Identifying GST Exempt Trusts

Take-Away: There are 5 different situations in which an irrevocable trust is exempt from the 40% generation skipping transfer tax. The efficient use of that $11.7 million GST exemption is critically important.

Background: With many individuals presently exploring the use of gifts to use their applicable exemption amounts (while they still exist at such high levels) it is important to remember that the generation skipping transfer tax (GSTT) is imposed in addition to federal gift and estate taxes. It, too, is a 40% flat tax. If gifts are currently made to existing irrevocable trusts, those transfers could implicate those otherwise GST-exempt trusts. A few critical definitions follow.

– Skip Person: Recall that this term of art is used to define when a transfer is subject to the generation skipping transfer tax (GSTT.) It is a direct or indirect transfer to a person who is one generation removed from the transferor’s, e.g. the transferor’s grandchild.

– Non-Skip Person: This is a person who is not a skip person. An example is child of the settlor of a trust.

– GST Inclusion Ratios: For GST tax purposes, a trust will either be a GST exempt trust (meaning that the trust has an inclusion ratio of zero, i.e. no GST tax is imposed on distributions or the termination of the trust), a GST non-exempt trust (meaning the trust has an inclusion ratio of one, i.e. the full GST tax is imposed on transfers from the trust or on the trust’s termination) or a mixed inclusion ratio trust (meaning the trust has an inclusion ratio greater than zero and less than one.)

Consequently, distributions from and terminations of beneficial interests in a GST exempt trust will not be subject to the GST tax, while distributions and terminations of beneficial interests in non-exempt GST trusts will be fully taxed at the 40% rate. For trusts with a GST mixed inclusion ratio, distributions and the termination of beneficial interests in those trusts will be subject to the GST tax, albeit at a reduced tax rate. [IRC 2642(a)(2).]

GST Exempt Trusts: There are 5 different situations, or a combination of them, when an irrevocable trust will be a GST exempt trust.

1. Grandfathered Trust: A grandfathered GST exempt trust is a trust that was irrevocable on or before September 25, 1985. [Regulation 26,2601-1(b).] While keeping that calendar date in mind is fairly simple, the sad fact is that the trust’s ‘grandfathered’ status can be lost by subsequent events.

– Direct and Constructive Contributions: One such event is the contribution of additional assets to the trust or the release or lapse of a general power of appointment over the grandfathered trust, which is in effect a constructive addition to the trust.

– Delaware Tax Trap: Also, triggering the Delaware Tax Trap with the exercise of a second power of appointment that extends the Rule Against Perpetuities can cause the grandfathered trust to lose its GST exempt status.

– Modifications: A modification of a grandfathered GST exempt trust can terminate its grandfathered GST exempt status if it does not fall under one of the Regulation’s  ‘safe harbors.’ [Regulation 26,2601-1(b)(4).] Perhaps most noteworthy of the ‘safe harbors’ is a trust decanting if the trust or state law does not require the consent or approval of any trust beneficiary. Thus, a trust decanting may not be treated as a modfication of the grandfathered GST exempt trust.

2. Gallo Trust: This exemption is neither found in the original Tax law or the Regulations. It is an amendment to the Tax Retorm Act of 1986. The Gallo wine family lobbied for this exemption. Generation skipping transfers from a trust for the benefit of one grandchild, funded up to $2.0 million but only before January 1, 1990, will not be subject to the GST tax unless additions have been made to that ‘Gallo’ trust after December 31, 1989 and the trust has not been modified after that date.
3. Annual Exclusion Gifts: There is also a GST exemption for annual exclusion gifts, but with conditions attached. [IRC 2642(c).] If all of the requirements are met then if the transfer qualified for the federal gift tax annual exclusion, it will also qualify for the GST annual exclusion. In short, the transfer will be treated as GST exempt without the use of any of the transferor’s GST exemption. Like most of the tax law, however, the ‘devil is in the details.’

– Conditions: For a transfer to a trust to qualify for the GST tax annual exclusion, the trust must have (i) one beneficiary who is a skip person; and (ii) if that skip person beneficiary dies before the trust is completely distributed, the remaining assets of the trust must be included in the beneficiary’s gross estate. 

– ILIT Trap: Consider a typical irrevocable life insurance trust (ILIT) which  is intended to benefit all of the settlor’s descendants, and which relies on crummey withdrawal rights to pay the policy premium. Transfers to the ILIT relying on crummey withdrawal rights will not satisfy the GST annual exclusion rules, even though the gifts will qualify for the federal gift tax annual exclusion, because of the multiple withdrawal rights held by all of the trust beneficaries under the ILIT. Consequently, if multiple skip persons are ILIT beneficiaries who are given notice of the transfers to the ILIT, which they can then withdraw, those transfers will consume part of the settlor-insured’s GST exemption amount to the extent the trust beneficiary with the withdrawal right is a skip person.

4 & 5. GST Exemption Allocation: An individual’s GST exemption amount can be affirmatively allocated to any trust, or if the GST exemption has not been affirmatively allocated it may be subject to automatic allocation under the Tax Code.

– Affirmative Allocation: An individual can affirmatively allocate his/her GST exemption to transfers made by that individual during their lifetime. A decedent’s personal representative can also allocate a decedent’s unused GST exemption for transfers occurring on the decedent’s death. This allocation is made by an attachment to the the federal gift or estate tax return.

