Business Succession Planning Texas

The Pursley Law Firm business succession planning attorney can assist you with family, small business and gift tax issues in Houston, Dallas, Fort Worth and throughout Texas.

Estate and gift taxes are levied on transfers of assets, rather than on the assets themselves. Assets held in trust can escape this transfer taxation entirely at the death of the beneficiary if the beneficiary does not have too much control over the trust. Therefore, a generation-skipping trust can save significant estate taxes by "skipping" the taxable estates of the beneficiaries. The following example illustrates the problem:

Grandfather dies in 2006, leaving $2,000,000 to a trust for the benefit of Mother (after payment of all estate taxes in Grandfather's estate). Mother receives support distributions throughout her life. At her death, the trust has grown to $3,000,000, and Daughter becomes the new beneficiary. At Daughter's death, the trust corpus has grown to $4,000,000, and Grandson becomes the new beneficiary.

If Grandfather had left the $2,000,000 directly to Mother, her estate would have to pay $1,350,000 in estate taxes on the $3,000,000 she has at her death (assuming she has other assets equal to the estate tax exemption amount, and the estate tax rate is 45%). So Daughter would inherit only $1,650,000. Assuming the same rate of growth, Daughter will have $2,200,000 at her death, and the estate tax on this will be $990,000. Grandson will receive $1,210,000, instead of the $4,000,000 in the first example. A generation-skipping trust would have saved $2,790,000 in future dollars.

GST Tax Exists to Limit Generation Skipping

The generation-skipping transfer tax is designed to prevent the tax savings of skipping estate tax. The generation-skipping transfer tax taxes the trust at the end of each generation in an amount similar to what the estate tax would have been. In some situations, the GST tax takes a much greater bite than the estate tax would have taken, and can create greater administrative hassles. As a result, it is rarely better to pay GST tax instead of estate tax. The draconian nature of the GST tax suggests that it isn't intended to raise revenue so much as it is to force assets back into the estate tax system. However, one result of the system's design is that an attorney who is not familiar with it can accidentally create an estate plan that increases taxes instead of avoiding them. Despite the existence of the GST tax, generation-skipping planning opportunities are still available, and a savvy planner can make the most of them for clients who are interested in saving taxes for future generations.

GST Tax Taxes Generation-Skipping Transfers

 The GST tax is levied on "generation-skipping transfers." Under IRC  §2601 (IRS Code)

Generation-skipping transfers come in three flavors:

  • Direct skips
  • Taxable distributions
  • Taxable terminations

[IRC §2611.]

Whether a transfer fits in one of these categories depends on whether a "skip person" is receiving some of the property in some form. [IRC §2612.] Thus, the GST tax is essentially a tax on transfers to skip persons.

Definition of Skip Person

An individual is a "skip person" if he or she is assigned to a generation that is two or more generations below the transferor. [IRC §2613(a)(1).]

This definition, and the policy behind the GST tax, leads to the following rules of thumb:

  • Grandchildren are skip persons, but children are not
  • Ancestors are never skip persons, no matter how many generations away; the GST tax falls only on downstream transfers
  • A spouse (or former spouse) of the transferor is never a skip person, even if the spouse is much younger than the transferor. [IRC §2651(c)(1)]
  • The spouse of a descendant of the transferor is assigned to the same generation as the descendant. [IRC §2651(c)(2)]
  • A trust is a skip person if all of the beneficiaries are skip persons. [See IRC §2613(a)(2) and the discussion later]

A non-skip person is anyone who is not a skip person. [IRC §2613(b).] Technically, only trusts and individuals can be skip persons. However, corporations, partnerships, and other entities can be treated as trusts for GST purposes. [See IRC §2652(b) (defining "trust" to include "any arrangement (other than an estate) which, although not a trust, has substantially the same effect as a trust").]

Therefore, a charity (which by definition can have no individual owners or beneficiaries) is a non-skip person, but a "family corporation" that exists to hold investment property and make periodic distributions to family members is treated as a trust and can be a skip person.

