surface in the estate plan. Many times, the client’s situation does not currently trigger GST tax. For example, clients with a taxable estate have three adult children who are married without children. At this point in time, one might determine any GST tax planning to be unnecessary because the clients do not have grandchildren. The practitioner then drafts the client’s documents accordingly—often explaining this rationale through an example of the client walking out of the office and getting hit by a bus or a similar example of an unexpected immediate death.
But what if incorporating GST tax planning into the estate plan is on the relatively near horizon for the client? Building off the example in the previous paragraph, in two years, clients have two grandchildren. With all of the flexibility built into wills and trust instruments to account for facts that are not currently in the client’s fact pattern (and may never be), there should also be default provisions in estate planning documents that address the potential need for future GST tax planning.
As previously mentioned, failing to account for a potential transfer subject to the GST tax can result in unnecessarily depleting family wealth. Proactive GST tax planning, similar to many of the trustee or executor powers allowing multiple maneuvers, can mitigate complications in trust and estate administration. Below are examples that the Authors have compiled from their respective planning practices.
A few of the GST tax planning provisions concern the efficient use of GST-exempt property, meaning the appropriate use of trust assets that are not exempt from GST tax and the preservation of assets that are exempt from GST tax. Example language includes:
Considerations for Trustee when Making Discretionary Distributions. In determining whether or not to exercise any discretionary power to distribute income or principal of any trust created hereunder, including the power to distribute income or principal of any trust created hereunder pursuant to an ascertainable standard, the Trustee may, but shall not be required to . . . (iv) take into account whether the trust is exempt from any Federal or state estate tax or the GST tax.
Discretion for GST-Exempt and Nonexempt Trusts. The Trustee shall consider the tax implications of making distributions from a GST-Exempt Trust for a beneficiary if a Nonexempt Trust hereunder for such beneficiary has not been exhausted.
Similarly, many documents will also direct that taxes be paid from assets that are not exempt from GST tax when possible.
To prevent the triggering of the Delaware tax trap when engaged in GST tax planning, practitioners may want to include a provision similar to the following if a limited power of appointment might be exercised.
Perpetuities Savings Clause. If a beneficial interest created by the exercise of this power of appointment is not indefeasibly vested no later than the day preceding the last day on which the recipient trust [insert name of trust] could exist if the law which is applicable to such trust requires its termination within a period of time shorter than provided by the terms of the appointing trust [insert name of trust], the interest shall, on that date, vest indefeasibly in the person(s) who own that contingent or defeasible interest, or if the person(s) or share(s) cannot be ascertained, each such interest shall vest indefeasibly in the then income beneficiaries of the trust or share, in proportion to their income interests, or if their proportions are not fixed, then completely in the person(s) in the nearest degree of relationship to me, or, if none is related, in the person(s) of the closest generation to me (under the rules in Section 2651 of the Internal Revenue Code).
To prevent mixed inclusion ratio trusts, practitioners may want to include provisions allowing for the division of trusts into GST-exempt and nonexempt trusts and the granting of authority to hold any receipt of property in a separate trust if such receipt in an existing trust would terminate the wholly GST-exempt status of a trust. This authority is not as common as it should be within documents, as the problem of tainting a GST-exempt trust is common when assets from a trust created under one instrument are added to a trust created under another instrument. The following provision is an example of language that may be included in a trust for the purposes discussed above.
Division of Trusts.
Mitigating potential GST tax exposure is important when drafting trust provisions. Aside from giving the trustee discretion to apply appropriate GST exemption to protect against GST events, the settlor of the trust may consider including a provision that can be triggered to give the beneficiary enough power over his or her trust share to cause inclusion in such beneficiary’s estate for federal estate tax purposes. This maneuver would cause the grantor to move down a generation for GST tax purposes so that no GST event occurs when distributions are made to a beneficiary’s descendants. Including a provision in a trust that gives a beneficiary a general power of appointment in certain instances can accomplish this planning.
With the estate and GST tax rates being equal and the exemption amounts being so high, this provision’s greatest value may be the income tax efficiency. The estate inclusion triggered by the general power of appointment would allow the trust assets over which the beneficiary has such a power to obtain a step-up in basis at death to help save income taxes for future beneficiaries. Rather than being specific to GST tax efficiency, this provision allows for general tax efficiency through authorizing an independent trustee to grant a beneficiary a general power of appointment.
The following example provision will intentionally trigger estate inclusion for GST avoidance planning purposes.
Authority to Grant General Power of Appointment. Notwithstanding any other provisions restricting powers of appointment in this Trust Agreement, the Independent Trustee of a trust hereunder, in the Independent Trustee’s sole and absolute discretion, may grant the Primary Beneficiary of such trust, in the best interests of the Primary Beneficiary, the power to appoint the then-remaining balance of the income and principal of such trust, if any, in such manner, in such estates, in trust or otherwise, as the Primary Beneficiary may have designated, including to the Primary Beneficiary’s estate, in the Primary Beneficiary’s Will by specific reference to this general power of appointment; provided, however, the Independent Trustee, in the Independent Trustee’s sole and absolute discretion, may also restrict or revoke the Primary Beneficiary’s general power of appointment granted in this paragraph in the best interests of the Primary Beneficiary.
