Generation Skipping Transfer: Trusts and Taxes
I. Overview of the Generation-Skipping Transfer Tax
- Reason behind the GST Tax. The federal generation-skipping transfer (“GST”) tax is primarily designed to prevent the tax-free transfer of wealth from a grandparent to his grandchild or great-grandchild. Prior to the advent of the GST tax, families could avoid the death tax that is imposed upon each generation by skipping a generation or two on at least a portion of the wealth. Thus, a family could bypass death taxes at least once or twice as the family wealth moved down the bloodline.
- History. The GST tax, originally enacted in 1976 and subsequently superseded by the current law enacted in 1986, represents Congress’ effort to stop these generation-skipping tax-free transfers. Instead, the new tax laws impose a tax at each generation regardless of whether the assets have actually been used or enjoyed by each generation.
- The Current Law. Thanks to the new American Taxpayer Relief Act of 2013 (“ATRA”), the GST tax rates and exemptions are again unified with the Gift and Estate tax rates and exemptions. Under ATRA the law currently allows each person a $5.25 million exemption from the GST tax ($5 million, indexed for inflation). For a married couple, the amount is doubled ($10.5 million). The maximum tax rate for GST, Gift and Estate taxes is now 40%.
- Combined Tax Rates. In the event GST tax is imposed together with either Estate or Gift tax, the two taxes together could equal up to 64% of the assets above the exemption amounts, so that only a small portion goes to the grandchild.
II. Characteristics of GST Trusts
- Dynasty Trusts. GST trusts are sometimes called Dynasty Trusts or Legacy Trusts. (Caution: GRATs are not GST exempt). Using such trust allows for GST exempt trust assets to remain outside of the transfer tax system until distributed free of trust. As such, GST trusts are usually established as continuing trusts without a set date for distribution. Instead distributions are generally discretionary. Otherwise, the GST exemption is lost upon termination of the trust.
- Grantor Trusts. Usually a GST trust is a Grantor Trust, while the grantor is living. Upon the death of the grantor a Grantor Trust will become a complex trust, with its own Federal Tax ID number and the responsibility to report and pay taxes for itself. Grantor Trusts are created when the Grantor of a trust retains for himself or herself one of the powers listed in IRC §§ 671-679.
- Independent Trustee. If discretionary distributions are allowable under the trust instrument to exceed the ascertainable distribution standard (i.e., health, education, maintenance and support), then distribution approval must be received by an Independent Trustee, as defined in Internal Revenue Code (“IRC”) Section 672(c). The person appointed as an Independent Trustee may only be a qualified corporation or a person who would be independent as to the grantor and beneficiaries (i.e., not subordinate and not related).
- Limited Powers of Appointment. The GST trust should expressly prohibit any grantor or beneficiary from exercising a power of appointment, either directly or indirectly, in favor of himself or herself, his or her estate, his or her creditors or the creditors of his or her estate. A power of appointment should not apply to any “incidents of ownership” with respect to life policies insuring the life of a beneficiary which are owned by a GST trust. Powers of appointment can also not be made in favor of anyone to whom the grantor or beneficiary owes a support obligation.
- Rule Against Perpetuities. Consider using a state where the Rule Against Perpetuities (RAP) has been repealed or extended. The RAP laws for the “Big Six” are as follows:
- Nevada – Interest is valid if it actually vests either within a life or lives in being plus 21 years or within 365 years. Nev. Rev. Stat. §§ 111.103 to 111.1039, effective Oct. 1, 2005.
- Delaware – In 1995, the RAP was repealed for personal property. Real property held in trust must be distributed not later than 110 years from the later of its purchase or its other acquisition by the trust. 25 Del. Code § 503(b), effective July 18, 1996.
- South Dakota – RAP abolished in 1983. S.D. Cod. Laws §§ 43-5-1, 43-5-8, 55-1-20.
- Alaska – No RAP, however, must exercise powers of appointment within 1,000 years. Alas. Stat. §§ 34.27
- Wyoming – Interest is valid if it actually vests either within 1,000 years. Wyo. Stat. § 34-1-139(a).
- Utah – Interest is valid if it actually vests either within a life or lives in being plus 21 years or within 90 years. Utah Code §§ 72-2-1201 to 72-2-1209.
- Future of GST Trusts. President Obama’s 2012 budget would have provided that on the 90th anniversary of the creation of a trust the GST exclusion allocated to the trust would terminate. Understand that GST trusts might be on the chopping block.
- GST Carve-out Provisions and Trustee Discretion to Allocate GST Exemption. Revocable trusts should be established such that the trustee is either required to carve-out GST exempt assets (setting them aside in a separate trust) or in the least the trustee should be provided with the discretion to allocate GST exemption to trusts upon the death of a grantor. When allocating to the QTIP or Credit Shelter Trust, allocation should be done in such a way as to create an inclusion ratio of either one or zero for all trusts.
