The CPA Journal

A direct skip involves a transfer of an interest in property to a skip person. Although certain trusts may qualify as skip persons, generally the term refers to persons two generations below that of the transferor. An example of a direct skip is when a grandmother gives a grandchild an outright gift of $100,000. A taxable termination occurs when a trust terminates in favor of a skip person. Similarly, a taxable distribution is any distribution (other than a direct skip or termination) from a trust to a skip person.

If a trust terminates in favor of skip persons, a taxable termination occurs and the GST tax generally applies. The tax is deferred in situations where a non-skip person (e.g., a son or daughter) has an interest in the trust property. GSTs may result even when they are not anticipated. For example, a trust for children may terminate in favor of grandchildren if a child dies prior to receiving the trust corpus, a possibility that often occurs in insurance trust planning; failure to include tax-planning provisions may subject the trust principal to unnecessary tax.

The GST tax is imposed at the maximum federal estate tax rate applied to the portion of the transfer subject to tax. The GST tax rate will decline along with the scheduled federal estate tax rate reductions under the 2001 Tax Act (from 50% in 2002 to 45% in 2007). In addition, the GST tax exemption will increase along with the scheduled increase in the applicable exclusion amount.

Although the GST tax is scheduled to be repealed in 2010, planning is important under present law and as a precaution if outright repeal fails to occur. For example, if a taxpayer creates a trust for her child for life and upon the child’s death to the child’s descendants, the child’s death will result in a taxable termination. Alternately, if the taxpayer establishes a trust allowing the trustees to sprinkle trust income or principal in favor of a spouse and descendants, any distributions made to the taxpayer’s spouse or children would not be considered taxable distributions. Payments made to her grandchildren, however, would be considered taxable distributions. Under the new rules, it is irrelevant whether such distributions are made from income or principal. The tax is based upon the maximum estate tax and gift tax rate multiplied by the inclusion ratio (the percentage of the transfer that exceeds the GST tax exemption allocated to the transfer).

For example, in a trust with $1 million and no GST tax allocated exemption, the inclusion ratio is one and the tax rate is the maximum estate tax rate. If the taxpayer allocates all of her exemption to the trust, the inclusion rate becomes zero and thereafter all transfers from this trust are free of GST tax, even if the trust dramatically increases in value above the exemption amounts. If she allocates only $500,000 of her exemption to the trust, the inclusion ratio is .5 and the effective tax rate is .5 times the then maximum estate tax rate. The GST exemption can be allocated during life or by the executor after death.

Use the Exemption Effectively

The above examples show that effective use of the GST exemption is crucial in tax planning and a key element in estate tax planning. An individual is permitted to allocate the GST exemption in the manner that best utilizes it. Allocations may also be made by an executor, and the IRC provides for automatic allocation in certain instances. If allocations are not made, the IRC and Treasury Regulations specify the order and manner of the exemption’s allocation.

Automatic Allocations

The 2001 Tax Act provides more flexibility in making GST allocations. Prior to the 2001 Tax Act, an automatic allocation applied only to direct skips, which could avoid GST tax if the skip was less than the transferor’s unused exemption. No automatic allocation was applied to taxable terminations or distributions, however.
Under the 2001 Tax Act, if an individual makes an indirect skip to a GST trust [defined in IRC section 2632(c)(3)], the available unused exemption is automatically allocated to provide for the smallest GST taxable event.

An example of such an indirect skip would arise in a life insurance trust in which children receive principal after age 46 and grandchildren are contingent or successor beneficiaries. (The definition of a skip trust given in the 2001 Tax Act includes trusts that could be a GST trust with respect to the transferor unless the trust provides that more than 25% of the trust corpus must be distributed to, or withdrawn by, a non-skip person before that person reaches age 46. For example, a trust that provides for such distributions on the child’s 45th birthday is not a GST trust.)

An individual can reject this automatic allocation by making an election on a timely filed gift tax return for the calendar year. Such an election may be desirable in the first years of insurance trusts when cash value accumulations for premiums paid are less than the cash value increases in the policy held by the trust. In such a case, a late allocation will result in less utilization of the exemption. If the indirect skip does not exceed the unused exemption, no GST tax will result.

