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George F. Bearup, J.D. Senior Legal Trust Advisor

11-Feb-20

GST Taxation – Taxable Terminations: Part III

Background: A GST taxable termination is the termination, by death, lapse of time, release of a power, or otherwise, of an interest in property that is held in trust. Any termination of a present interest held in a trust will be treated as a taxable termination unless one of two specified exceptions applies. As a generalization, it is better for a transfer to be classified as a taxable termination rather than a taxable distribution from the trust. (A taxable distribution is covered in Part IV of this series.)

Taxable Termination Exceptions: Two exceptions to a taxable termination result if either: (i) immediately after the termination, a non-skip person has an interest in the property; or (ii) at no time after such termination of the interest may a distribution, including distributions on termination, be made from the trust to a skip person. [IRC 2612(a) (1).] If the trust itself terminates, the only exception that applies is the first, which deals with whether a non-skip person possesses an interest in the property previously held in trust. A taxable termination can occur despite the continuation of the trust, but only if neither of the two exceptions applies.

Partial Terminations: A partial termination applies when the termination of the interest held in trust is the result of a death of a lineal descendant of the transferor and such termination causes a distribution to be made to one or more skip persons. [IRC 2612(a) (2).]

  • Example: Dad creates and funds trust for the lifetime benefit of his children, son and daughter, separate shares for each. With regard to daughter’s trust share, the remainder interest in the trust share passes to daughter’s children on daughter’s death. The termination of daughter’s trust share on her death is a partial termination. Thus, a partial termination applies only with respect to the property that is distributed to skip persons, and not to any property that remains in the trust, e.g. son’s trust share. [Treas. Reg. 26.2612-1(b) (2).]

Sometimes a termination of an interest in property held in trust does not constitute a taxable termination for GST purposes, such as when the second exception exists, i.e. no possibility of any subsequent distributions being made to a skip person.

GST Taxation Inclusive: Unlike a direct skip transfer, a taxable termination is taxed on a tax inclusive basis. The taxable amount is determined without any reduction for GST taxes generated by the taxable termination. Thus, the effective tax rate on taxable terminations is the same as the top marginal federal estate tax rate, i.e. 40%. The taxable amount is determined on the basis of the value at the time of the GST subject to a consideration paid-offset.

  • Trustee Pays the GST Tax: The trustee is responsible for paying and filing the necessary GST tax return. [IRC 2603(a); Form 706GS (T).Treas. Reg. 26.2662-1(b) (2).] The source for the payment of the GST tax is the property with respect to which the taxable termination occurs, but this source of payment can be overridden by the terms of the trust instrument.
  • GST Taxation/Inclusion Ratio: This is best explained (or an attempted explanation if you are still awake) by an example.
  • Example: Father dies. Father’s residuary estate, which has a federal estate tax value of $21 million after deducting federal and state estate taxes chargeable to that amount, passes to a trust that is established for his Daughter. The trust is to terminate on the Daughter’s death. Upon the trust’s termination, the trust assets, which are not includible in Daughter’s taxable gross estate, pass outright to Daughter’s descendants. Father’s Personal Representative allocates Father’s full unused and available GST exemption of $11.6+ million to Daughter’s trust. Daughter dies one year after her Father. At the time of Daughter’s death, the trust estate has grown to $23 million. The trust’s applicable fraction is 0.524 [$11+ million (applied GST exemption) divided by $21 million (value of assets transferred on Father’s death) = 0.524.] Accordingly, the GST inclusion ratio for the trust created for Daughter and her descendants is 0.476 [1.0 less 0.524 = 0.476.] All of Daughter’s descendants, who are skip persons, are the only persons with an interest in the trust property after the trust’s termination on Daughter’s death, which caused the taxable termination. The amount to be distributed to Daughter’s descendants of $23 million will be subject to a GST tax of $4,379,200 [$23.0 million (amount distributed on termination) X 40% (GST flat rate tax) X 0.476 (GST inclusion ratio) = $4,379,200.)

Examples:  Some examples follow where a taxable termination for GST taxes results.

Classic Taxable Termination: Dad’s Will creates a trust that pays income to Daughter for her lifetime. The testamentary trust terminates on Daughter’s death. If on Daughter’s death the trust estate passes outright to Daughter’s children, a taxable termination occurs on Daughter’s death. Daughter’s interest in the trust terminated and because of that termination, Daughter’s children, all of whom are skip persons, will receive all of the property previously held in the testamentary trust.

Continuing Trust: The same facts as above, except that the trust continues after Daughter’s death for the benefit of Daughter’s descendants, who are the only permissible distributees under the trust. In this situation, a taxable termination also occurs because after the termination of Daughter’s interest in the trust, the only persons with interests in the property held in the trust were Daughter’s descendants, all of whom are skip persons. As a result, no non-skip person possesses an interest in the property immediate after the termination, and trust distributions could only be made to a skip person by the trustee after the termination of Daughter’s interest. If, however, daughter’s husband is a beneficiary of the continuing trust along with his children, then a non-skip person is a potential trust beneficiary, which results in there not being a taxable termination, until the husband’s death due to the second exception.

Charitable Trust Termination: Grandfather creates a charitable lead trust (CLAT) with a 20-year term. At the end of the charitable lead term the CLAT’s assets are payable to Grandfather’s Son, but if the Son is not then living, then the CLAT assets are distributed to Son’s descendants. If Son died during the 20-year charitable term, there would not be a taxable termination on Son’s death. Generally, Son would not have been a permissible distributee during the 20-year charitable term, and as a result, Son’s death would not cause the termination of a present interest in the CLAT. Even if Son had been a permissible distributee under the CLAT, a non-skip person, i.e. the charitable beneficiary, would possess a present interest in the trust property immediately after Son’s death. However, in the event of Son’s early death, there would be a taxable termination at the end of the 20-year term.

Partial Termination: Dad creates and funds a trust for the benefit Son and Daughter. The trustee possesses the discretion to make distribution to either Son, or Daughter, or both of them from the same pool of trust assets. The trust instrument provides that upon either Son or Daughter’s death, one-half of the trust estate is distributable to the deceased child’s descendants. Upon the subsequent death of the other child, the remaining trust estate passes to the descendants of the surviving child. If Son dies first, a taxable termination occurs as to the property that is distributed from the trust to Son’s descendants because of the partial termination. All of Son’s descendants are skip persons. No non-skip person has an interest in the distributed property, which makes the first exception described above inapplicable. After the partial termination on Son’s death, trust distributions can be made from the remaining trust estate to a skip person, e. the terminating distribution to Daughter’s descendants, which makes the second exception described above also inapplicable.

Charitable Beneficiary: Similar facts as described just above, except that part of the trust continues for Daughter’s lifetime, and on Daughter’s subsequent death, the remainder trust beneficiary is a designated charitable entity and not Daughter’s descendants. When Son dies, survived by Daughter, no taxable termination has occurred because of the second exception that is described above; at no time after the termination of Son’s interest in the trust can a distribution be made from the trust by the trustee to a skip person. The only possible distributees at that time are Daughter and the charitable organization, both of whom are non-skip persons. However, the partial termination rule applies because Son was a lineal descendant of the transferor, Dad, and one-half of the trust estate distributed on Son’s death went solely to skip persons, Son’s descendants. Consequently, there has been a taxable termination to that one-half of the trust estate, not a taxable distribution, when Son dies.