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Generation Skipping Transfer -- Trusts and Taxes
Generation Skipping Trusts aren’t just for the very wealthy. They are a good way for families to transfer assets from the grandparents’ generation to their grandchildren and great-grandchildren without exposing those assets to several levels of tax. If the second generation in a family is already comfortable financially, the grandparents can set up a generation-skipping trust providing for all of their descendants--children, grandchildren, even great-grandchildren. This ensures that all of the descendants can benefit from the trust assets, allowing the grandchildren or great-grandchildren to eventually receive the remaining funds without the imposition of estate taxes first when the children (second generation) die, and AGAIN when the grandchildren die.
For example, a moderately wealthy older couple could provide in their revocable trust that on their deaths some or all of their estate pass into a generation-skipping trust, reserving the ultimate distribution for their grandchildren, while still making the trust assets available to their children (also know as lifetime beneficiaries) for their needs. If the couple transferred those assets outright to the children, and then the children transferred the assets to the grandchildren, the assets could be taxed twice, each time at the estate tax rate of about forty-five percent (45%). The tax is imposed when the assets pass from the grandparents to their children, and then again when the assets pass from their children to their grandchildren. By establishing a generation-skipping trust, the couple makes sure the assets are taxed only once, at the time of the initial transfer to the trust.
Generation Skipping Transfer (GST) trusts are also often used to save a family’s wealth from ex-spouses and creditors by providing protection for family assets. Because the children (second generation) never technically own the assets (they only have a right to distributions for reasonable needs), the trust assets have some protection from the claims of creditors or divorcing spouses in that second generation.
If a child in the second generation goes through a nasty divorce, the divorcing spouse can't lay claim to a share of the assets in the GST trust, because the assets legally don't belong to the child or his/her ex-spouse. They're for the benefit of the entire group of descendants of the grandparents. Also, if the grandparents fear that one of their children is a spendthrift and would waste his inheritance quickly, a generation-skipping trust allows the child to have access to the trust assets but not necessarily direct control over the amount or timing of distributions.
Likewise, if a child funds a start-up company and provides personal guaranties and the company drowns in debt, the trust assets can't be directly tapped to pay the debts, because the child doesn't own those assets. The assets would also be protected in the event of other financial catastrophes, such as large gambling debts or an uninsured car accident. A creditor could get a judgment against the child, but they can't go directly after the assets in the trust, because the assets wouldn't be assets of the child.
Of course, the IRS is not going to allow you to pass all of your wealth to future generations without imposing a tax. That tax is the Generation Skipping Transfer Tax. GST tax is a second transfer tax that is imposed in addition to the estate or gift tax on transfers to skip persons. A skip person is a person assigned to a generation which is two or more generations below the generation assignment of the transferor, i.e., the transferor’s grandchild or great grandchild. (IRC 2613(a)(1)).
The IRS does allow unlimited transfers to skip persons to cover tuition expenses which are made directly to the provider of the qualified educational services, or to cover medical expenses made directly to the provider of qualified medical services. Those payments are excluded from the definition of a generation skipping transfer (and are excluded as taxable gifts as well).
Additionally, the IRS gives you an exemption (an amount you can pass without incurring GST tax--similar to the estate tax exemption) so careful estate planning to utilize that exemption is important. The exemption is the limit on the amount that can be transferred into a GST trust without incurring GST tax. In 2009, the exemption amount was $3,500,000, but in 2010 there is total repeal of the GST tax. Unfortunately, the GST tax is restored in 2011 with a rate of 55% and the possibility of only a $1,120,000 exemption. So, any transfers to a GST trust in excess of that limit will be subject to gift or estate tax when the senior generation passes along the assets to children, and an additional GST tax when the middle generation of beneficiaries (children) die and the property is transferred to the third-generation beneficiaries (grandchildren).
When you have an individual who wishes to benefit her children and more remote issue you need to do some planning. If the individual transferor simply leaves assets to a very large trust (exceeding the transferor’s GST tax exemption) for the benefit of her children and more remote issue, she effectively wastes her GST tax exemption. Distributions from the trust to grandkids and more remote issue would be subject to a partial GST tax.
So, if you decide to draft a trust where the assets are held in trust for the lifetimes of your children, ultimately passing to future generations, it is necessary to include provisions to avoid the GST tax. In order to minimize or eliminate the tax, your trust should have provisions that allow two trusts to be created; one wholly exempt from GST tax (the GST exempt trust), and one that would be entirely subject to GST tax (the GST non-exempt trust). Distribution to non-skip (or second generation) beneficiaries could be made from the GST non-exempt trust. The non-skip beneficiary can also be given a general testamentary power of appointment over the GST non-exempt trust.