In a similar effort to provide flexibility and promote tax efficiency, the following provision would allow an amendment by an independent trustee for a number of reasons, including changes in the tax law.
Trust Protection. The Independent Trustee may amend the provisions of this Trust Agreement at any time, for the sole purposes of addressing (a) any changes in Federal or state income, estate, or GST tax system or regulations thereto, arising as a result of applicable case law or legislative changes in Federal or applicable state law, (b) changes in the Federal or applicable state law that affect the Trustee’s administration of any trust created hereunder, (c) any perceived ambiguities in the language of this Trust Agreement, as determined by the Independent Trustee, in the Independent Trustee’s sole and absolute discretion, and (d) any scrivener errors that might otherwise require court construction, modification, or reformation; provided, however, that, unless granted under another provision of this Trust Agreement, the Independent Trustee shall be prohibited from making any amendments that would result in (a) the increase, reduction or any change in any beneficial interests under this Trust Agreement, or (b) the inclusion of any trust created hereunder in the Trustee’s or any other person’s estate, if such trust were not intended to be so included in such person’s estate prior to such amendment.
Many practitioners provide this authority to a trust protector or trust advisor, instead of an independent trustee, and some would say that the use of a trust protector or trust advisor avoids the application of a fiduciary standard.
The inclusion of a trust provision regarding the settlor’s intent that automatic allocations of the GST exemption should apply may be helpful in the future even though such an intention may be overridden through affirmative elections on the settlor’s gift tax return. Another benefit of such a provision is that it forces the drafting attorney to fully consider the intended GST tax status of the trust. Lastly, when compared to the “Division of Trust” provision described above, the following provision provides stronger language preventing mixed inclusion ratio trusts.
GST Intent. The Settlor intends that automatic allocation of the Settlor’s GST exemption under Section 2632(c)(1) of the Code will [not] apply to property transferred to a trust created hereunder, unless the Settlor makes a different allocation or election effective under the Code at any time. If GST tax exemption is allocated to a trust created hereunder which would result in a trust with an inclusion ratio greater than zero (0) and less than one (1), then the Trustee shall divide such trust into a GST-Exempt Trust and a Nonexempt Trust.
As mentioned above, a reverse QTIP election would change the identity of the transferor from the surviving spouse to the decedent spouse who created and funded the QTIP trust. In effect, this election enables the maximization of the decedent’s GST exemption. For documents that contain “QTIPible” trusts, the following provision provides flexibility.
Reverse QTIP Election. Notwithstanding any other provision of this Trust Agreement, if and to the extent that the Settlor’s Personal Representative or the Trustee, as the case may be, makes a Reverse QTIP Election, then the Settlor directs the Trustee to hold the property to which the Reverse QTIP Election applies in a separate trust upon the same terms and conditions and for the same uses and purposes as are set forth in Article [VI]. If the Trustee makes a QTIP Election, then the Trustee shall be further authorized (but shall not be required) to make an election pursuant to Section 2652(a)(3) of the Code (and similar Section(s) of any other Federal revenue laws) to treat the trust or any part of the trust created under Article [VI] as though no such election pursuant to Section 2056(b)(7) of the Code had been made.
Continuing with the theme of flexibility and ensuring separation of GST-exempt and nonexempt portions of the trust, the following provision authorizes the trustee to allocate the GST exemption after a decedent’s death in case the executor forgets to do so or, alternatively, affirms the trustee’s authority to allocate GST exemption if the trustee is a statutory executor.
Allocation of GST Exemption. The Trustee shall be authorized (but shall not be required) to elect exemption from the applicability of Section 2632(b) of the Code, and the Trustee shall be authorized to allocate, in accordance with the provisions of Section 2632(a) of the Code, any unused portion of the GST exemption available to the Settlor (or to the Settlor’s estate) under Section 2631 of the Code to any dispositions of property under this Trust Agreement or to any dispositions of property outside of this Trust Agreement in such manner and in such amounts and proportions as the Trustee shall, in the Trustee’s sole and absolute discretion, deem appropriate. All determinations by the Trustee as to the proper allocation of such unused exemption shall be conclusive and binding upon all persons having or claiming any interest in the Settlor’s estate. If GST exemption is allocated to a trust created hereunder which would result in a trust with an inclusion ratio greater than zero (0) and less than one (1), then the Trustee shall divide such trust into a GST-Exempt Trust and a Nonexempt Trust.
The above GST tax planning provisions are not universally applicable to all clients, but similar to other types of powers- and savings-type clauses in wills and trust instruments, they should be considered to avoid the GST tax or mitigate its application when unanticipated.