Descendants of Grandparents and the 25-year Rule

The same skip person rules apply to collateral relatives of the transferor, as long as they are descendants of a grandparent of either the transferor or the transferor's spouse (or former spouse). [IRC §2651(b)(1).]

However, if a recipient falls outside of this category, a generation is defined as 25 years, with the transferor deemed to be in the exact middle of his generation. [IRC §2651(d).] Thus, the generation below the transferor begins 12.5 years after the transferor's date of birth, and ends 37.5 years after the transferor's date of birth. [IRC §2651(d)(2).] Anyone who is more than 37.5 years younger than the transferor is a skip person under this rule. [IRC §2651(d).]

Therefore:

  • A first cousin who is 40 years younger than the transferor is not a skip person, because a first cousin is a descendant of the transferor's grandparents, and thus is subject to the rule of IRC §2651(b) (which is based on relationship instead of age)
  • A second cousin who is 40 years younger than the transferor is a skip person because IRC §2651(b) does not apply. Second cousins are descendants of a great-grandparent, but not of a grandparent, and thus would fall under the 25-year rule of IRC §2651(d)

Move-up Rule

If a descendant of the transferor is deceased at the time the transfer is made, that descendant's children (and more remote descendants) are each moved up a generation. [IRC §2651(e)(1).] This is illustrated by the following example:

If Daughter dies and is survived by her child Grandson, Mother can make direct gifts to Grandson without GST tax consequences, because Grandson is no longer a skip person. However, gifts to Grandson's children are still subject to GST tax because they are treated as being two generations below Mother.

The Move-up Rule applies only to the transferor's descendants (and the descendants of the transferor's spouse or ex-spouse). However, if the transferor has no descendants, the rule is extended to the descendants of the transferor's parents (e.g., grandnephews and grandnieces whose parents are deceased). [See IRC §2651(e)(1)(A) (limiting application to individuals who are descendants of the transferor's parent) and IRC §2651(e)(2) (further limiting application to transferor's descendants unless transferor has no living descendants at the time of the transfer).]

The Move-up Rule applies only if the non-skip person is dead at the time the transfer is subject to estate or gift tax. [IRC §2651(e)(1)(B).] However, in the case of a QTIP trust, the transfer is not considered to be made until the death of the transferor's spouse (assuming that no reverse QTIP election has been made).

Amount of GST Tax

Rate

The GST tax has only one tax rate: the maximum estate tax rate in effect at the time of the transfer. [IRC §2641.]

As the Economic Growth and Tax Relief Reconciliation Act of 2001 lowers the top estate tax rate from 55% to 45%, the GST rate has been going down with it. The GST rate is 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007 through 2009. [See IRC §2001(c)(2) ("phasedown" of maximum estate tax rates).] In 2011, EGTRRA will expire under its sunset provision, and the rate will go back up to 55%, unless Congress acts to make the rate change permanent.

Exemption

The GST tax rate is applied to the value of the transferred property, after subtracting any GST exemption allocated to the property or trust that is involved in the transfer.

Starting in 2004, every transferor has a lifetime exemption against GST tax equal to the estate tax exemption equivalent. [IRC §2631(c).] Thus, the GST exemption is $1,500,000 in 2004 and 2005, $2,000,000 in 2006 through 2008, and $3,500,000 in 2009. [See IRC §2010(c) (table of applicable credit amounts).] In 2011, unless Congress intervenes, the GST exemption will be determined under the law in effect before 2001, under which it was $1,000,000, indexed for inflation from 1998. [IRC §2631(c) (prior code provision).]

The size of the exemption opens several tax planning opportunities. If the exemption is $1,500,000, a testator can use it to create a $1,500,000 dynasty trust that will last for several generations, without losing principal to estate taxes or GST taxes at each generation level. Married transferors can double that initial amount to $3,000,000. Alternatively, transferors can allocate small amounts of the exemption to lifetime gifts, so that an irrevocable life insurance trust can be made wholly exempt from GST taxes.