When the non-skip beneficiary of a trust has a general testamentary power of appointment over the trust, GST tax is avoided. In such case, the assets of the trust are includable in that non-skip beneficiary’s gross estate for federal estate tax purposes. Because the assets of the trust are included in the non-skip beneficiary’s estate, that non-skip beneficiary will be treated as the current transferor of trust assets for purposes of the GST tax. Even if skip persons are the remainder beneficiaries of the trust, their receipt of trust assets is not a generation skipping transfer if they are one generation below the non-skip or lifetime beneficiary of the trust who is now deemed the transferor.
For example, parents create a trust for their child for life with remainder to that child’s children. If child is given a general power of appointment over the trust assets, the trust will be included in child’s estate and distributions to grandchildren will not be subject to GST tax. Because child is treated as transferor, grandchild will not be considered a skip person.
This plan works best when child does not have an estate large enough to cause estate tax liability so it is advantageous to trigger inclusion in child’s estate rather than subject the trust to a GST tax.
The above technique is also good to use when the GST trust exceeds the amount of your GST tax exemption.
To review, to avoid the GST tax the trust is divided into a generation-skipping tax exempt trust, and a generation-skipping tax non-exempt trust. Each child is given a general power of appointment over her non-exempt, or GST taxable trust, so that it will be included in her estate at estate tax rates which are likely to be less than the generation-skipping tax rate. The GST tax exempt trust will go on to grandchildren avoiding GST tax because it is exempt. If child is not given a general power of appointment the entire GST tax non-exempt trust will be subject to GST tax.
The calculation of the GST tax is confusing to say the least, and just when you think you may have mastered it, you realize that it changes depending on the factors involved. Because of the complexity, this memo will not try to explain the calculation of the GST tax in great detail. Instead it will briefly discuss how it is calculated and give a few examples and leave the actual number crunching to the CPAs.
How the GST tax is calculated depends on the taxable event, and there are three types of taxable events: direct skips, taxable distributions, and taxable terminations.
A direct skip transfers assets to skip persons and the GST tax is imposed at the same time as the estate or gift tax because no non-skip person has a present interest in the transferred property at that time. An example of a direct skip is a direct gift to a grandchild or to a trust benefitting only grandchildren. A direct skip is subject to gift or estate tax as well as GST tax. A transfer to a trust solely for the benefit of a grandchild is a direct skip subject to GST tax but subsequent distributions from the trust to grandchild are not treated as taxable distributions and the termination of the trust in favor of that grandchild is not treated as a taxable termination. After the initial transfer to the trust, for purposes of subsequent distributions, the transferor is treated as assigned to the generation immediately above the grandchild’s generation. (If a great grandparent makes a large gift to great grandchild and both grandparent and parent are still alive, only one taxable direct skip occurs even though the property skips two or more generations, and only one GST tax payment is made.)
A taxable distribution occurs when there is a distribution from a trust to a skip person. This occurs when a trustee makes a distribution of trust income or principal to a skip person that does not qualify as a direct skip or a taxable termination. A taxable distribution can also be constructive i.e. the lapse of a power of appointment.
A taxable termination occurs when the interest of the last non-skip person terminates. An example of a taxable termination is when a grandparent sets up an irrevocable trust for a child that provides that a on the child’s death the trustee distribute remaining property to grandchild. When the child dies, a taxable termination occurs and GST tax is imposed when the trustee turns the remainder trust assets over to the grandchild.
Liability for payment of the GST tax depends on the taxable event causing the tax (IRC 2603). If a taxable distribution occurs, the transferee must pay the GST tax. If a taxable termination or direct skip from a trust occurs, the trustee of the trust pays the GST tax. If the taxable event is a direct skip that is not a direct skip from a trust, the transferor must pay the GST tax.
The GST tax rate is the maximum federal estate tax rate multiplied by the inclusion ratio. Consequently, calculation of the inclusion ratio becomes very important. Because a generation skipping transfer may be wholly or partially exempt due to the imposition of the GST exemption, only the portion of the generation skipping transfer that is not exempt or excluded is effectively subject to the GST tax. The non-exempt portion is calculated using the inclusion ratio and applicable fraction.
The inclusion ratio adjusts the tax rate of any given generation skipping transfer. It is simply one minus the applicable fraction determined for the trust from which such transfer is made or, in the case of a direct skip, the applicable fraction determined for such direct skip. Defining the inclusion ratio this way ensures that the inclusion ratio will always be some number between zero and one. Because the inclusion ratio is multiplied by the maximum federal estate tax rate to achieve the applicable tax rate, it is best to achieve an inclusion ratio of zero for trusts.
The applicable fraction referred to above is calculated as follows. The amount of GST exemption allocated to a trust or allocated to property transferred in a direct skip divided by the value of the property transferred to the trust or involved in the direct skip less the sum of any federal estate tax or state death tax actually recovered from the trust attributable to the transferred property; and any gift or estate tax charitable deduction allowed with respect to the transferred property.