- Problems with Multiple Grantors. Because GST exemption must be allocated to a GST exempt trust, problems might arise where multiple people (grantors) contribute property to a trust. If one grantor allocates GST exemption to his or her trust transfer and another grantor does not, then the exclusion ratio of the trust (ratio of trust assets excluded from GST tax) will be greater than zero, thereby leading to additional complexity in accounting, distribution, and tax-paying decisions.
- Power to Remove and Replace Trustees. A beneficiary of a GST trust may have the power to remove and replace trustees, so long as the trustee to be appointed is Independent, as set forth in IRC Section 672(c), or so long as such trustee to be appointed is limited to making distributions under an ascertainable standard.
- Use of Trust-owned Personal and Real Property. To the extent advisable or practical by the Trustee, a beneficiary of a GST trust can use and enjoy trust owned property. Proper care should be taken to make sure any such trustee authorizing such use and enjoyment is doing so as an Independent Trustee under IRC Section 672(c), or that such enjoyment constitutes use under an ascertainable standard.
- GST Trusts Should have S-Corp Language. Because GST Trusts are established to exist in (near) perpetuity, they should have provisions allowing the trust to own Subchapter S corporation stock. Qualified Subchapter S Trusts can be set up under Section 1361(d) of the Code (“Qualifying Subchapter S Trust” or “QSST”) or under Section 1361(e) of the Code (“Electing Small Business Trust” or “ESBT”).
III. Allocating GST Exemption & Types of Skips
- Allocation of Exemption. In order for the assets of a trust to be exempt for GST tax purposes, GST exemption must be allocated to such trusts upon gift or at the time of death. Allocation upon gift is made in the Grantor’s Form 709 Federal Gift Tax Return. Allocation upon death would be made in the Grantor’s From 706 Federal Estate Tax Return.
- Types of Skips. On Schedules A and D of Form 709 (for gifts) and Schedule R of Form 706 (for estates) it is necessary to allocate GST exemption direct skips, and permissible to allocate GST exemption to indirect skips. A direct skip occurs when a trust is established solely for skip persons. An indirect skip occurs when a trust is set up for both skip persons and non-skip persons.
- Automatic Allocation for Indirect Skips. Where a trust is set up for both skip and non-skip persons, it is generally advisable to allocate GST exemption to the trust from the outset, because it can be difficult to determine how much of the trust assets, if any, will ultimately be distributed to skip persons versus non-skip persons. In the event non-skip persons require use of GST trust assets where the inclusion ratio is zero, the Trustee might make a loan of trust assets, rather than an outright distribution, to avoid unnecessary wasting of exempt assets. Where a GST trust has a carve-out of assets with an inclusion ratio of one, those assets should first be distributed to non-skip persons, if possible.
IV. Taxable Distributions and Terminations
- Taxable Distributions. Taxable distributions occur when non-exempt assets (where inclusion ratio is equal to one) are distributed to a skip-person. At such time, any non-exempt assets will be subject to the 40% GST tax.
- Taxable Terminations. A taxable termination occurs at the time all of the non-skip persons become deceased or otherwise become ineligible as beneficiaries of a non-exempt trust (where the inclusion ratio is equal to one), leaving only skip-persons as permissible beneficiaries. At such time, any non-exempt assets will be subject to the 40% GST tax.
- Obligation to Pay. IRC Section 2603 provides that the liability for payment depends upon the event causing taxation. With taxable distributions, the transferee beneficiary must pay the GST tax. When a taxable termination occurs, the trustee of the trust is responsible for paying the GST tax. If the taxable event is a direct skip from the outset, the transferor (grantor) pays the GST tax.
V. Other Odds and Ends
- Tuition and Medical Services. Current tax law does allow unlimited transfers to skip persons to pay qualified tuition expenses made directly to the provider of those services, or to cover medical expenses where payments are made directly to the provider of those services.
- A Word on Portability. Unless an outright gift to skip person(s) is made upon the death of a first spouse, the use of some type of a GST trust is necessary to preserve the GST exemption of the first spouse to die. Even though our new estate tax laws make the estate tax exemption automatically portable from one spouse to another, no such portability option exists with respect to the GST tax exemption.
- Beneficiary should be aware of Inclusion Ratio. For non-exempt GST trust assets with an inclusion ratio of 1, the beneficiary should be allowed some form of a general power of appointment such that prior to, or at death, the beneficiary can appoint those assets in such a way as to utilize his or her own GST exemption. Without this provision, the beneficiary’s own GST exemption may be lost upon the beneficiary’s death.