Inclusion Ratio

Tax Rate is Multiplied by the Inclusion Ratio

Every generation-skipping transfer has an inclusion ratio. The inclusion ratio is a fraction between 1 and zero, and can be 1 or zero as well. [IRC §2642.] The GST tax rate is multiplied by the inclusion ratio before it is used to calculate the tax. [IRC §2641(a).] Thus, if a generation-skipping transfer made in 2006 has an inclusion ratio of 1/2, the rate applicable to that transfer is 23%: 1/2 times 46%, the maximum federal estate tax rate for 2006.

Computation of the Inclusion Ratio

If no GST exemption is allocated to the property or trust involved in the transfer, the inclusion ratio is 1, so that the transfer is taxed at the full GST rate. If GST exemption is allocated, and the amount allocated is equal to the value of the property being transferred in a direct skip (or the initial value of a generation-skipping trust), the inclusion ratio is 0, so that the transfer or trust is wholly exempt from the GST tax. [IRC §2642(a)(1)-(2).]

If the GST exemption is less than the value of the property or trust, the transfer will have a fractional inclusion ratio equal to 1 minus the "applicable fraction." [IRC §2642(a)(1).] The numerator of the applicable fraction is the amount of the GST exemption allocated, and the denominator is the value of the transfer on the date of the transfer (minus any estate or death taxes paid out of any trust receiving the transfer, or any charitable deduction allowed for the transfer). [IRC §2642(a)(2).]

Two Trusts Can Simplify Administration and Minimize Taxes

If a trust is destined to have a fractional inclusion ratio, it is usually preferable to create two trusts, so that one trust can have an inclusion ratio of 0, and the other can have an inclusion ratio of 1. This eliminates the administrative burden of keeping track of the inclusion ratio. The two trusts can be given names that indicate which one has the ratio of zero, such as: The "Smith Exempt Trust" and the "Smith Non-Exempt Trust."

Having two trusts also allows the trustee to administer them differently to attain tax advantages. The exempt trust can be invested for growth, while the non-exempt trust can be invested for income, so as to limit the growth of the portion that will generate GST tax at the next taxable termination. The trustee has the flexibility to make distributions out of one trust or the other, after taking into account the nature of the distribution, the applicable tax, the generation assignment of the beneficiary, etc. For example, distributions to skip persons might usually be made out of the exempt trust, to avoid generating GST taxes. However, a distribution to pay educational expenses of a skip person might be paid out of the non-exempt trust instead, because educational expenses are excluded from the definition of generation-skipping transfer, and this exclusion would be effectively wasted if the distribution is made out of an exempt or partially exempt trust. [IRC §2611(b)(1).]

Creating two trusts also gives the transferor the ability to avoid GST entirely without losing the benefits of the exemption. The non-exempt trust can grant each beneficiary a testamentary general power of appointment, so that estate tax will be paid at each generation level instead of GST tax. [See Treas Reg §26.2612-1(b)(1)(i).] But the exempt trust can avoid both estate taxes and GST taxes for as long as the Rule Against Perpetuities allows.

If a will creates a generation-skipping trust that is larger than the GST exemption, it is not possible to add general powers of appointment after the death of the testator. However, it is possible to divide the trust into a non-exempt and exempt trust, if the will or state law authorizes such division. [Treas Reg §26.2654-1(b)(1)(ii).] The two trusts must provide in the aggregate for the same succession of interests of beneficiaries as the original trust. [Treas Reg §26.2654-1(b)(1)(ii)(A).] If the division does not meet the requirements of the Treasury Regulations, then the GST Exemption will have to be allocated pro rata between the two trusts, and each one will have the same fractional inclusion ratio.

Division Into Two Trusts May Be Made at Any Time

Before the Economic Growth and Tax Relief Reconciliation Act of 2001, a division of a testamentary trust was required to be made before the estate tax return is due in order to avoid the pro rata allocation. [Treas Reg §26.2654-1(b)(1)(ii)(B) (certain divisions would still be recognized as timely made if the executor attaches a statement to the return that indicates how the trust will be divided and the divided trusts funded).] However, beginning in 2001, trusts with fractional inclusion ratios can be divided at any time into two trusts, one exempt and one non-exempt. [IRC §2642(3)(C).] This statute, authorizing "qualified severances," promises to greatly simplify the administration of generation skipping trusts that were not divided at the appropriate time. However, unless Congress intervenes, this provision will sunset in 2011, so tax plans must still be made with the old law in mind. [See also IRC §2654(b) ("nothing in this chapter shall be construed as authorizing a single trust to be treated as 2 or more trusts").]