– Automatic Allocation: The GST exemption allocation is automatically allocated to transfers to trusts that are classified as skip persons, i.e. a trust with only skip persons as trust beneficiaries, often called GST Trusts. Restated, a GST Trust is a trust from which a taxable distribution or taxable termination is likely to occur in the future.

– Automatic Allocation Exceptions: There are six exceptions from the definition GST Trust where a transferor’s GST Exemption will not automatically be allocated to transfers to the trust.

46. A trust more than 25% of which must be distributed to non-skip persons before the age of 46. Example: A trust for a child with outright distribution required to the settlor’s child at age 45;
47. A trust more than 25% of which must be distributed to non-skip persons living on the death of a person more than ten years older than the transferor. Example: A trust created for the settlor’s parent with the immediate distribution to the settlor’s child after the parent’s death;
48. A trust more than 25% of which must be distributed to the estate or estates of one or more non-skip personsor is subject to a general power of appointment exercisable by one or more non-skip persons, if one or more non-skip persons die on or before.a date or event described in the prior to exceptions, i.e. A or B. Example: A trust created for a child who has a general power of appointment over the trust until age 40, after which the settlor’s grandchildren are the trust beneficiaries, and the child dies prior to age 40.
49. A trust any portion of which would be included in the gross estate of a non-skip person if such person died immediately after the transfer. Example: A transfer is made in trust for the benefit of the settlor’s child, with the remainder interests to grandchildren, in which the child held a general power of appointment over the trust assets;
50. A charitable lead annuity trust, charitable remainder annuity trust, or a charitable remainder unitrust; and
51. A charitable lead unitrust if the trust principal passes to a non-skip person if alive at the end of the annuity payment period.

Accordingly, there will be occasions when the automatic allocation of the transferor’s GST exemption will be applied, and situations when it will not be applied, depending upon the terms of the irrevocable trust. The settlor may not be aware that part of his/her GST exemption has been allocated, even when that was not his/her intent, or there will be occasions when the GST exemption will not be allocated when the settlor wanted it to be allocated. Note that the settlor can opt-out of the automatic GST exemption allocation rules with a timely election.

Observations: These exceptions to the GST Trust rules and the automatic allocation of the transferor’s GST exemption to the transfers to the trust can create a lot of confusion in some basic estate planning strategies,With the definition of a GST Trust being so complicated, it may cause unwanted allocations of a transferor’s GST exemption in some situations and not produce allocations when desired in other situations. A few examples follow:

– ‘Hanging’ Crummey Withdrawal Rights: Many crummey withdrawal rights are structured to lapse after a period of time, e.g. the beneificary’s withdrawal right is the greater of 5% of the trust’s principal or $5,000 each year. The balance of the withdrawal right in excess of such amount does not lapse and may be withdrawn by the beneficiary in subsequent years, aka a ‘hanging power.’ Often in dynasty-type trusts these withdrawal rights are given to the settlor’s children and grandchildren, or maybe even more remote descendants. While this might very well be the type of trust that the settlor would likely want to allocate his/her GST exemption, but due to the fourth exemption (D above) such a trust would be disqualified as a GST Trust to which the automatic allocation would occur. The trust would not be classified as a GST Trust if there is a hanging power with respect to any beneficiary.

– GRATs: The Tax Code prevents any affirmative or automatic allocation of the transferor’s GST exemption to property transferred to a trust during the estate tax inclusion period, or ETIP. [IRC 2642(f).] The ETIP is the period of time during which, if the settlor were to die, the assets of the trust would be included in the settlor’s taxable estate, e.g. a grantor retained annuity trust, or GRAT. As a result, a GRAT is usually not intended to be GST exempt. Yet if the remainder beneficiary of the GRAT is a skip person or a GST Trust, the settlor’s GST exemption will automatically be allocated to the appreciated GRAT assets on the termination of the settlor’s retained annuity. To avoid this situation, the settlor will have to file an ‘election out’ of the automatic GST exemption allocation rules.

Sales to Grantor Trusts: Generally a sale to a trust for adequate consideration is not a transfer that requires allocation of any GST exemption to make the assets exempt from the GST tax. However, if there is a deemed gift to the trust because the value transferred is greater than the consideration received, then the settlor will have to make an affirmative allocation of his/her GST exemption to the trust for the trust to be GST exempt.

Gift Splitting: Gift-splitting by a spouse is an easy way for the spouse to inadvertently use his/her own GST exemption. [IRC 2513 and 2652(a)(2).] These rules are complicated by themselves, but the point is that a spouse who is asked to split gifts in a year may be ‘wasting’ part of his/her GST exemption amount.

ILITs: As noted above, crummey withdrawal rights used in conjunction with funding an ILIT and used by the trustee to pay policy premiums, where there are multiple ILIT beneficiaries, will not qualify for the GST annual exclusion. That means that the settlor’s GST exemption will be consumed with those annual exclusions gifts to the ILIT over several years, when probably the settlor thought that because the federal gift tax annual exclusion was available, those transfers would be GST exempt as well, which is not the case.

Conclusion: Multiple technical rules apply to the GST tax and to the efficient and effective use of an individual’s available GST exemption, especially when trying to identify if it is a GST Trust that is subject to the automatic allocation of GST exemption. As more and more individuals ponder making large lifetime gifts in 2021 to stay one step ahead of the tax man, keep in mind that the GST tax (40%) is the same as the federal estate tax that prompts making large lifetime gifts this year.