Generation-Skipping Transfer Tax: Its Bite Is Worse Than its Bark
It is no secret that Chapter 13 of the Internal Revenue Code of 1986, as amended,1 other
wise known as the generation-skipping transfer (GST) tax, contains one of the most complex set of rules in the Internal Revenue Code. Indeed, a few years ago the American Institute of Certified Public Accountants prepared a proposal to substantially modify the GST tax law in order to eliminate tax traps that may cause massive liabilities for taxpayers and their advisors.2 Perhaps the best quotation regarding the GST tax is the following: “[T]he GST tax is a deceptive and deadly tax with which to reckon. It strikes without warning. Furthermore, its calculations are so inhumanely convoluted that the GST tax can send estates into a black hole of confusion from which no lawyer can extract them—or so it seems.”3
Simply stated, the GST tax rate is the maximum federal estate tax rate,4 which currently is 55 percent.5 The tax is imposed on transfers of property made from one generation to another generation which is two or more generations below the transferor’s generation ( e.g., a transfer of property from a grandparent to a grandchild).6 Accordingly, the cost of making a mistake in this area of the Code can be significant.
This article discusses some of the GST tax provisions that may apply to those trusts commonly used as part of an estate plan that is designed to reduce estate and gift tax exposure. In most cases, these provisions are apparent, but in some, they are not. The authors hope that the article is used by practitioners as a checklist for each estate plan to ensure that the complex provisions regarding GST tax have been properly addressed.
When is GST Tax Exemption Allocated?
Every individual has a $1,030,000 GST tax exemption.7 In general, the allocation of GST tax exemption can exempt all or a portion of a GST from GST tax. In order to exempt a GST from GST tax, the exemption must be properly allocated and there are specific rules regarding such an allocation.8
If a gift is made to a skip person,9 any unused portion of the individual’s GST tax exemption is automatically allocated to the transferred property.10 With respect to gifts made to a nonskip person11 during life, GST tax exemption is allocated on Schedule C (the GST tax schedule) of a federal gift tax return (Form 709).12 If GST tax exemption is allocated on a timely filed federal gift tax return, the value of the property transferred is used to determine the amount of exemption that is allocated.13 A gift tax return is timely filed if it is filed by the due date of the return, including extensions actually granted.14 If GST tax exemption is allocated on a late federal gift tax return, the value of the property as of the date the return is filed is used to determine the amount of exemption is allocated.15 There is also a convenience rule which allows a taxpayer to elect to use the value of the trust’s property as of the first day of the month the late return is filed instead of the value as of the date the return is actually filed.16
An example should illustrate how important it is to allocate GST tax exemption on a timely filed gift tax return. Assume that taxpayer gifts internet stock to a perpetual irrevocable gifting trust, of which the beneficiaries are the taxpayer’s descendants, and that the trust will continue for the longest period allowed under law, subject to the rule against perpetuities. On July 1, 1997, the stock has a value of $500,000, and on July 1, 1999, the stock has a value of $2,000,000. If taxpayer allocates $500,000 of his GST tax exemption on a timely filed federal gift tax return, all distributions from the trust to skip persons, at any generation, will be exempt from GST tax.
On the other hand, if taxpayer fails to allocate GST exemption on a timely filed gift tax return, the value of the trust’s property on the date the late return is filed must be used to allocate the exemption. In this example, if a return is filed on July 1, 1999, the taxpayer will not have a sufficient amount of GST tax exemption to allocate and all future distributions from the trust to skip persons will be subject to GST tax. Because only $1,010,00017 of exemption will be available to allocate, approximately 50 percent of each distribution will be subject to GST tax.