However, the timing flexibility of IRC §2642(3)(C) applies only if the trust is divided into two trusts in such a manner that one will have an inclusion ratio of 1 and the other will have an inclusion ratio of 0. [IRC §2642(3)(B)(ii).] Congress clearly intended for this provision to solve only the problem of fractional inclusion ratios. If it is desirable for some reason to create separate trusts with varying fractional inclusion ratios, the division must be made under the old rules and before the due date of the estate tax return. [Treas Reg §26.2654-1(b)(3) ("An individual's GST exemption under §2632 may be allocated to the separate trusts created pursuant to this section at the discretion of the executor or trustee").]

If the trust instrument is silent on the issue of division, Texas law authorizes division of the trust without a judicial proceeding if such division will "result in a significant decrease" in taxes. [Prop C §112.057.] Because it is not clear what would constitute a "significant" decrease, it is prudent to include a division of trusts provision in the will or trust document. Also, an explicit provision can authorize additional purposes for division, and can eliminate the requirement that beneficiaries receive 30 days' advance notice of the division.

Direct Skips vs. Taxable Distributions & Terminations

Direct Skips

A direct skip is a transfer that is both:

  • Subject to gift or estate tax
  • Made to a skip person

All outright gifts to skip persons are direct skips.

Payment of the Tax

For direct skips, the transferor (or his executor) is liable for the GST tax on the transfer. [IRC §2603(a)(3); Treas Reg §26.2662-1(c)(iii)-(v).] The taxable amount is the value of the property received by the transferee. [IRC §2623.] Thus, the transferor does not have to pay GST tax on the GST tax itself; direct skips are tax-exclusive. However, the transferor does have to pay estate or gift taxes on the amount of GST taxes paid; the estate tax allows no deduction for GST taxes paid, and the payment of GST taxes is treated as an additional gift subject to gift or estate tax. [IRC §2515.]

For taxable terminations, the trustee is liable for the GST tax on the transfer. [IRC §2603(a)(2).] The taxable amount is all of the property with respect to which the tax occurred, minus a deduction for administration expenses and other items that are deductible for estate tax purposes under IRC §2053. [IRC §2622.] The tax is paid out of the property that is the subject of the transfer, unless the governing instrument provides otherwise. [IRC §2603(b).] Because there is no deduction for GST taxes paid, taxable terminations are tax-inclusive. Unlike with direct skips, the tax is based on the entire value of the trust, not the net amount.

For taxable distributions, the recipient is liable for the GST tax on the transfer. [IRC §2603(a)(1).] The taxable amount is the property received by the recipient, plus any GST tax paid by the trustee out of other assets of the trust. [IRC §2621 (the recipient can deduct expenses associated with paying the GST tax).] Thus, taxable distributions are also tax-inclusive.

The tax-inclusive or tax-exclusive nature of a transfer can have a significant effect on the total amount of GST taxes paid. Not having to pay tax on the tax can save a lot of dollars. However, the only way to avoid this is with a direct skip, which typically means paying the GST taxes earlier in time. Indeed, it may sometimes be preferable to add non-skip beneficiaries to a trust to defer GST taxes. [But see Treas Reg §26.2612-1(e)(2)(ii) ("An interest which is used primarily to postpone or avoid the GST tax is disregarded for purposes of chapter 13."] The decision of whether to make direct skips or not will depend on a number of factors, including the relative ages of the beneficiaries, the intended distributions of the trust, and the amounts involved.

