September 18, 2023
Generation Skipping Transfer Tax – Alive and Well
Take-Away: Many ‘old’ irrevocable trust may soon be terminating or entering into new phases, where the generation skipping transfer tax (GSTT) will increasingly apply, with non-skip beneficiaries dying and with skip persons becoming eligible to receive trust distributions. Reacquainting ourselves with the GSTT rules is probably timely as these ‘old’ trusts start to mature.
Background: The generation skipping transfer tax (GSTT) was born in 1985. Since the GSTT exemption currently is $12.92 million most of us tend to ignore it. However, the reality is that since this GSTT has been around for 37 ½ years, many distributions from irrevocable trusts may now start to be subject to the GSTT. [IRC 2601 to IRC 2664.] Understanding the GSTT and how its exemption is applied is a challenge, to say the least.
GSTT: Some of the GSTT basics follow as part of our understanding of how to deal with the tax.
GSTT Rate: The GSTT rate is 40%, in addition to the federal estate tax or the federal gift tax.
GSTT Transfers: The GSTT applies to lifetime transfers that occur after September 25, 1985 and to testamentary transfers by individuals who die after October 22, 1986. Trusts in existence before those dates are exempt from the GSTT tax, so long as no new contributions are made to those exempt trusts, or those trusts are not modified to extend their exempt duration to other trust beneficiaries. (That’s the easy part!)
Skip Persons and Direct Skips: If a transfer is made outright or to a trust in which the only beneficiaries are skip persons, i.e. the transferor’s grandchild or younger, or to a non-relative individual who is 37 ½ years younger than the transferor, then the transfer is a direct skip, and the GSTT may be due at the time of the transfer.
Indirect Skip: If the transfer is made to a trust that includes a non-skip person as a beneficiary e.g. the transferor’s child, then the transfer is classified as an indirect skip. The transfer itself does not cause a GSTT. Instead to the extent that the trust is not exempt from the GSTT, then the GSTT applies to certain distributions from the trust, i.e. to a grandchild of the transferor-settlor.
Taxable Distributions: If a trust is not fully exempt from the GSTT, transfers to beneficiaries who are skip persons are taxable distributions. In the case of a taxable distribution, the transferee, i.e., the beneficiary-grandchild, must pay the GSTT by April 15 of the year after the distribution is made. The trustee files Form 706-GS(D-1) to report that transfer and provides a copy to the grandchild-beneficiary.
Taxable Termination: If the interests of all non-skip persons terminate, and only skip persons are left as beneficiaries, there is a taxable termination.
Example: An irrevocable trust is created by Ron for his children’s lifetime. When Ron’s lasts child dies, the trust terminates with the distribution of trust assets to Ron’s then living grandchildren in shares of equal value. The termination of Ron’s trust will result in a taxable termination. With a taxable termination, the entire trust is subject to the GSTT. The trustee then files a Form 706-GS(T) and the trustee pays the GSTT. [IRC 2612(a).]
‘Move Down’ Rule: If a taxable termination occurs, the transferor is deemed to move down one or more generations for purpose of generation assignment, such that a new generation is now considered non-skip persons. [IRC 2653.] Then, on the death of the last member of that generation, another level of GSTT will result.
GSTT Exemption Allocation: As noted above, the GSTT exemption is currently $12.92 million. However, as a surprise to many, the GSTT exemption it cannot be ported to a surviving spouse. The allocation of that GSTT exemption is when some bewildering rules come into play. A transferor can apply his/her GSTT exemption to a trust and make the trust exempt from GSTT altogether. Consequently, this exemption is a critical tool to avoid GSTT for future generations, e.g., a dynastic trust that is to continue well beyond the common law Rule Against Perpetuities, where the distributions to trust beneficiaries like great, great grandchildren will be without any gift, estate or GSTT.
Determination of GSTT Exempt Status: The allocation of GSTT exemption to transfers during life is reflected on a Form 709 Gift Tax Return. An allocation of the GSTT exemption at death is reported on Form 706, Schedule R. Trustees need to be aware of these returns to ascertain if a trust is fully GSTT exempt. These returns are the starting point in this analysis.
Automatic Allocations: The GSTT can also be automatically allocated based on a set of default rules applicable to the kind of transfer. These rules apply whether or not that automatic allocation is reflected on the completed tax return or whether the return was even filed. For a transfer on death, unless the decedent opts out of those automatic rules on a timely filed federal estate tax return, a decedent’s unused GSTT exemption will be automatically allocated based on an order of priority. [IRC 2632(e).] For lifetime transfers, unless the donor opts out of those rules on a timely filed gift tax return, the GSTT exemption is automatically allocated to a transfer to a trust which is defined as a GST Trust that occurs on or after January 1, 2001. [IRC 2632(c)(3)(A).]
GST Trust: The automatic GSTT exemption allocation rules are intended to be logical. If a trust has a certain potential to skip generations, the law presumes that the transferor intends to allocate his/her GSTT exemption to the transfer to the trust. The problem is that that the definition of GST Trust is rule based and that definition can be overbroad in its application, resulting in allocations that the settlor did not want to make. These highly technical rules of a GST Trust will not be covered here, but suffice it to say that they need to be reviewed if the goal is to not waste the transferor’s GSTT exemption when the likelihood of the trust making a distribution to a skip person is remote. In these situations the transferor would presumably not intend for their trust to benefit future generations of beneficiaries.
