Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

7-Feb-20

GST Taxation- A Direct Skip: Part II

Take-Away: A direct skip transfer of assets from an individual to another individual who is two or more generations removed from the transferor is subject to the generation skipping transfer (GST) tax. A transfer of assets to a trust can also constitute a taxable GST direct skip. What should be a relatively simple concept to understand becomes less apparent when some variations are considered. The good news is that a direct skip GST transfer is tax exclusive in effect.

Background:  A direct skip is a transfer of an interest in property to a skip person. [IRC 2611(a).]

  • Example: Grandfather makes a gift directly to his grandchild.

The direct skip transfer is subject to either the federal gift tax (lifetime gift) or the federal estate tax (a transfer under the deceased transferor’s Will or trust.) Alternatively, the transfer results from the extinguishment of a life estate, where a remainder interest to the retained life estate interest passes to a skip person. [IRC 2612 (c) (1).]

  • Example: Grandmother deeds the family cottage to her grandchild, reserving to Grandmother a life estate interest in the cottage, i.e. the classic ladybird deed. On Grandmother’s death, when her life estate is extinguished, a direct skip GST tax is imposed. Like a trust transfer, a ladybird deed would be subject to the estate tax inclusion period (ETIP) delay in applying the Grandmother’s available GST exemption, since the value of the cottage in which Grandmother retained a life estate, is included in Grandmother’s taxable estate for estate tax calculation purposes.[IRC 2036(a)(1).]

It is not necessary that a gift or estate tax actually be paid for a direct skip taxable transfer to occur; it is sufficient that the transfer constitutes either a taxable gift for gift tax purposes, or that the transferred interest is includible in the transferor’s gross estate for federal estate tax calculation purposes, e.g. the ladybird deed.

Time of Direct Skip Transfer: Ignoring for the moment that a gift that may be subject to the estate tax inclusion period (ETIP) [which was described in Part I such as a ‘delayed’ transfer to a skip person that arises from the use of a QPRT or GRAT,) the transfer that constitutes a direct skip is deemed to occur at the same time as the transfer occurs for federal gift or federal estate tax reporting purposes. Accordingly, if the transferor’s residuary estate passes to a trust which is treated as a skip person, i.e. all the beneficiaries of that trust are skip persons, a direct skip has occurred on the transferor’s death, even though the trust is not actually funded until the completion of the administration of the transferor’s probate estate.

Taxable Amounts: In the case of a direct skip, the taxable amount is the value of the property that is actually received by the transferee. [IRC 2623.] The value of the property that is received as a direct skip is determined at the time of the GST transfer. [IRC 2624(a).] If, however, the property is included in the transferor’s taxable estate, then the value used for federal estate tax purposes is also used for GST tax calculation purposes, taking into account special use valuations [IRC 6166, if available] or alternate valuation purposes under IRC 2032. [IRC 2624(b), if available.]

Tax Exclusive Calculation: As an important generalization, a direct skip transfer is taxed at a more favorable effective tax rate than other GST transfers. The favorable taxation of the direct skip transfer results from the tax exclusive manner in which the taxable amount is determined. In contrast, for taxable terminations and taxable distributions [Parts III and IV] the GST tax is computed on a tax inclusive basis. Tax exclusive basis means that the amount that is subject to the GST tax is the amount that remains after the tax itself is paid.

  • Example: Grandfather makes a direct skip transfer to his granddaughter in 2019 of $2.8 million. (I should be so lucky!) Grandfather’s direct skip transfer of $2.8 million to granddaughter will produce $800,000 of GST taxes, assuming that the GST tax is paid out of the $2.8 million of the transferred property and no part of Grandfather’s GST exemption applies or is available to shelter the gift. The ‘taxable amount’ is the $2.0 million remaining after paying the $800,000 in GST taxes. The effective tax rate on the direct skip transfer to the granddaughter is roughly 28.6%.  Conversely, if the amount had been transferred to the granddaughter as a taxable termination or a taxable distribution from a trust in 2019, that transfer to the granddaughter would generate a $1.120 million generation skipping transfer tax,  with an effective GST tax rate of 40% [$2,800,000 X 40% = $1,120,000.]