Exclusions

Annual Exclusions

A direct skip that qualifies for the gift tax annual exclusion may also be excluded from the GST tax, if either:

  • The transfer is made outright
  • The transfer is made to a trust that (i) has only one beneficiary and (ii) will be included in the beneficiary's estate for federal estate tax purposes

[IRC §2642(c)(2)]

Medical & Educational Expenses

A transfer for the benefit of a skip person is not a generation-skipping transfer if it is made to pay for the medical expenses or tuition of that skip person. [IRC §2611(b)(1).] This is the same exclusion as the one allowed for gift tax purposes. [IRC §2503(e); IRC §2611(b)(1) (granting the exclusion for GST purposes whenever the gift tax exclusion applies).]

There is no dollar limit on this exclusion, and it is available in addition to the annual exclusion. [Treas Reg §25.2503-6(a).]

The transfer must be made directly to the educational institution or medical provider. [Treas Reg §25.2503-6(b).] Therefore, a transfer to a trust that is required to use the funds to pay the beneficiary's tuition does not qualify for the exclusion. [Treas Reg §25.2503-6(c), Example (2).] Similarly, a transfer made directly to the skip person as reimbursement for qualifying expenses does not qualify for the exclusion. [Treas Reg §25.2503-6(c), Example (4).]

The tuition exclusion applies only to tuition at a qualifying educational institution. [See Treas Reg §25.2503-6(b)(2).] It does not cover room and board, books, or supplies. [See Treas Reg §25.2503-6(b)(2).] However, the student does not need to be a full-time student. [See Treas Reg §25.2503-6(b)(2).]

Transfers to prepaid tuition plans (also known as 529 plans) do not qualify for this exclusion. [IRC §529(c)(2)(A)(ii); see also Treas Reg §25.2503-6(b)(2) (qualifying educational institution must maintain faculty and regular curriculum).] However, tuition that is prepaid directly to a particular school may qualify for the exclusion. [Technical Advice Memorandum 199941013 (10/18/1999) (allowing the exclusion where Grandmother prepaid 10 years worth of tuition at her grandchildren's private elementary and secondary school, under a written agreement with the school that made the payments nonrefundable).]

The medical expense exclusion applies to medical expenses that are deductible for income tax purposes; over-the-counter medications are not included. [Treas Reg §25.2503-6(b)(3).] The exclusion will not apply if the expenses are reimbursed by the skip person's health insurance.

General Powers of Appointment

A person making a generation-skipping transfer can usually avoid GST taxes by granting a general power of appointment to the person whose estate is being skipped. If the property is included in a person's estate for federal estate tax purposes, that person will become the "transferor" for GST purposes, even if that person is not the person who originally transferred the property. [IRC §2652(a)(1)(A).] Since "skip person" is defined by reference to who the transferor is, changing the transferor can convert a skip person into a non-skip person, which can prevent the transfer from being classified as a generation-skipping transfer.

Allocation of the Exemption

Whether or Not to Allocate

If a person has an estate that exceeds the amount of the GST exemption, the exemption must be allocated among the bequests. [For the size of the exemption, see §15:21.] If a person makes taxable gifts during his lifetime, he must choose whether to allocate GST exemption to those gifts (although in some cases allocations may be automatic).

Allocating the GST exemption to a lifetime transfer is not always desirable, because of the potential for wasting it. Unlike the estate tax, which is generally calculated at the time of transfer, the GST tax may not be payable until many years after the initial transfer, or may not ever become payable.

Timely Allocations vs. Late Allocations

A transferor allocates the GST exemption to a transfer by electing to do so on a gift tax return (or on an estate tax return, if the transferred property is included in the transferor's gross estate). An allocation of the GST exemption to a lifetime transfer does not have to be made at the time of transfer, but can be allocated at any time between the date of transfer and the due date of the transferor's estate tax return (including extensions actually granted).