Even when there is an obvious need for GST planning, practitioners often make mistakes in structuring their GST tax planning approaches.
Many revocable living trusts are drafted with formula bequests that direct a GST-exempt trust to be funded with assets having a value equal to the decedent’s maximum available GST exemption. If history is any indication, the GST tax rules may change again in the next round of tax reform. This unpredictability requires that practitioners use caution when drafting living trusts and to anticipate changing GST tax exemption amounts and the possible repeal of the GST tax itself. Below are three common scenarios in which having a default GST-exempt trust-funding formula may create unintended and problematic consequences for the client and his or her family.
The introduction of portability to the transfer tax world beginning in 2011 has allowed for many married clients to defer transfer tax planning until the death of the surviving spouse. Simply put, portability allows an individual to “port” (or transfer) upon death any of his or her gift and estate tax exemption not used by the individual during life or upon death to his or her surviving spouse. Thus, portability generally allows a married couple to fully utilize both of their gift and estate tax exemptions, even when the first spouse to die owns assets at the time of death having a value equal to less than his or her remaining estate tax exemption or his or her estate plan leaves his or her assets to the surviving spouse or charity so that his or her remaining estate tax exemption is not used. Prior to portability, any gift and estate tax exemption not used during life or upon death was lost. Although portability may have simplified estate tax planning for some individuals, it may lead to a loss of the GST exemption because portability is not applicable to the GST exemption. Although portability allows for the use of both spouses’ estate tax exemptions, if an individual does not use his or her GST exemption during life or at death, it is forever lost. Accordingly, it is imperative that practitioners consider the GST tax consequences of utilizing portability and communicate the consequences of doing so to their clients.
Even if an estate plan is structured to maximize the use of a client’s GST exemption (e.g., by funding a trust for the benefit of descendants and allocating GST exemption to the trust so that the trust has an inclusion ratio of zero), the particular distribution provisions of the trust may cause the well-intended plan to be inefficient from a GST tax perspective. This would occur, for example, if the dispositive provisions of the trust provided for mandatory distributions of income or principal to the trust beneficiaries. Examples of these types of distribution provisions include provisions requiring all of the trusts income to be distributed to one or more beneficiaries each year and provisions requiring mandatory distributions of principal to the beneficiaries upon the occurrence of a particular event (e.g., attaining a particular age or graduating from college). A better approach from a GST tax perspective would exclude any provision requiring distributions of income or principal and give the trustee discretion to make distributions to the beneficiaries. Only in a rare situation would good reason exist to force distributions out of a GST-exempt trust, and this is especially true only if another trust exists from which distributions may be made that is not GST exempt.
If distributions must be made from a GST-exempt trust to a beneficiary who is a non-skip person, the GST exemption that was allocated to the distributed assets is essentially wasted. The reasons for this are twofold. First, the assets could have passed directly from the settlor to the non-skip person without the use of any GST exemption. As a result, the distribution of assets from a trust to which the GST exemption was allocated is inefficient. Second, the assets in the GST-exempt trust are removed from the transfer tax system and will pass from generation to generation without the imposition of transfer tax. However, if assets are distributed to a beneficiary who is a non-skip person, the assets will be included in the non-skip person beneficiary’s estate (to the extent the distributed assets are not consumed by the non-skip person beneficiary during his or her life). Thus, the non-skip person beneficiary would need to allocate his or her GST exemption (a second allocation of GST exemption to the same assets) to the assets in order for them to pass from generation to generation without the imposition of transfer tax.
Moving from these common drafting mistakes to the administration of older trusts, a common mistake is to taint the GST-exempt status of a grandfathered trust. A “grandfathered trust” is a trust that was irrevocable on or before September 25, 1985, the effective date of the modern GST tax. These trusts are not subject to the GST tax provided certain changes have not been made to the trust since that date.
Determining whether a trust is a grandfathered trust is key to ensuring that its GST-exempt status is not tainted, with the result that a portion of the trust assets become subject to the GST tax. If the trust was executed prior to September 25, 1985, the practitioner must determine whether the trust was irrevocable on or before that date. All trusts in existence on September 25, 1985, are considered irrevocable unless (1) on September 25, 1985, the settlor held a power with respect to the trust that would have resulted in gross estate inclusion under section 2038; (2) the settlor retained a power to alter the shares of trust beneficiaries; or (3) the trust holds life insurance on the settlor’s life and the settlor possessed incidents of ownership in the policy that would result in gross estate inclusion under section 2042.
A special set of rules apply if the trust at issue is a testamentary trust created under a will or revocable trust instrument. Testamentary trusts will be irrevocable only if (1) no amendments were made after October 21, 1986, that resulted in the creation of or increase in the amount of a GST; (2) no addition was made to the testamentary trust after October 21, 1986, that resulted in the creation of or increase in the amount of a GST; and (3) the decedent who created the testamentary trust died before January 1, 1987.