Who Pays the Direct Skip GST Tax?: The GST tax that is imposed on a direct skip is usually paid by the transferor. [IRC 2603(a) (3).] If it is a direct skip transfer from a trust, the GST tax is paid by the trustee. [IRC 2603(a) (2).] In either case, the source for payment of the GST tax is the property that is involved in the direct skip transfer. However, this allocation of the GST tax can be trumped by provisions in the transfer instrument. Even if the statute’s tax allocation is overridden by the transfer instrument, the direct skip transfer is still taxed on a tax exclusive basis, though the tax will be higher because the taxable amount, i.e. the amount received, is not reduced by the GST tax.

  • ‘Second’ Gift: Another important point to keep in mind is if the transferor pays the GST tax on a direct skip,  that results in a second taxable gift itself. [IRC 2515.]
  • Example: Grandmother makes a $200,000 lifetime gift to grandson, which is a direct skip Grandmother elects to pay the $80,000 GST tax on that transfer out of Grandmother’s own assets. Grandmother is treated as having made an additional $80,000 taxable gift which, in turn, increases the total reportable taxable gifts made by Grandmother by such direct skip transfer from $200,000 to $280,000 [$200,000 gift + $80,000 gift tax paid.] However, because of the tax exclusive nature of direct skip transfers, the taxable amount of the GST transfer remains at $200,000. Note that the same result, i.e. a taxable gift of $280,000 and a direct skip of $200,000, occurs if the gift to the grandson is $280,000 but the $80,000 GST tax is paid by the grandson from the transferred $280,000 of assets.

Time of Payment: The GST tax due on a direct skip transfer is at the same time as the related gift tax or estate tax is due. Extensions of time in which to pay the GST tax can be granted by the IRS. If the direct skip occurs on the transferor’s death, e.g. a testamentary transfer of a closely held business to a skip person, then the GST tax can also be paid on an installment basis if the transferor’s estate qualifies for the installment payment of federal estate taxes that are due on a closely held business interest.[IRC 6166(I).]

Examples of Direct Skip: A classic direct skip example and some of its variables to it follow, all of which should lead to the conclusion that what should be straightforward concept when dealing with a gift from a grandparent to a grandchild is not always the case.

