The issues faced by trust and estate lawyers sometimes include complex tax analysis. One of those issues arises when an irrevocable trust skips a generation with trust assets going directly to grandchildren. That event may trigger a tax that is known as the federal generation-skipping transfer (GST) tax. The GST tax can be partially avoided by a carefully devised estate plan. If not avoided, it must be identified at the time such tax is triggered, which in some cases occurs at the time of the death of the initial, first generation trust beneficiary. This article will attempt to assist lawyers in identifying scenarios where the GST tax may come into play so as to avoid or properly identify this menacing tax on generational wealth transfers.
The Origination of the Generation-Skipping Transfer (GST) Tax
Before the initial 1976 implementation of the GST tax in the internal revenue code, well-to-do individuals and their well-paid estate planners had found a loophole in the code that allowed them to pass their wealth to future generations without estate taxes by using life estate vehicles. Since life estates were not subject to federal estate tax, one could create a life estate for their children, followed by a life estate for their grandchildren, and so on through the generations, which allowed them to transfer tremendous wealth to their subsequent generations tax-free. To combat their perceived abuse of the code, Congress implemented the GST tax in 1976. However, Congress retroactively repealed the 1976 version in favor of a newer version of the GST tax in the Tax Reform Act of 1986. The 1986 version of the GST tax remains in place, but GST exemptions and allocations have been adjusted for inflation periodically.1
What Is the Generation-Skipping Transfer Tax?
The federal GST tax was designed to work together with the federal estate tax and federal gift tax to ensure taxes are paid on the transfer of wealth to each generation. While the estate tax imposes tax on the transfer of assets at death, the gift tax ensures that the estate tax cannot be avoided through lifetime giving. In turn, the GST tax ensures that taxpayers cannot avoid the estate and _____________________________________
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gift taxes by using long-term trust vehicles to transfer wealth directly to grandchildren or later generations. The tax rate and exemption amount for GST tax purposes, however, are set by reference to the estate tax rules. GST tax is imposed using a flat rate equal to the highest estate tax rate (40% in 2016). GST tax is imposed on cumulative generation-skipping transfers in excess of the generation-skipping transfer tax exemption amount in effect for the year of the transfer. The generation-skipping transfer tax exemption for a given year is equal to the estate tax exemption amount in effect for that year ($5.45 million for individuals and $10.9 million for married couples in 2016).
GST tax is imposed on transfers, either directly or in trust, to a “skip person.” A direct skip is a transfer of an interest in property to a “skip person” that is also subject to estate or gift tax. An “indirect skip” is defined as any transfer of property (other than a direct skip) made to a GST trust. The Internal Revenue Code defines a skip person as a beneficiary in a generation more than one generation below that of the transferor (e.g. grandchildren and great-grandchildren). However, a skip person may also be a trust. The term GST trust means a trust that could have a generation-skipping transfer with respect to the transferor. Trusts are skip persons if (1) all interests in the trust are held by skip persons, or (2) no person holds an interest in the trust and at no time after the transfer may a distribution (including distributions and terminations) be made to a non-skip person2. Safe harbors exist that can be used in drafting a GST trust; however, the safe harbors are complex and beyond the scope of this article.
Types of Taxable Generation-Skipping Transfers
Transfers subject to the GST tax include three types of generation-skipping transfers: (1) direct skips, (2) taxable distributions, and (3) taxable terminations. A direct skip is any transfer of an interest in property to a skip person. A taxable distribution is a distribution from a trust to a skip person (other than a taxable termination or direct skip). If a transferor allocates GST tax exemption to a trust prior to the taxable distribution, subsequent GST tax on that allocation may be avoided. A taxable termination is a termination (by death, lapse of time, release of power, or otherwise) of an interest in property held in trust unless, immediately after such termination, (1) a non-skip person has an interest in the property, or (2) at no time after the termination may a distribution (including a distribution upon termination) be made from the trust to a skip person.3
GST Tax Traps for Practicing Lawyers
Legal counsel engaging in any practice related to wills and trusts, estate planning, or tax advisory services should be prepared to recognize when GST tax might be triggered, and if involved in the original estate planning, be prepared to properly allocate GST tax exemptions. Generation-skipping giving is most common among families with high net worth, and the IRS understandably keeps a keener eye on transfers of wealth exposing the transferor or transferee to large tax bills. In turn, if counsel for a wealthy transferor, newly rich skip person, or well financed trust misses a trigger for GST tax, he or she may be exposed to liability in the form of large tax penalties or interest on unpaid taxes. Furthermore, if a client ends up paying unnecessary taxes because his or her counsel had misallocated GST tax exemptions or failed to allocate exemptions at all, the counsel may be exposed to further liability under certain circumstances.