An election to allocate the GST exemption to a specific transfer may be made at any time before the transferor’s estate tax return is filed. Generally, the allocation is made on a timely filed gift tax return for the year of the transfer, making the value subject to GST tax the value for gift tax purposes. Before the 2001 Tax Act, if an allocation was not made on a timely filed gift tax return, then the value for GST tax purposes was the value on the date of the allocation. If the gift or trust had appreciated in value, the higher value would be used, resulting in more taxes or more exemption used.

Inadvertent Failure to Allocate

Prior to the 2001 Act, there was no relief for an inadvertent failure to elect an allocation of GST tax exemption to a transfer, but the 2001 Tax Act adopted allocation rules that should minimize problems in this area. Also, the 2001 Tax Act directed the IRS to issue regulations that allow late allocations when the taxpayer intended a particular allocation of exemption and inadvertently failed to do so. The statute requires that the IRS’s decision be based on all facts and circumstances.

If the IRS grants relief from the failure to timely allocate the GST exemption, then the value on the date of transfer to the trust would be used for determining the exemption. In most cases this will be beneficial to the taxpayer; therefore, the IRS may often refuse to grant such discretion. Statements of intent to minimize GST tax and create a trust with the lowest possible inclusion ratio may be helpful. Taxpayers should rely on timely GST allocations rather than the IRS’s discretion.

General Power of Appointment

Wills and trusts should contain provisions that will assist fiduciaries in minimizing the GST tax and properly allocating that tax to the intended beneficiaries. Clear drafting will avoid conflict among beneficiaries. One alternative would be for the planning instruments to include a provision that grants a power of appointment to a trust beneficiary. This power is usually granted only with the consent of an independent party, or “consenter.” For example, if the amount of the GST tax exceeds the estate tax paid by the estate of the child, it may be advantageous to appoint principal upstream so that it is included in the child’s estate. Alternatively, a child may be granted a power of appointment sufficient to include the amount in the child’s taxable estate. A general power of appointment may include, for example, the power to appoint to the beneficiary’s creditors or to the beneficiary’s estate.

Consideration should also be given to using the power of appointment when the prior estate is in a lower bracket. The amount included in the power of appointment would be limited to such amount that would not increase the net death taxes in the child’s estate over the amount of the aggregate GST. Such a clause might include a provision that taxes are to paid out of the amount subject to the power of appointment unless the beneficiary’s will specifically states otherwise, thus protecting other beneficiaries from having to pay an unfair allocation of the GST.

To preserve the intended distribution of assets, the general power of appointment may be available only with the consenter’s consent. The consenter is selected by the taxpayer and is included in the will or trust. More than one person may be selected, and they should be individuals whose exercise of such power would not result in estate inclusion to any person other than the intended beneficiary. To minimize conflict, the consenter should be independent and not have an interest in the property subject to the power.

Allocation of GST Exemption to a Specific Trust

Wills and trusts should include provisions that allocate the GST exemption in accordance with the individual’s wishes.

It is advisable to allocate the GST exemptions so that one trust has an inclusion ratio of zero and one trust has an inclusion ratio of one. All distributions to non-skip persons should be taken from the trust that would be subject to the GST. The GST tax can be eliminated by completely depleting this trust. Any general power of appointment would also be first allocated to the trust with an inclusion ratio of one.

Wills and trusts should be drafted to include provisions that provide clear guidance for executors and trustees in determining how to make allocations and distributions. If the trust is to provide sprinkling powers for children and grandchildren, then payments to the grandchildren would come out of the trust with an inclusion ratio of zero, thereby avoiding the GST. The planning instruments should also include provisions that would allocate any new receipts, such as from pourover wills, to this trust, so the exemptions do not become mixed. Clear directives for the executors and trustees demonstrate the decedent’s intent to meet the various requirements of the IRC and Treasury Regulations. The documents should also delineate where mandatory distributions of principal and income should first be charged. The allocation will differ whether the distribution is being made to a skip person or a non-skip person.

Qualified Severance of Trusts

In order to receive the benefits above, it may be necessary to divide a single trust into two: one exempt, one taxable. The new rules help facilitate this.