How is GST Tax
In addition to allocating GST tax exemption on a timely filed basis, the exemption should be allocated properly. In general, the allocation must clearly identify the trust to which the allocation is being made, the amount of the GST tax exemption allocated to it, and if the allocation is late or if an inclusion ratio18 greater than zero is claimed, the value of the trust’s assets at the effective date of the allocation.19
Schedule C of Form 709, the federal gift tax return, is not very clear with respect to the form of the notice of allocation. In fact, the schedule itself does not include a form for the notice. While line 5 of Part 2 of Schedule C states, in bold, that a notice of allocation must be attached, and also refers to the instructions regarding such a notice, many taxpayers have failed to include the required notice and, instead, attempted to allocate exemption to a trust on another place on Schedule C of the gift tax return.20
The IRS has been very lenient in some private letter rulings regarding an improper allocation of GST tax exemption, provided that the taxpayer has substantially complied with requirements of the regulations regarding the allocation.21 In each of these rulings, the taxpayer relied on Hewlett Packard Company, 67 T.C. 736 (1977), acq. in result, 1979-1 C.B. 1. which held that elections may be held to be effective where the taxpayer complies with the essential requirements of a regulation even though the taxpayer failed to comply with certain procedural directions therein.
Practitioners should review a client s prior gift tax returns to determine whether prior allocations of GST tax exemption were done properly. In cases where it is unclear, the practitioner should consider advising the client to request a private letter ruling before any additional allocation of exemption is made so that the client knows the exact amount of GST tax exemption that is remaining.
Allocating GST Tax Exemption During an Estate Tax Inclusion Period
There are special rules regarding the allocation of GST tax exemption during an estate tax inclusion period; these rules are commonly known as the ETIP rules. An ETIP is any period after a gift is made in which the value of the property transferred would be included in the transferor’s gross estate for estate tax purposes if the transferor died.22 For example, if an individual gifts a personal residence to a qualified personal residence trust, the term of the trust would be an ETIP because the value of the trust’s assets would be included in the transferor’s gross estate if the individual died during the trust’s term.
An individual is unable to effectively allocate GST tax exemption until the end of the ETIP.23 If an individual allocates exemption during an ETIP, the value of the property for GST tax purposes is the value of the property at the end of the ETIP or the value of the property upon the death of the transferor, whichever occurs earlier.24 Furthermore, an allocation of GST tax exemption during an ETIP is irrevocable.25
repared, the practitioner should determine whether an ETIP is involved. If so, the practitioner should consider whether GST tax exemption should be allocated, even though additional exemption may need to be allocated at the end of the ETIP if the property appreciates, or whether the practitioner can rely on his or her tickler system to remind him or her that GST tax exemption may need to be allocated at the end of the ETIP. The danger with allocating GST during the ETIP is that the property could depreciate and the allocation is irrevocable; thus, a portion of the GST tax exemption allocated could be wasted. The property could also appreciate and additional exemption would need to be allocated to exempt the trust from GST tax; the practitioner will need to monitor this growth very closely in an effort to maintain an inclusion ratio of zero. The danger with waiting until the end of the ETIP is that the practitioner could fail to advise the client that an allocation must be made at that time. To the extent possible, trusts should be drafted to avoid an ETIP.