After determining that a trust is grandfathered, the practitioner will want to avoid certain changes to the trust to preserve its grandfathered status. Two types of changes that taint the exempt status are (1) additions to the trust and (2) modifications of the trust occurring after September 25, 1985.
Grandfathered status is generally tainted if an actual or constructive “addition” to the trust has been made after September 25, 1985. If an actual or constructive addition has been made to a grandfathered trust after this date, a pro rata portion of subsequent GSTs will be subject to the GST tax.
Avoiding an actual addition is relatively straight forward, but a constructive addition can unknowingly taint the grandfathered trust status. A “constructive addition” occurs upon (1) the taxable release, exercise, or lapse of a general power of appointment over the trust; (2) the release or exercise of a nongeneral power of appointment that extends the vesting period beyond the perpetuities period that originally applied to the trust; or (3) the creation of a second power of appointment that may be exercised to extend the vesting beyond the perpetuities period that originally applied to the trust.
Notwithstanding the foregoing, the exercise of a nongeneral power of appointment (most commonly called a “limited power of appointment”) is not a constructive addition if two conditions are met: (1) the power was created in a grandfathered trust and (2) the power is not exercised in a manner that may postpone or suspend the vesting, absolute ownership, or power of alienation of an interest in property beyond what is commonly known as the federal perpetuities period. Note, however, that the exercise of a power of appointment is subject to different rules than a trustee’s exercise of a fiduciary power, which would encompass decanting or modification of a grandfathered trust, as detailed below.
To ensure that a grandfathered trust remains GST exempt through a trust modification after September 25, 1985, the modification should be within one of the modification safe harbors set forth in the Treasury regulations. Jeopardizing grandfathered trust status via a trust modification has become increasingly more common as decanting has increased in popularity.
The first safe harbor for modifying a grandfathered trust provides that a distribution of principal from a grandfathered trust to a new trust will not cause the new trust to be subject to GST tax (i.e., the new trust will inherit the grandfathered trust status of the decanted trust) if either (1) the terms of the governing instrument of the grandfathered trust authorize distributions to the new trust without the consent or approval of any beneficiary or court or (2) at the time that the grandfathered trust became irrevocable (which had to have been prior to September 25, 1985), state law governing the trust authorized distributions to the new trust without the consent or approval of any beneficiary. Also, the terms of the new trust cannot extend the time for vesting of any beneficial interest beyond a period measured by 21 years after the death of any life in being at the time that the grandfathered trust became irrevocable.
The second safe harbor to avoid adversely affecting the grandfathered status of a trust applies in connection with a court-approved settlement that was the product of arm’s-length negotiations and is within the range of reasonable outcomes under the governing instrument and applicable state law.
The third safe harbor provides for a judicial construction of a trust instrument if the judicial action involved a bona fide issue and the construction is consistent with applicable state law that would be applied by the highest state court.
The fourth safe harbor, a catch-all provision, prevents termination of grandfathered trust status for any modifications to a trust that does not (1) shift a beneficial interest in the trust to any beneficiary who occupies a generation lower than the generation occupied by the person or persons who held the beneficial interest prior to the modification and (2) extend the time for vesting of any beneficial interest in the trust past the period provided for in the grandfathered trust.
Before making changes to an older trust, practitioners should check the date of the trust to determine the trust’s qualification as a grandfathered trust in order to avoid subjecting trust assets to the GST tax by failing to comply with the grandfathered trust addition and modification rules.
Similar to additions to grandfathered trusts, other types of transfers require special attention to avoid GST planning mistakes. Nontaxable gifts generally do not attract GST tax. As a result, an affirmative allocation of GST exemption to a nontaxable gift is generally not necessary to avoid GST tax, and the automatic allocation rules are generally inapplicable. Nontaxable gifts include gifts qualifying for the gift-tax annual exclusion under section 2503(b) and gifts for medical or educational expenses under section 2503(e).
Determining whether a transfer to or on behalf of an individual is a nontaxable gift is relatively straightforward. Determining whether a transfer to a trust is a nontaxable gift is much more complicated and mistaken assumptions are often made.
Gifts to a trust qualify for the gift-tax annual exclusion (and such gifts are therefore nontaxable gifts) if the beneficiaries have a present interest in the trust. A beneficiary will have a present interest in a trust if the beneficiary has “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from the property.” The most common way for beneficiaries to have a present interest in a trust is for the trust agreement to provide each trust beneficiary with a power to withdraw a portion of each contribution made to the trust each year (typically limited, with respect to each beneficiary, to the gift-tax annual exclusion amount). These withdrawal powers are commonly referred to as Crummey Powers. By including Crummey Powers in a trust, the transferor is able to make transfers to the trust each year free of the gift tax in an amount equal to the gift-tax annual exclusion multiplied by the number of beneficiaries with a Crummey Power.