  • Classic Example of a Direct Gift Skip: Grandmother makes an outright gift to her granddaughter. That transfer of property to the granddaughter constitutes a completed taxable direct skip A direct skip has occurred unless the ‘move-up’ rule (described in Part I) applies, i.e. the granddaughter’s parent has died before the gift from Grandmother.
  • Classic Trust Direct Skip: Grandfather creates a testamentary trust that permits discretionary distributions to his grandchildren, grandchildren who are his son’s descendants. If son is living at the grandfather’s death, a direct skip has occurred because the trust is a skip person- all the present interests in the trust are held by son’s descendants, and all of those descendants are skip persons as they relate to Grandfather- two or more generations below him.
  • Trust Not a Direct Skip Due to Move-up‘ Rule: Same example with the Grandfather creating the trust for son and grandchildren, except that son predeceased his father (Grandfather.) There is no direct skip because all the present interests in the testamentary trust are held by son’s children; son’s children are treated as Grandfather’s children by virtue of the ‘move-up’ rule. Consequently, any distributions from the trust to the grandchildren will not be generation skipping transfers because the grandchildren will continue to be treated as Grandfather’s children (not grandchildren), i.e. the grandchildren will be treated as non-skip persons for the purpose of testing the GST taxability of distributions from the trust.
  • Trust Not a Direct Skip Due to Non-Skip Person as Trust Beneficiary: Same example with the Grandfather creating the trust for son and grandchildren, except that the testamentary trust includes son as one of its permissible distributees (along with son’s children.) If son is living at the time of Grandfather’s death, there has not been a direct skip since one of the trust beneficiaries, son, is a non-skip person. After son’s subsequent death, the continuing trust for the grandchildren will be treated as a skip person.
  • Trust a Direct Skip Due to Beneficiary Disclaimer: If son is a permissible distributee of Grandfather’s testamentary trust, and son makes a qualified disclaimer of his interest in the trust shortly after Grandfather’s death, then the trust is a skip person and distributions from the trust will be subject to the GST tax. The ‘move-up’ rule does not apply because son actually survived his father, i.e. son was living at the time of his father’s (Grandfather’s) death. In this case the Tax Code ignores son’s disclaimer and focuses on the fact that son actually survived his father, which in turn eliminates the applicability of the ‘step-up’ exception. [Treas. Reg. 26.2652-1(a) (2) (iv).] In sum, qualified disclaimers by a trust beneficiary are ignored for GST purposes and can cause immediate GST taxation of distributions from the trust.
  • Trust Not a Direct Skip Due to Trust’s Survivorship Provision: The trust created by Grandfather for his son and grandchildren contains a 30-day survivorship provision for the trust beneficiaries; a trust beneficiary is deemed to not have survived the trust settlor (Grandfather) if that beneficiary is not living 30 days after Grandfather’s death. Son survives Grandfather, but only by 10 days. Since the testamentary trust’s survivorship provision has a term of 90 days (or less) no direct skip has occurred. Even though son was alive at the time of his father (Grandfather’s) transfer to the trust on the Grandfather’s death, the ‘move-up’ rule will be still be applied and no direct skip will have occurred with the transfer to the trust on Grandfather’s death. [Treas. Reg. 26.2652-1(a) (iii).] Unlike a qualified disclaimer, a trust instrument’s express condition of survivorship (not to exceed 90 days) will be respected for GST purposes.
  • Calculation of Direct Skip GST Tax: Grandfather dies in 2019. Grandfather’s Will makes a $3.0 million specific bequest to a trust to be established for the lifetime benefit of his grandson. Grandfather’s Will directs the personal representative of his estate to apply Grandfather’s unused GST exemption to this transfer to the trust for the grandson. Assume the ‘move-up’ rule is not implicated since the grandson’s parents are still alive. Assume that due to prior lifetime GST transfers, Grandfather’s estate has available $1.0 million in GST exemption that is available to be applied to the $3.0 million transferred to grandson’s trust. Assume further that Grandfather’s Will does not overrule the general rule as to the source of payment of the GST tax, i.e. a net gift-transfer is not contemplated by the Will. [IRC 2603(c).] Finally, assume Grandfather’s Will exempts the $3.0 million from the payment of any federal estate or state estate taxes that are attributable to that specific bequest of $3.0 million that passes to the grandson’s trust. The trust established for grandson is a skip person; therefore, the $3.0 million to be transferred to the trust is a direct skip. However, the taxable amount of that direct skip bequest is not $3.0 million; rather, it is the amount that is received by the trustee after the Grandfather’s estate’s payment of the GST tax. The taxable amount is based on the trustee’s receipt, not the nominal amount of the transfer to the trust. The numerator of the applicable fraction is $1.0 million (the GST exemption.) The denominator of the applicable fraction is computed on an after-tax basis, and is equal to the $3.0 million amount transferred, minus the GST tax paid by the estate, which means the denominator is simply the taxable amount. The ultimate GST tax owed by the Grandfather’s estate is $571,429. [$3.0 million GST transfer X 40% tax rate X 1-$1.0 million exemption divided by taxable amount, or $400,000.]

Still awake?

Conclusion: The most important points to remember is that the GST tax imposed on a direct skip transfer is more lenient than a taxable termination or taxable distribution, as the direct skip GST tax is tax exclusive in nature. Disclaimers by a child could accelerate the GST tax as the effect of the disclaimer is ignored- the disclaimant is treated as surviving the transferor.

Stay tuned for Parts III and IV that deal with taxable terminations and taxable distributions where the GST tax is applied.