the ETIP Rules
To avoid the issue of whether to allocate GST tax exemption during an ETIP, practitioners should consider using certain trust provisions to preclude the trust from having any GST tax potential. Three commonly used trusts to reduce estate tax exposure are the qualified personal residence trust (QPRT), the grantor retained annuity trust (GRAT), and the grantor retained income trust (GRIT).26 Each one of these trusts contains an ETIP because the value of the trust (or a portion of the value in some cases) would be included in the grantor’s gross estate if the grantor predeceases the term of the trust.27
The ETIP becomes a problem in the QPRT, GRAT, and GRIT if one of the beneficiaries predeceases the grantor. In most cases, if a beneficiary predeceases the time at which his or her remainder interest vests, the beneficiary’s descendants would ultimately receive the beneficiary’s share in the trust on a per stirpital basis. For example, it is not uncommon for such a trust to include a provision which distributes the balance of the assets to the grantor’s descendants, per stirpes, upon the expiration of the term of the trust. In such a case, if a nonskip person beneficiary predeceases the term, the distribution to the predeceased nonskip person’s descendants would be a GST, because such beneficiaries would be skip persons. Unless GST tax exemption is allocated to the trust, such an eventual distribution would be subject to GST tax and, in all likelihood, exemption would not have been allocated because of the ETIP rules.28
There are two ways to avoid the possible imposition of GST tax in the QPRT, GRAT, or GRIT without allocating GST tax exemption. First, the trust could be drafted so that the balance of the trust upon the expiration of the trust’s term would be distributed to nonskip persons only. For example, if the grantor of a QPRT wants his or her children to be the remainder beneficiaries of a QPRT, the terms of the trust could distribute the balance of the trust’s assets upon the expiration of the trust’s term in equal shares to the grantor’s children or the survivor(s) thereof. If the grantor wants his or her entire estate, including the value of the QPRT, to be divided evenly on a per stirpes basis, it would be necessary to include an equalizing provision in the grantor’s testamentary document to account for the possibility that one of the children could predecease the term of the QPRT. For example, if the grantor has two children, the grantor’s will or revocable trust could include a provision such as the following:
“Upon grantor’s demise, if either of grantor s children predeceases the term of [name of QPRT] and a distribution was made from [name of QPRT] to grantor’s child who survived the term of the [name of QPRT], the trustee shall distribute an amount equal to the amount distributed to the grantor’s surviving child from the [name of QPRT] to the descendants of the child who predeceased the term of the [name of the QPRT], per stirpes.”
A second, and perhaps simpler, alternative would be to include a provision in the trust which distributes the balance of the trust’s assets upon the expiration of the trust’s term evenly to the grantor’s children or to the estate of any predeceased child. While such a provision would avoid the complexities of an equalizing allocation, a distribution to a child’s estate could disrupt the grantor’s overall estate plan. For example, the child’s will could leave all of the child’s assets to the child’s surviving spouse, which may be contrary to the parents’ wishes.
The Separate Share Rules
One of the most significant traps for the unwary in the GST tax regulations is the separate share rule.29 In general, separate shares of a single trust will be treated as separate trusts for GST tax purposes only if the separate share exists from and at all times after the creation of the trust.30 The significance of this rule is that GST tax exemption cannot be allocated to a separate share of a trust unless such share existed from the inception of the trust. If a separate share of a trust has GST tax potential and such share was not established at the inception of the trust, it would be necessary to allocate exemption to the entire trust to exempt such share from GST tax. Such an allocation would unnecessarily use a portion of the exemption if any other share of the trust did not have GST tax potential.
The separate share trap is best understood by example. Assume that a grandfather establishes an irrevocable gifting or insurance trust for the benefit of his three children and seven grandchildren. It is contemplated that the grandfather will gift $100,000 to the trust and that such gift will qualify for the $10,000 annual gift tax exclusion31 under Crummey v. Com r. , 397 F.2d 82 (9th Cir. 1968). During the grandfather’s life, the trustee of the trust has the discretion to distribute income and/or principal to the children or grandchildren, in equal or unequal proportions, for health, education, maintenance or support needs. Upon the grandfather’s demise, the trust will be divided into four equal shares, one for each of the children (or the then living descendants of a predeceased child, per stirpes) and one for the grandchildren who survive the grandfather; the share for the grandchildren will be divided in equal shares for the surviving grandchildren at that time. In this scenario, the distribution to the grandchildren upon the grandfather’s demise will be subject to GST tax unless GST tax exemption is allocated to the trust. The problem is that exemption cannot be allocated to the share for the grandchildren only because the share for the grandchildren did not exist from the inception of the trust. If exemption is allocated, it must be allocated to the entire trust. Thus, GST exemption would be wasted with respect to the portion of the trust that would be ultimately distributed to the children.
In order to avoid the result in the preceding example, separate shares could be established at the inception of the trust for any share that would ultimately be distributed to a skip person. creating a separate share, the transferor could allocate GST tax exemption to such separate share. Language should also be included in the trust which treats any gift made to such a trust as being made proportionately to the separate shares. Such language should also trigger the automatic allocation rules previously discussed.32 Thus, if the transferor failed to allocate exemption on a gift tax return, it would automatically be allocated for him.