Example: Ron creates an irrevocable trust that is created for his spouse ‘s lifetime benefit, then for the benefit of Ron’s daughter. Ron’s secondary intent is to benefit grandchildren through his daughter, but only if Ron’s daughter dies earlier than anticipated, i.e. his daughter dies before age 40 when the trust is otherwise scheduled to terminate and distribute his assets to his daughter. Unless Ron opts out of the automatic GSTT allocation rule, then Ron’s GSTT exemption is applied to his transfer to the trust, when there is a strong likelihood that there will never be a distribution from the trust to his grandchildren.
Fixing a Missing Allocation: If a GSTT allocation does not appear on a Form 709 or Form 706, one option is to revise the gift or estate tax return. But if the limitations period has run with regard to that return, or the transferor is concerned about restarting a statute of limitations period for other items that were disclosed on the tax return, that might not be a viable option. If the transferor is alive, one option is to attach a Notice of Automatic Allocation to a future gift tax return that is filed. This would bring the reporting of lifetime gifts to the IRS’s attention. Another option is to take the position that the trust is exempt from GSTT by deliberately making a distribution to a skip person and then filing a 706-GS(D-1) which reflects that no GSTT is due. Either of these options puts the IRS on notice of the trustee’s conclusion of the trust’s GSTT exempt status.
Retroactive Allocation: A more complex situation is when the GSTT exemption was automatically applied, or not applied at all, and the transferor wants to go back and modify that allocation based on the transferor’s actual intent. There is no easy solution in this situation. Once the limitations period for the estate or gift tax return has passed, the transferor is not able to go back and reallocate the GSTT exemption to the trust. If a trust is not fully exempt from the GSTT, and if the transferor is still alive, or if the issue is identified at the transferor’s death, the taxpayer could allocate additional GSTT exemption based on complicated rules and valuations. The challenge with this approach is that the late allocation is based on the value in the trust at the time the late allocation is made, not the value of the assets when they were initially transferred to the trust.
Qualified Severance: Yet another option, which is even more complicated, if the trust is only partially exempt from GSTT, is for the trustee to pursue a qualified severance either on the transferor’s death, or during the donor’s lifetime, when an exempt portion and a nonexempt portion of the same trust are created. [IRC 2642(a)(3); Regulation 26.2642-6.]
Private Letter Rulings: The IRS will also issue a private letter ruling [PLR] with regard to the allocation of GSTT exemption. [Regulation 301.9100-3.] However, the IRS will not issue a PLR if the trustee decants the trust assets and wants to know if the decanting will cause the trust to lose its GSTT exempt status.
Administering a GSTT Trust: More than just worrying about potential taxable terminations when a trustee is liable to pay the GSTT, the trustee also needs to keep in mind and preserve the GSTT exempt status of the trust. Under the Michigan Trust Code there are numerous situations available to modify an irrevocable trust, e.g. judicial modification, nonjudicial settlement agreement, unexpected circumstances, decanting, et. seq., just to name a few. This flexibility in changing the terms of a trust might present a GSTT trap. By modifying a GST exempt trust, the parties may inadvertently cause a trust to lose its GSTT-exempt status. The Regulations contain some safe harbors that allow some trust modifications while preserving the GSTT exempt status of the trust, but it is important to follow those safe harbor rules to the letter. [Regulation 26.2601-1.]
Trustee Exposure: While some options exist to address a trust that is not fully exempt from the GSTT, in some cases there are no options to re-allocate the GSTT exemption. One reported decision where the issue of the GSTT exemption was litigated was Hobbs v. Legg Mason Inv. Counsel & Trust Co., No 3:09-CV-9-SA-DAS, 2011 WL 39044 (N.D. Mississippi, January 5, 2011.) In that case various trusts, some exempt from the GSTT and others not, were established on the death of the settlor and his spouse. Distributions were later made to beneficiaries, the plaintiffs, who were skip persons. After a few years of distributions the trustee then informed the beneficiaries that the prior distributions to them were taxable distributions and that they were liable for that GSTT plus interest. The beneficiaries sued the trustee. The trial court held that the trustee had no duty to modify the trusts to avoid the GSTT liability, and consequently the claim against the trustee was dismissed. However, the trial court also found that the trustee could have breached its duty by failing to notify the beneficiaries of the GSTT liability, and it permitted that claim against the trustee to go to trial.
Conclusion: Unlike federal gift and estate taxes, the transfer tax is due fairly soon after the event, i.e., the taxable gift or the decedent’s death. In contrast, a transfer to an irrevocable trust, the GSTT lies in wait for future events to occur. The GSTT may soon increasingly apply to trusts as they enter a new era with non-skip persons, e.g., children beneficiaries, dying and with skip persons, e.g., grandchildren beneficiaries, becoming eligible for distributions from the family trust. A trustee’s ability to identify, preserve, and maximize a trust’s GSTT exempt status is critical to preserve that family wealth, all the while creating new administrative burdens for the trustee.