The mistaken belief that a transfer to a trust which qualifies for the gift-tax annual exclusion also qualifies for the GST-tax annual exclusions (with the assumed result that neither the automatic allocation rules apply to allocate the GST exemption to the transfer nor an affirmative allocation of the GST exemption is necessary to make the trust GST exempt) is surprisingly common. As discussed above, in addition to qualifying for the gift-tax annual exclusion (generally by the inclusion of Crummey Powers in the trust), a transfer to a trust qualifies for the GST-tax annual exclusion only if the trust is a “section 2642(c) trust.” A trust will qualify as a section 2642(c) trust only if (1) the trust is for the benefit of a single beneficiary who is a skip person and (2) if the beneficiary dies during the term of the trust, the trust assets would be included in the beneficiary’s gross estate.
Most trusts that include Crummey Powers are for the benefit of multiple beneficiaries in order to maximize the amount of assets the transferor can contribute to the trust each year free of the gift tax. Because these trusts are not for the benefit of a single beneficiary, the trusts do not qualify as section 2642(c) trusts; consequently, transfers to such a trust cannot qualify for the GST-tax annual exclusion (despite such transfers qualifying for the gift-tax annual exclusion). Rather, the transferor’s GST exemption would be automatically allocated to the trust with respect to each contribution made to the trust in each year during which the trust is a GST trust. The failure to recognize that the GST exemption is automatically allocated to a trust can have significant adverse effects on future estate planning transactions.
For example, assume that client (who is not married) creates a trust for the benefit of his four children and six grandchildren (the “Gifting Trust”). With respect to all contributions made to the Gifting Trust in a particular year, each of the client’s ten descendants has a right to withdraw up to $15,000 (the gift-tax annual exclusion amount). As a result, client can gift up to $150,000 per year to the Gifting Trust without using any gift tax exemption. Client has made a $150,000 gift to the Gifting Trust each year for the past twenty years, resulting in $3 million of tax-free gifts to the Gifting Trust. Client’s accountant, who has been preparing his gift tax returns each year, has assumed that transfers to the Gifting Trust qualified for the GST-tax annual exclusion and, as a result, has failed to account for any reduction in client’s GST exemption.
In a later year, client, desiring to use all of his $11.7 million gift and GST exemptions, creates a new trust (the “Grandchildren Trust”) solely for the benefit of his grandchildren (the trust is a skip person) and gifts $11.7 million to the Grandchildren Trust. Client believes that he has made a transfer to the Grandchildren Trust that is free from both gift and GST tax, but because the Gifting Trust did not qualify as a section 2642(c) trust (it had multiple beneficiaries), $3 million of client’s GST exemption has been automatically allocated to the Gifting Trust over the past 20 years. As a result, client had only $8.7 million of GST exemption remaining when he made the gift to the Grandchildren Trust, with the result that $3 million of the gift is subject to GST tax.
An eye-opening trap concerns hanging withdrawal rights, which can switch on and switch off the GST status of a trust. As noted above, a trust is excluded from the definition of a GST trust if any portion of the trust would be included in the gross estate of a non-skip person if such person died immediately after the transfer to the trust. Often, each of the Crummey Powers for all of the transferor’s descendants are structured to lapse after a certain period of time up to the greater of five percent of the trust principal and $5,000 each year to avoid having an estate inclusion for a Crummey beneficiary. The balance of the withdrawal right in excess of such an amount (commonly referred to as a “hanging power”) does not lapse and may be withdrawn in subsequent years (in addition to the amount otherwise subject to withdrawal in that particular year). These types of trusts are often long-term trusts intended to benefit all of the transferor’s descendants and to be exempt from GST tax. At the creation of the trust, the trust is a GST trust, qualifying for automatic allocations of the GST exemption.
A common occurrence would disqualify this type of trust from being a GST trust, prohibiting automatic allocations of the GST exemption. This switch could happen if, at any time, a child of the transferor has the power to withdraw (in the aggregate) more than the annual exclusion amount. If the aggregate amount that a child may withdraw in a particular year exceeds the gift-tax annual exclusion amount, a portion of the trust would be included in the child’s gross estate if the child were to die immediately after the transfer to the trust, thus causing the trust to cease to be a GST trust.
For example, assume that a transferor transfers $100,000 to an irrevocable trust for the transferor’s descendants. In Year 1, the transferor’s child has a withdrawal right over $15,000 (the annual exclusion amount) of the gift to the trust, and this right lapses only to the extent of $5,000. The next year, the transferor transfers an additional $100,000 to the trust. In Year 2, the child has the right to withdraw $15,000 of the Year 2 contribution, plus the hanging amount of $10,000 from Year 1. As a result, the child has a withdrawal right of $25,000 in Year 2—exceeding the gift-tax annual exclusion amount. If the child were to die in Year 2, he or she would have an estate tax inclusion for a portion of the trust. This possibility of an estate tax inclusion means that the trust does not qualify as a GST trust in Year 2 and for so long as a non-skip beneficiary has a withdrawal right exceeding the gift-tax annual exclusion amount.