GST Tax Exclusion
Most clients are familiar with the $10,000 annual gift tax exclusion under §2503(b) of the Code. However, many clients are surprised to learn that there is a separate $10,000 annual exclusion rule under the GST tax provisions of the Code for gifts made in trust.33 In general, there are two ways to make a gift to a trust which qualifies under the $10,000 annual exclusion rule. First, a gift can be made to a Crummey trust; if the beneficiary is given a right to withdraw the gifted property for a reasonable period of time after the gift is made to the trust, the gift should qualify as a $10,000 annual exclusion gift for gift tax purposes.34 Second, a gift made to a §2503(c) trust qualifies as a $10,000 annual exclusion gift for gift tax purposes. While these gifts qualify as $10,000 gifts for gift tax purposes, there are additional rules that must be satisfied for a gift to qualify for the $10,000 annual gift tax exclusion for GST tax purposes when a gift is made to a Crummey trust. A gift to a §2503(c) trust impliedly qualifies for the $10,000 annual exclusion for GST tax purposes because the trust must be included in the beneficiary’s estate under §2503(c) if the beneficiary dies prior to attaining the age of 21, which is one of the requirements under §2642(c), as discussed below.35
Under §2642(c) of the Code, a gift to a trust will not qualify as a $10,000 annual exclusion gift for GST tax purposes unless 1) during the life of the beneficiary, no portion of the trust may be distributed to (or for the benefit of ) any person other than such beneficiary, and 2) if the trust does not terminate before the beneficiary dies, the assets of such trust will be included in the beneficiary’s gross estate. Accordingly, to satisfy these rules, a Crummey trust should only have one beneficiary and should include a provision which would cause the trust to be included in the beneficiary’s gross estate if the beneficiary predeceases the term of the trust.36
The requirement regarding the inclusion in the beneficiary’s estate is often overlooked in a Crummey trust. If such requirement is not satisfied, the transferor will need to use a portion of his or her GST tax exemption to prevent the imposition of GST tax. The requirement can be satisfied by including a provision in the trust which distributes the balance of the beneficiary’s trust to the beneficiary’s estate or pursuant to a testamentary general power of appointment exercisable by the beneficiary if he or she dies prior to the termination of his or her trust.
Tax Exemption to Charitable Lead Trust
A charitable lead trust (CLT) is a trust which pays a fixed amount to one or more charities for a fixed term or over a measuring life; at the end of the term or upon the death of the individual whose measuring life is being used, the balance of the trust is distributed to nonharitable beneficiaries ( i.e., individuals or noncharitable trusts for the benefit of individuals). There are two types of CLTs: a charitable lead annuity trust (CLAT) and a charitable lead unitrust (CLUT). A CLAT pays a fixed amount or a fixed percentage of the value of the assets contributed to the trust at inception; this amount does not change over time. A CLUT pays a percentage of the value of the assets at the beginning of each year; the annual amount changes each year as the value of the trust’s assets appreciate or depreciate.
A distribution at the end of the trust’s term to a skip person may be subject to GST tax. In order to exempt all or a portion of such a distribution from the tax, GST tax exemption would need to be allocated. However, there are special rules regarding the allocation of GST tax exemption to a CLAT, which do not apply to a CLUT.37 In general, it is impossible to allocate GST tax exemption to a CLAT with exact precision because the Code provides an adjustment to any allocation that is made to the trust. The adjustment is based on the §7520 rate used to compute the gift or estate tax charitable deduction for the actual period of the annuity. The amount of exemption that is allocated to the CLAT is increased by an amount equal to the interest that would accrue if an amount equal to the amount of exemption were invested at such rate, compounded annually.