For example, assume that in 2007 transferor makes a cash gift of $2,212,000 to his granddaughter. This cash gift is clearly a direct skip. The first $12,000 of this gift automatically has an exclusion ratio of zero because the first $12,000 of a gift in 2007 would have been subject to the annual exclusion. Transferor’s GST exemption, assuming it hasn’t been used for other gifts, was $2,000,000 in 2007. If Transferor allocates the full $2,000,000 to the gift, the applicable fraction is $2,000,000 (the amount of exemption allocated) divided by $2,200,000 (the value of the property transferred, which is not reduced by any death tax paid, or charitable deduction, but which is reduced by the IRC 2503(b) annual exclusion amount, which is excluded as a generation-skipping transfer). In this example, the applicable fraction is .909 and the inclusion ratio is 1 minus the applicable fraction, which equals .091. (The inclusion ratio is always rounded to the nearest 1,000th). The applicable tax rate is, therefore, .091 times the maximum federal estate tax rate of 45%, which equals .04095 or 4.095%. This tax rate is multiplied by the entire taxable amount of $2,200,000 to result in a GST tax of $90,090. Because this is a lifetime direct skip outside a trust, this tax is paid by Transferor.
As you can see from the above example, protecting as much of your assets as possible from GST tax is very important. As you can also see, any inclusion ratio other than zero or one causes complexity and difficulty in calculating tax and can and should be avoided. The use of separate trusts for the same beneficiaries, one with an inclusion ratio of zero and the other with an inclusion ratio of one, facilitates easier trust administration. This can be accomplished by giving the trustee of a GST trust the discretion to create separate trusts and apply transferor’s entire GST tax exemption to one trust and none to the other, and then giving the middle generation beneficiary a general power of appointment over the non-exempt trust, as described earlier in this memo.
A further planning technique allows the surviving spouse some flexibility in using and applying a GST tax exemption. A little background on this technique is useful. A qualified terminable interest property (QTIP) election allows more of a decedent’s estate to qualify for the marital deduction while still giving the decedent some control over the disposition of the assets. A QTIP election is an election made for gift and estate tax marital deduction planning only. A reverse QTIP is made for GST tax purposes and it basically says to ignore the QTIP election for GST planning.
A reverse QTIP election is commonly used to avoid GST tax. Typical estate plans which seek to avoid estate tax at the death of the first spouse create a minimum of three trusts: one utilizing the decedent spouse’s applicable exclusion amount (the credit shelter, exemption, or bypass trust); one qualifying for the marital deduction (the marital or QTIP trust), and one containing the surviving spouse’s property (the survivor’s trust). Generally, if the GST exemption is identical to the annual exclusion amount, the exemption trust will be entirely exempt from estate, gift, and GST taxes. However, it is possible that, at the death of a spouse, these amounts would be different.
For example, Husband and Wife have a collective estate of $10,000,000, of which $1,000,000 is Husband’s separate property. Husband makes a lifetime gift of $1,000,000 cash to his children from a prior marriage, using his separate property. If the remaining assets are community property, then Husband’s estate at his death is approximately $4,500,000. If Husband died in 2007, his remaining applicable exclusion amount would be $1,000,000, which is the $2,000,000 applicable exclusion less his $1,000,000 lifetime gift. Under the typical estate plan, the survivor’s trust would be funded with $4,500,000, the exemption trust would be funded with $1,000,000, and the QTIP trust would be funded with $3,500,000. The GST exemption is $2,000,000 as Husband’s GST exemption was not affirmatively or automatically allocated to any GST transfer during his lifetime. It is easy to allocate the first $1,000,000 of Husband’s GST exemption to the exemption trust, causing that trust to have a zero inclusion ratio. The excess $1,000,000 GST exemption can be allocated to the marital trust, which must distribute income entirely to the surviving spouse, and the surviving spouse must be the sole lifetime beneficiary of the trust. The QTIP trust would be included in the estate of the surviving spouse and thus the surviving spouse would become the transferor for GST tax purposes. As a result, Husband would have lost at least $1,000,000 of his GST exemption. If a reverse QTIP election is made then Husband would not lose any of his GST exemption.
The surviving spouse cannot make a reverse QTIP election on part of the trust, but most estate plans of this nature allow the trustee to divide the QTIP trust into two trusts, one of which is wholly exempt from GST tax (benefitting from the reverse QTIP election) and the other which is not wholly subject to GST tax. The inclusion ratio of the exempt trust would be zero and the inclusion ratio of the non-exempt trust would be one.
Trusts with provisions for grandchildren and great-grandchildren are a wonderful estate planning tool, as long as the provisions are properly drafted and the administration of the trust is handled by someone with an understanding of the GST tax. As shown in this memo, GST trusts and the possible tax that comes with them is something to be carefully considered and discussed because improper planning can have expensive and unwanted results.