Under the Treasury Regulations, if a single trust is drafted to contain substantially separate and independent trust shares for different beneficiaries, each share may be treated as a separate trust. This will help trustees in allocating the GST exemption. The document should, however, include the authority for the trustee to allocate available exemption to specific trusts, in accordance with the testator’s intent. The IRC clearly states that additions to and distributions from such trusts are allocated pro rata among the separate trusts—unless the governing instrument expressly provides otherwise. Therefore, it is extremely important for the governing instrument to contain provisions allowing the executor to allocate the exemption in a non–pro rata manner.

Prior to the 2001 Tax Act, a single trust included in the gross estate could be divided only if certain requirements were met:

In order to rely on the discretionary authority under the trust instrument, the terms of the new trust could not differ with respect to the interest of the beneficiaries.

The 2001 Tax Act provides for similar requirements and procedures and removes some burdens contained in the prior regulations. Under the 2001 Tax Act, trusts may be severed provided that such a division is made on a fractional basis and that the terms of the new trusts, in the aggregate, provide for the same succession of interests of beneficiaries as provided in the original trust. Under the 2001 Tax Act, a qualified severance under the 2001 Tax Act may now be made at any time (rather than before filing the federal estate tax return).

Under the prior regulations, the executor was also required to provide the proper disclosure on the estate tax return. The executor was required to indicate that separate trusts will be created, describe the manner in which the trust was to be severed, and disclose how the trust was to be funded. The prior regulations were a trap for the unwary and did not provide for extensions.

The prior regulations also provided that the disclosure should indicate whether the trusts were severed on a fractional basis. The new statute incorporates this requirement. The divided trust will include an appropriate amount of appreciated assets, or, if expressed as a pecuniary amount, a fair allocation of assets reflecting the net appreciation or depreciation from the valuation date to the date of severance. The purpose of this requirement is to avoid saddling one trust with a larger amount of tax liability or asset appreciation. The IRS is attempting to eliminate this ability to increase the value of the exempt trust at the expense of the non-exempt paying trust.

Notwithstanding the flexibility of the new statute, the governing documents should provide for severance and allocation. Precise drafting will provide guidance to the trustees and executors and minimize conflict. Inclusion of appropriate GST provisions will help avoid the costs and uncertainty of a proceeding in the Surrogates Court.

The allocations and disclosure required by the regulations should be made on Schedule R of the decedent’s federal estate tax return. Recent private letter rulings (PLR) have allowed extensions to sever trusts for GST tax purposes. In PLR 20004008, the executors properly allocated the decedent’s unused GST exemption to a trust provided in the will; however, they failed to indicate that the trust would be severed and failed to sever the trust at the time of the filing. The IRS determined that the will provided sufficient evidence of the taxpayer’s intended allocation of the exemption to the exempt trust and that the executors acted reasonably and in good faith. The IRS granted an extension of 60 days from the date of the ruling to sever the trust.

The 2001 Tax Act allows the qualified severance to be made at any time under the terms of the governing instrument or local law. The 2001 Tax Act also directs the IRS to prescribe forms and reporting requirements.

Substantial Compliance

Although the 2001 Tax Act provides helpful remediation of some troublesome aspects of the GST tax, the rules are still complex. In recognition of this, the 2001 Tax Act now allows the IRS to grant “substantial compliance” relief in instances where the taxpayer intended to achieve a certain allocation but failed to properly do so. The IRS must consider all relevant circumstances, including the governing instrument. Clear directives and expressions of intent are important in all documents. This is consistent with the holding of PLR 20004008.

Retroactive Allocation

As already mentioned, a taxable termination or distribution may result when none was intended. A transferor would not generally allocate the GST exemption to a trust that the transferor expects will benefit only children and non-skip persons. If the child dies unexpectedly, however, the 2001 Tax Act allows a transferor to make a retroactive allocation of any unused GST exemption. The allocation is made to previous transfers to a trust in chronological order. (The child must be a lineal descendent of the transferor’s grandparent or of a grandparent of the transferor’s spouse or former spouse, and is assigned to a generation below the transferor and predeceases the transferor.)

The retroactive allocation election is made on a timely filed gift tax return for the calendar year in which the non-skip person died. The value of such a transfer for GST tax purposes is calculated as if a timely GST tax allocation election occurred.