While a taxpayer can certainly make certain assumptions regarding investment return on assets, it would be impossible to know the exact amount of GST tax exemption that should be allocated to a CLAT. Thus, if a practitioner drafts a CLAT with a skip person as a beneficiary, the practitioner should advise the client of the uncertainty regarding the allocation of GST tax exemption. The advisor may want to monitor the growth of the assets owned by the CLAT to determine whether additional GST tax exemption may need to be allocated at a later date.
Reverse QTIP Elections
Fortunately, the IRS has simplified the mechanism to make a reverse QTIP election under §2652(a)(3).38 On Schedule R (the GST tax schedule) of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, it is no longer necessary to make an affirmative election to make a reverse QTIP election. Part 1 of Schedule R states that “[y]ou no longer need to check a box to make a section 2652(a)(3)(special QTIP) election. If you list qualifying property in Part 1, line 9 below, you will be considered to have made this election.”39 As indicated in the instructions, prior estate tax returns required the preparer to check a box to make a reverse QTIP election.40
While on a going forward basis it appears to be very difficult to inadvertently not make a reverse QTIP election,41 practitioners who represent a surviving spouse should review Schedule R of the first dying spouse’s federal estate tax return to determine whether a reverse QTIP election was made on such return. If such an election was not made, the practitioner should then determine whether a QTIP election was made on Schedule M of the return.42 If such an election was made on Schedule M, the practitioner should review the QTIP trust to determine whether the QTIP trust has any GST tax potential. If the QTIP trust has GST tax potential, the practitioner should consider advising the surviving spouse to apply to the IRS for §9100 relief in order to make a late reverse QTIP election. In the past, the IRS has been very lenient in granting such relief.43
The determination of whether a QTIP trust has GST tax potential may not be so obvious. For example, if the QTIP trust contains a power of appointment, there may be GST tax potential. Specifically, if the surviving spouse has a limited power of appointment over the balance of the QTIP trust, the surviving spouse could exercise it in favor of skip persons which would be a GST; such an exercise would be subject to GST tax to the extent GST tax exemption is not available to prevent the imposition of the GST tax.
If a reverse QTIP election was not made and it is possible to obtain §9100 relief, it may not be too late to utilize the first dying spouse’s GST tax exemption, even though the surviving spouse’s federal estate tax return was already filed and a closing letter may have already been received. using the first dying spouse’s GST exemption, the surviving spouse will have additional GST tax exemption to use elsewhere.
The issues discussed in this article represent only a few of the traps in the GST tax provisions of the Code. Undoubtedly, Chapter 13 of the Code contains a complex set of rules. Whenever a practitioner is preparing an estate planning document that contains a provision that may distribute an asset to a skip person at some point in time, or whenever a practitioner is advising a personal representative of an estate or trustee of a trust that may distribute assets to a skip person, the practitioner should consider the GST tax issues; unfortunately, these issues are not usually very obvious and can often be overlooked.
1 Unless otherwise stated, all references to the Internal Revenue Code or the Code are to the Internal Revenue Code of 1986, as amended.
2 Proposals for Certain Amendments to the Generation-Skipping Transfer Tax, by members of the American Institute of Certified Public Accountants and other professional organizations (1998).
3 Robert L. Mosham, Avoiding a GSTT Asteroid , 13 Probate & Property 24 (March/April 1999)
4 I.R.C. §2641(a)(1).
5 I.R.C. §2001(c).
6 I.R.C. §§2601, 2611, 2612, 2613, 2621, 2622 and 2623. There are certain exceptions to the imposition of the tax, such as the predeceased ancestor exception. See,e.g. , I.R.C. §2651(e).
7 I.R.C. §2631(a). The Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997), included a provision which would index the exemption, beginning in 1999, for inflation. In 1999, it was increased to $1,010,000. Rev. Proc. 98-61, 1998-52 I.R.B. 18. In 2000, it was increased to $1,030,000. Rev. Proc. 99-42 I.R.B. 568.