However, a late allocation can have consequences:

  • If the allocation is made on a timely filed gift tax return for the year of the transfer, the gift is valued as of the date of transfer. [Treas Reg §26.2632-1(b)(2)(ii)(A)(1) (effective date of allocation); IRC §2642(b)(1) (valuation of transferred property)]
  • If the allocation is made on a later gift tax return, the gift is valued as of the date the gift tax return is filed. [Treas Reg §26.2632-1(b)(2)(ii)(A)(1) (effective date of allocation); IRC §2642(b)(3) (valuation of transferred property); see also Treas Reg §26.2632-1(d)(1) (allocations made after the transferor's death with respect to lifetime transfers that are not included in the gross estate should be made by the executor on a gift tax return, not the estate tax return)]

An allocation made on a timely filed gift tax return becomes irrevocable on the due date for that gift tax return. [Treas Reg §26.2632-1(b)(1)(ii).] Any other allocation is irrevocable when made. [Treas Reg §26.2632-1(b)(2)(ii)(A)(2).]

If the transferred assets increase in value after the date of transfer, a late allocation results in more GST exemption being used up by that particular transfer. Thus, it usually pays to make the allocation sooner rather than later.

Retroactive Allocations

Late Allocation may be Treated as Timely

In certain circumstances, a late allocation is treated as a timely allocation. That is, the property is valued as of the date of transfer, even if the allocation is not made until years later. [IRC §2632(d); IRC §2642(g).]

A retroactive allocation may be made by the transferor if a non-skip person dies before the transferor. For other circumstances, the transferor must apply for a private letter ruling. Both of these rules became effective in 2001; before that, no retroactive allocations were allowed.

Statutory Retroactive Allocations

The transferor can retroactively allocate GST exemption to a trust if a non-skip beneficiary predeceases the transferor. [IRC §2632(d).]

The predeceasing non-skip beneficiary must be a descendant of the transferor's grandparent (or a descendant of a grandparent of the transferor's spouse), and must be assigned to a generation below that of the transferor. [IRC §2632(d)(1)(B)(i).] Furthermore, the transferor must make the allocation on a timely-filed gift tax return for the year of the predeceasing non-skip beneficiary's death.

Under these circumstances, the allocation is effective as of immediately before the beneficiary's death, and the property is valued as of the date it was originally transferred to the trust. This rule eliminates a significant amount of the risk inherent in not allocating the GST exemption at the time of the transfer, making it easier to plan from the beginning. It also avoids imposing a draconian tax on families in which deaths occur out of order.

Extensions in Individual Cases

In any situation not covered by IRC §2632(d), a transferor who misses the deadline for a timely allocation must apply for a private letter ruling to get an extension of the deadline.

In granting such extensions, the IRS will consider all relevant circumstances, including evidence of intent contained in the trust instrument. [IRC §2642(g)(1)(B).] The transferor must also show that he acted reasonably and in good faith, and that the granting of the extension will not prejudice the interests of the government. [Treas Reg §301.9100-3(a).] For example, a transferor will be deemed to have acted in good faith if he reasonably relied on erroneous professional advice, or if his request for relief is filed before the failure to make a timely election is discovered by the IRS. [See Treas Reg §301.9100-3(b)(1).]

The IRS has granted a number of extensions under the new rules. In one case, a husband and wife were granted an extension of time to allocate GST exemption to lifetime trusts after their CPA failed to follow their attorney's instructions. [Private Letter Ruling 200229032.] In another case, the executor was granted an extension of time to allocate GST exemption to inter vivos transfers in trust. [Private Letter Ruling 200235013.]

Deemed Allocations

Basic Rules

Unallocated Exemption is Deemed Allocated

If neither the transferor nor his executor makes any GST exemption allocation before the due date of the appropriate estate or gift tax return, the deemed allocation rules apply. [See IRC §2632.] Some of the deemed allocation rules have existed since the current GST tax was enacted, but additional rules were added in 2001.

Original Rules

Before 2001, deemed allocation occurred in only two situations:

  • After the transferor's death
  • To direct skips made during the transferor's lifetime

[IRC §2632(b)(1).]