This fact pattern highlights (1) the narrowness of the definition of a GST trust because this is a trust to which the transferor would most likely want automatic allocations of the GST exemption to be made and (2) the risks in relying on the automatic allocation of the GST exemption. Controlling the GST status of a trust through elections and affirmative allocations is wise.
Despite the benefits of taking control of GST allocations through election statements and affirmative allocations, many practitioners fail to properly allocate the GST exemption on the gift tax return. Often, a practitioner will rely on the default allocation rules when an affirmative allocation should be made for a variety of reasons. Properly allocating a sufficient GST exemption to a transfer will exempt that transfer from GST tax or ensure that trust assets will not be subject to GST tax.
An affirmative allocation of the GST exemption may be made at any time before the date prescribed for filing the estate tax return, including extensions. If property is to be held in trust, the allocation of the GST exemption is made to the entire trust rather than to specific trust assets. A timely allocation of the GST exemption is made on a timely filed gift tax return for transfers during life and on a timely filed estate tax return for transfers at death. For a timely allocation of the GST exemption, the property transferred or the trust to which the property is transferred will be exempt from the GST tax if the amount of the GST exemption allocated is equal to the value of the property transferred on the date of the transfer.
An affirmative allocation of the GST exemption to a lifetime transfer to a trust is made by filing a Notice of Allocation with the gift tax return reporting the gift. The Notice of Allocation must be filed by the return preparer and must fulfill specific requirements set forth in the regulations and instructions to the gift tax return. There are different rules depending on the type of election: an election in, an election out of direct skips, and an election out of indirect skips. On a Notice of Allocation, the practitioner must clearly identify the trust and the trust’s EIN, if known, state the value of the assets at the effective date of the allocation, state the amount of the GST exemption allocated or the formula used, and state the inclusion ratio of the trust. Often, gift-tax return preparers skip Schedule D, Computation of Generation-Skipping Transfer Tax, for any number of reasons, or do not include a Notice of Allocation, or both.
For an affirmative allocation of GST exemption at death, the decedent’s executor may allocate the decedent’s GST exemption that the decedent did not use during life. The executor would make allocations to trusts being funded at death on Schedule R of the decedent’s estate tax return. Similar to gift tax returns, tax preparers often skip completing or including a Schedule R.
One of the main reasons that tax return preparers may skip detailing the GST allocation on gift and estate tax returns is the availability of automatic allocations of the GST exemption. Just as portability provides a false sense of security for estate tax planning, so does the automatic allocation rules for GST tax planning. Both sets of rules help when the tax planning is neglected, but those rules also allow practitioners to avoid analysis of the rules to truly maximize the benefits of the assets.
The purpose of the automatic allocation rules is to avoid inadvertent GST tax when it is anticipated that the taxpayer would have wished to allocate the GST exemption. Starting in reverse, at death, the automatic allocation rules apply to allocate the decedent’s unused GST exemption, pro rata, to direct skips and then, to the extent that any GST exemption remains, pro rata, to trusts from which a taxable termination or taxable distribution may occur.
During lifetime, a taxpayer’s unused GST exemption will be automatically allocated to any direct skip transfer (including direct skip transfers in trust), unless the taxpayer elects out of the automatic allocation rules. If property is transferred to a trust, the transfer is a direct skip only if the trust is a skip person. The automatic allocation rules work well for direct skips, but have some defects for indirect skips. An “indirect skip” is a transfer to a GST trust (other than a direct skip trust). A taxpayer’s unused GST exemption will be automatically allocated to any transfer to a GST trust.
A “GST trust” is broadly defined as any trust that could have a GST with respect to the transferor. Despite its broad definition, certain trusts that otherwise satisfy the general definition of a GST trust are excluded from treatment as GST trusts. Examples include: (1) age 46 trusts; (2) ten year age difference trusts; (3) partial estate tax inclusion trusts; (4) non-skip person estate tax inclusion trusts; (5) charitable lead annuity trusts; (6) charitable remainder annuity trusts or charitable remainder unitrusts; and (7) charitable lead unitrusts if the non-charitable remainder beneficiary is a non-skip person.
The complex definition of a GST trust can be under-inclusive in some circumstances by failing to attract GST exemption to transfers to which allocation is desired, and over-inclusive in other circumstances by allocating the GST exemption to transfers to which an allocation is not desired. Common mistakes involving this imperfect definition of a GST trust are detailed herein concerning trusts with withdrawal rights and trusts subject to the estate tax inclusion period (ETIP). Due to the imprecise manner in which the automatic allocation rules function, practitioners need to be wary of relying on such rules for lifetime transfers.
Best practice is to first determine the desired GST tax status of a trust and then to make an election either in or out of the automatic allocation rules. If the trust is intended to be GST exempt, an appropriate amount of GST exemption should then be affirmatively allocated to the transfer. Proceeding in this manner (as opposed to relying on the automatic allocation rules) forms a record for review when the GST status may be in question.
Below are samples of the elections in and out of GST allocation on a gift tax return.