8 I.R.C. §2632.
9 A skip person is a natural person who is two or more generations below the transferor’s generation, or a trust in which all beneficial interests in the trust are held by skip persons or there is no person holding an interest in the trust and at no time after such transfer may a distribution be made from such trust to a non-skip person. I.R.C. §2613(a).
10 I.R.C. §2632(b).
11 A non-skip person is any person who is not a skip person. §2613(b).
12 Treas. Reg. §26.2632-1(b)(2)(i).
13 Treas. Reg. §26.2632-1(b)(2)(ii).
14 Treas. Reg. §26.2632-1(b)(1)(ii).
15 Treas. Reg. §26.2642-2(a)(2).
17 In 1999, the GST tax exemption was increased to $1,010,000. Rev. Proc. 98-61, 1998-52 I.R.B. 18.
18 In general, the inclusion ratio is the percentage of the trust that will be subject to GST tax upon a GST. See 2642.
19 Treas. Reg. §26.2632-1(b)(2)(i).
20 See, e.g., Priv. Ltr. Rul. 200017013 (January 20, 2000), Priv. Ltr. Rul. 199919027 (February 16, 1999); Priv. Ltr. Rul. 199909034 (December 4, 1998).
21 Id .
22 I.R.C. §2642(f)(3).
23 I.R.C. §2642(f)(1).
24 I.R.C. §2642(f)(2).
25 Treas. Reg. §26.2632-1(c)(1). But see Private Letter Ruling 199922045, in which the IRS concluded that an allocation of GST tax exemption made during an ETIP relating to a transfer made prior to December 27, 1995, the effective date of the final GST tax regulations, was void.
26 While §2702 of the Code effectively repeals the GRIT when the remainder beneficiary of such a trust is a descendant of the grantor, this type of trust is extremely effective when the remainder beneficiary is a niece or nephew of the grantor or an unrelated individual.
27 A detailed discussion of the QPRT, GRAT, and GRIT is beyond the scope of this article.
28 The predeceased ancestor exception in §2651(e) of the Code would not protect such a distribution from GST tax because such exception does not apply when the descendant of the grantor dies after the initial transfer of property is made to the trust.
29 Treas. Reg. §26.2654-1.
30 Treas. Reg. §26.2654-1(a)(1)(i).
31 See §2503(b).
32 Treas. Reg. §26.2654-1(a)(4).
33 See §2642(c).
34 Crummey v. Com’r ., 397 F.2d 82 (9 th Cir. 1968).
35 See, e.g ., Priv. Ltr. Rul. 9321055 (February 26, 1993); Priv. Ltr. Rul. 9218040 (January 30, 1992).
36 Under §2503(c), the trust must be payable to the minor beneficiary’s estate or the beneficiary must have a general power of appointment in order to qualify as §2503(c) trust.
37 I.R.C. §2642(e).
38 A reverse QTIP election is made to reverse a QTIP election made under §2056(b)(7) or §2523(f). When such an election is made, the donor spouse (when a gift is made to an inter vivos trust during life) or decedent spouse (when the decedent spouse leaves assets to a QTIP trust) remains the transferor for GST tax purposes. If such an election is not made, the donee or surviving spouse becomes the transferor for GST tax purposes.
39 See IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return (Rev. July 1999).
40 Until 1997, it was necessary to check a box to make a reverse QTIP election.
41 While it is difficult, it is not impossible. If a QTIP election is made on Schedule M of the return and the QTIP trust is not listed on Schedule R, a reverse QTIP election would not be made.
42 Similar to the reverse QTIP election, it is not necessary to affirmatively make a QTIP election on Schedule M in order for a QTIP trust to qualify for QTIP treatment, provided that the QTIP trust is identified on Schedule M.
43 See, e.g. , Priv. Ltr. Rul. 200015023 (January 11, 2000); Priv. Ltr. Rul. 200008038 (November 22, 1999). See also Douglas L. Siegler, When Bad Things Happen to Good People: Relief for Missed Tax Elections , 32 Philip E. Heckerling Inst. on Est. Plan. (1998).