Thus, before 2001, if a transferor created a generation-skipping trust that had non-skip beneficiaries, his GST exemption would not be automatically allocated to it until after his death. If the transferor wanted to make the trust exempt from the date of transfer, he would have to file a gift tax return. After the transferor's death, any unused GST exemption is automatically allocated first to direct skips made at the transferor's death, and then, if any GST exemption remains, to all testamentary trusts (or inter vivos trusts that still exist at the time of the transferor's death) that might someday produce a taxable termination or taxable distribution. [IRC §2632(e).] If the unused GST exemption is insufficient to fully cover all transfers within one of those two categories, the exemption is allocated pro rata among the transfers in that category. [Treas Reg §26.2632-1(d)(2).] The transferor can elect out of the deemed allocation rules on a timely-filed gift tax return (for transfers not included in the gross estate) or estate tax return (for transfers included in the gross estate). [Treas Reg §26.2632-1(d)(1).] A deemed allocation to an inter vivos direct skip becomes irrevocable on the due date of the gift tax return for the year of the transfer, and is effective as of the date of the transfer. [Treas Req §26.2632-1(b)(1)(ii).] All other deemed allocations become irrevocable on the due date for the transferor's estate tax return, and are made using values as determined for federal estate tax purposes. [Treas Reg §26.2632-1(d)(1).]

New Rules

Lifetime Transfers

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) retained the original rules for deemed allocations, but added deemed allocations for certain lifetime transfers that are not direct skips.

Beginning January 1, 2001, a transferor's GST exemption is automatically allocated to any lifetime transfer that is capable of producing a taxable termination or taxable distribution in the future, unless a statutory exception applies. [See IRC §2632(c).] As with the other provisions of EGTRRA, this statute will sunset in 2011 unless Congress acts to make it permanent. The new rules were designed to deal with the common problem of the client who creates a generation-skipping trust, then fails to follow through on filing annual gift tax returns.

Indirect Skip and GST Trust

The new rules introduce two new terms: the "indirect skip" and the "GST trust."

An "indirect skip" is any transfer that is all of the following:

  • Not a direct skip. [For what is a direct skip, see §15:40]
  • Subject to gift tax (whether or not gift tax is actually paid). This would include annual exclusion gifts
  • Made to a GST trust. [IRC §2632(c)(3)(A)]

A "GST trust" is a trust that could have a generation skipping transfer (unless it meets one of the listed exceptions). [IRC §2632(c)(3)(B).] The transferor's unused GST exemption is automatically allocated to any indirect skip made during his lifetime, unless he elects otherwise on a timely filed gift tax return. The exceptions to the "GST trust" definition are the core of the new rules. The definition of "GST trust" represents a legislative attempt to divide generation-skipping trusts into two categories:

  • Those that are likely to produce a GST transfer
  • Those that are not likely to produce a GST transfer

If a trust is not likely to produce a GST transfer, then the transferor probably did not intend to allocate GST exemption to the trust, so the statute does not automatically allocate it.

Exceptions to GST Trust Definition are Confusing

Despite the laudable goal of the new allocation rules, the end result is a statutory scheme that is confusing and vague, and likely to frustrate the intent of many taxpayers. In general, a trust will not be a GST trust if any of the following apply:

 

  • 25% of the corpus must be distributed to (or may be withdrawn by) non-skip persons before age 46 (or upon an occurrence that may reasonably be expected to occur before age 46, if Treasury Regulations have been issued to define "reasonably")
  • 25% of the corpus must be distributed to (or may be withdrawn by) non-skip persons "who are living on the date of death of another person identified in the instrument (by name or by class) who is more than 10 years older than" the distributes
  • 25% of the corpus must be distributed to the estates of non-skip persons (or is subject to a general power of appointment exercisable by such persons) if they die before becoming entitled to distribution under the previous two sections
  • Any part of the corpus would be included in a non-skip person's estate if he died immediately after the transfer - but a right to withdraw the gift tax annual exclusion amount (or less) will not count
  • The trust is a charitable lead annuity trust, a charitable remainder annuity trust, or a charitable remainder unitrust
  • The trust is a charitable lead unitrust with a non-skip beneficiary

[IRC §2632(c)(3)(B)(i)-(vi).] Although these exceptions seem straightforward, it can be difficult to determine how they apply to particular situations.

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