[Name of Trust with name of Settlor and Trustee, address and EIN]
A. Pursuant to Internal Revenue Code Section 2632(c)(5)(A)(ii) and Treasury Regulation Section 26.2632-1(b)(3)(ii), the taxpayer elects for the automatic allocation rules of Section 2632(c) to apply to the transfer by the taxpayer described on Schedule A, Part 3, Item ___, and to any future transfers to any trusts created under the [Name of the Trust], including the trust under [specific provision of the specifically named trust] and any other trusts that may be created under [specific other provisions of the specifically named trust]. As a result of this election, the inclusion ratio of the [Name of the Trust] is zero, and [Name of the Trust] shall be treated a GST trust.
Or for the election out:
[Name of Trust with name of Settlor and Trustee, address and EIN]
B. Pursuant to Internal Revenue Code Section 2632(c)(5)(A)(i)(II) and Treasury Regulation Section 26.2632-1(b)(2)(iii)(B), the taxpayer elects for the automatic allocation rules of Section 2632(c) not to apply to the transfer by the taxpayer described on Schedule A, Part 3, Item ___ and to any future transfers to any trusts created under the [Name of the Trust], including the trust under [specific provision of the specifically name trust] and any other trusts that may be created under [specific other provisions of the specifically name trust]. As a result of this election, the inclusion ratio of the [Name of the Trust] is one.
One specific time period that causes a common mistake in allocating the GST exemption is during the ETIP. Often, practitioners do not realize that the GST exemption generally cannot be effectively allocated during the ETIP. The ETIP is that period of time during which, if the transferor or the transferor’s spouse dies, the assets of the trust would be included in either of their estates. A trust will not be subject to the ETIP rule if (1) the possibility that the property will be included in the estate of the transferor or the transferor’s spouse is so remote as to be negligible (i.e., less than a five percent actuarial chance), (2) the transferor’s spouse possesses a power of withdrawal that is limited to the greater of $5,000 or five percent of the trust principal and this right terminates no later than 60 days after the transfer to the trust, or (3) a reverse QTIP election is made with respect to the transfer.
As mentioned above, a reverse QTIP election makes the decedent, instead of the surviving spouse, the transferor for GST tax purposes. Without this election, the transferor’s spouse would need to wait until death to allocate the GST exemption, and the transferor may not maximize the use of the GST exemption.
Non-QTIP trusts reveal how not knowing the ETIP rule can be costly. Even if an attempt were made to allocate the GST exemption to a trust during the ETIP, the allocation of the exemption will not be effective until the end of the ETIP, potentially leading to the allocation of much more of the transferor’s GST exemption than anticipated or having a mixed inclusion ratio trust. For example, the ETIP rule prevents allocating the GST exemption to a grantor retained annuity trust (GRAT) during the annuity period because, if the transferor were to die, the GRAT assets would generally be included in the transferor’s estate. Accordingly, GRATs are typically not intended to be GST exempt. When the remainder beneficiary of the GRAT is a skip person or a GST trust, the transferor’s GST exemption will be automatically allocated to the transfer of the presumably appreciated GRAT assets at the end of the GRAT term.
To prevent the GST exemption from being automatically allocated at the end of the ETIP, the transferor should file an election-out statement, electing out of the automatic allocation rules. Many tax preparers miss the requirement that transfers subject to the ETIP must be reported on Part 1 of Schedule D of the gift tax return in the Computation of GST tax as described below. The ETIP rule provides another reason that reliance on automatic allocations of the GST exemption is imprudent.
Gift-splitting can also lead to mistakes in allocating the GST exemption. If spouses elect to gift split, a transfer of property made by only one spouse is treated as if made 50% by each spouse, and all transfers made by either spouse during the year for which the election is made (other than transfers to each other) are deemed split for that year. As a result, each spouse becomes the transferor of 50% of the property for GST tax purposes, which may result in the automatic (and potentially unknowing) allocation of the non-donor spouse’s GST exemption.
A gift-splitting election may be made either on a timely filed gift tax return or on a late filed return, if such return is the first return filed by either spouse for the calendar year in which the gift was made. If the gift-splitting election is made on a late filed gift tax return, unintended GST tax consequences can result. The reason for this is that, as a result of the gift-splitting election, each spouse is treated as the transferor of 50% of the property for GST tax purposes.
If the transfer is made to a skip person or a GST trust, the automatic allocation rules result in each spouse’s GST exemption being automatically allocated to 50% of the transferred property. If the trust to which the transfer is made is intended to be GST exempt, then there should be no adverse consequences. In contrast, if the trust is not intended to be GST exempt, issues may arise. When a gift-splitting election is made on a late filed gift tax return, the taxpayers do not have the ability to elect out of the automatic allocations rules. Accordingly, irrespective of whether the trust is intended to be GST exempt, both spouses’ GST exemption will be automatically allocated to the trusts. Thus, practitioners should pay close attention to GST consequences when advising clients with respect to gift-splitting and how to report it on a gift tax return.
With the filing of gift tax returns each year comes the common mistake of incorrect or careless reporting of the GSTs. Schedules A and D of a gift tax return pose particular problems for preparers who are not well versed in reporting GSTs and the allocation of the GST exemption.
The GST planning mistake for Schedule A on the gift tax return is reporting a transfer to a trust on the wrong Part of the Schedule. This error may be a consequence of the evolution of Schedule A over the years or a preparer’s failure to understand the nuances of the GST tax rules. Schedule A forces a preparer to properly identify the specific aspects of the GST tax that apply to a transfer in order to select Part 1, 2, or 3 on which to report the gift. Part 1 is for gifts that are subject to the gift tax and not the GST tax. Part 2 is for direct skips, and Part 3 is for indirect skips. Thus, the preparer needs to know those GST terms to choose the correct part on which to report the transfer.
Part 1 of Schedule A may be erroneously used for a GST if the preparer does not realize that the gift may be subject to the GST tax. This Part, however, is not the one that typically causes confusion—Parts 2 and 3 do.
Part 2 of Schedule A is for direct skips, subject to both the gift and GST taxes. In the gift tax return context, a “direct skip” is a transfer of an interest in property to a skip person subject to gift tax. Part 2 also provides a box in column C to be checked if the taxpayer is electing out of the allocation of the GST exemption for the gift. If the box is unchecked, the taxpayer’s exemption sufficient to exempt that transfer from the GST tax is automatically allocated to the gift. Additionally, an explanation must be attached to the gift tax return describing the transaction and the extent to which the automatic allocation should not apply to the gift. As an alternative to providing such an explanation, the taxpayer must pay the GST tax with a timely filed gift tax return.
Part 3 of Schedule A is for “indirect skips,” which are transfers to a GST trust subject to the gift tax. As detailed above, determining whether the trust qualifies as a GST trust to which automatic allocation would apply is sometimes difficult. Similar to Part 2, Part 3 has a check-the-box election under column C that is often overlooked. If this Part 3 box is unchecked, the taxpayer’s GST exemption is automatically allocated to the gift. Part 3 has additional elections that may be made by checking the appropriate box in column C. The instructions for the gift tax return explain these three elections, which must be detailed on an “election statement.”
Without checking the box, automatic allocations apply. Election 1 prohibits an automatic allocation of GST exemption to that specific, current transfer. Election 2 prohibits the automatic allocation of the GST exemption to the current transfer and all other transfers to that trust in the future. Election 3 is helpful because qualification for a GST trust is not always clear. Election 3 deems the trust to be a GST trust for which all transfers to the trust are automatically allocated the taxpayer’s GST exemption. Even if a practitioner is diligent to ensure that the correct boxes are checked to elect out of a GST allocation, the practitioner must not overlook the need to include an election statement.
Avoiding these common reporting mistakes on Schedule A of the gift tax return requires a firm knowledge of the GST tax laws and the gift tax return instructions.
While tax return preparers often do their best to complete Schedule A of the gift tax return, they often demonstrate their indifference to the GST tax by ignoring the Computation of Generation-Skipping Transfer Tax under Schedule D of the gift tax return. Often Schedule D is left blank.
Part 1 of Schedule D is for reporting the GSTs as reported on Schedule A of the gift tax return to determine the nontaxable portions of any transfers and net transfers. Because of the confusion that exists regarding Schedule A, any potential mistakes from Schedule A are magnified in Schedule D. The fear of being stuck with the conclusions shown in column E for the net transfers may lead many gift-tax return preparers to leave Part 1 of Schedule D blank. More understandably, because of the complexity of Part 1, a preparer may simply have forgotten to report a transfer subject to the ETIP on this Part 1.
Allocating the GST exemption is very complex. Part 2 requires knowledge of many of the rules discussed above that commonly cause mistakes including: (1) a check-the-box election for reverse QTIP elections; (2) on line 4 of Part 2, reporting the amount of GST exemption allocated from gifts listed on Part 2 of Schedule A; (3) on line 5 of Part 2, reporting the amount of automatic GST exemption allocated from gifts listed on Part 3 of Schedule A, (4) opting out of those rules; and (5) allocating the GST exemption affirmatively using Notices of Allocation. In combination, the complex GST tax rules required to complete the GST Exemption Reconciliation correctly often leads to mistakes; an ability to decipher and master the GST tax rules is the only means to avoid these mistakes.
Avoiding the mistakes outlined in this Article will strengthen a practitioner’s advice by minimizing GST tax exposure for clients and their intended beneficiaries. An appreciation of these common mistakes and the complex and nuanced rules under the GST tax regime will enable a practitioner to maximize the assets available for clients to transfer to their chosen beneficiaries. By gathering the necessary facts, becoming versed in the GST tax rules, and avoiding the common mistakes outlined in this Article, a practitioner will be better equipped to provide holistic advice to the client.