Direct Skip Recognition. Direct skips are probably the easiest to recognize. Obvious forms of direct skips include a grandparent writing a check to a grandchild or an outright bequest from a grandparent to a grandchild at the former’s death. A taxpayers’ GST tax exemption is automatically allocated to direct skip transfers, unless the taxpayer has opted out of such treatment. Moreover, a taxpayer’s annual gift tax exclusion protects qualifying gifts from GST tax ($14,000 per donor per gift in 2016). Any $14,000 gift tax exclusion also does not count towards the taxpayer’s lifetime gift tax exemption. However, taxpayers who make any direct skips in excess of the gift tax annual exclusion must report all direct skips—including the annual exclusion—on Part 2 of Schedule A of IRS Form 709.4
Recognition of Generation-Skipping Trust Distributions. GST tax is imposed on taxable distributions from a trust made to a skip person.5 Unless a lawyer is specializing in trusts, tax advisory services, or estate planning, it may be advisable to retain specialized counsel or accounting advice when faced with a situation where counsel suspects generation-skipping transfers involving trusts are in play. To determine whether GST tax applies to a particular taxable distribution from a trust to skip person, counsel must first determine the inclusion ratio for that particular trust. The inclusion ratio generally equals the difference between 1 and the amount of a taxpayer’s GST tax exemption allocated to that trust’s assets over the total value of assets in the trust.6 Most estate planning lawyers will try to ensure that the inclusion ratio for a trust potentially exposed to GST tax liability is equal to either 0 or 1. An inclusion ratio of 0 means an interest in the trust is not subject GST tax, while a ratio of 1 means the entire amount of an interest in the trust is subject to GST tax. However, any ratio in between means that percentage of a trust distribution to a skip person is subject to GST tax. If a trust is making a distribution to a skip person and the trust’s inclusion ratio is greater than 0, the trustee is responsible for reporting taxable distribution on IRS Form 706-GS(D-1).7
Recognition of Generation-Skipping Taxable Terminations. As with generation-skipping trust distributions, it may be advisable to retain specialized counsel or accounting advice when faced with a situation where counsel suspects generation-skipping transfers involving trusts are in play. Further, similar to above, determination of GST tax on trust distributions as a result of a taxable termination requires calculation of the inclusion ratio for the trust being terminated. Distributions to skip persons as a result of a taxable termination are subject to GST tax to the extent that any percentage of the terminating trust’s assets were not allocated to the transferor’s GST tax exemption. If a terminating trust is making distributions to a skip person or a skip person will eventually have a right to receive assets in the terminating trust, the trustee may be responsible for reporting taxable termination on IRS Form 706-GS(T).8
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1 In 2010, both the federal estate tax and the federal GST tax were repealed for the 2010 tax year. However, the repeal expired on December 31, 2011, and both taxes were reinstated with adjustments for exemptions and allocations.
2 U.S. Cong. Joint Comm. on Taxation, History, Present Law, and Analysis of the Federal Wealth Transfer Tax System, The Joint Committee on Taxation, Congress of the United States 14, 21–22 (March 16, 2015), https://www.jct.gov/publications.html?func=startdown&id=4744 (follow “JCX-52-15 Download” hyperlink to download .pdf version of report) (last visited January 28, 2016).
3 Id. at 21–22.
4 U.S. Internal Revenue Service, 2105 Instructions for Form 709 United States Gift (and Generation-Skipping Transfer) Tax Return, IRS.Gov (2015) 7, https://www.irs.gov/pub/irs-pdf/i709.pdf (last visited January 28, 2016)">.
5 Remember that skip persons may be individuals OR qualifying trusts.
6 1 – (GST Tax Exemption Allocation/Value of Trust Assets)
7 U.S. Internal Revenue Service, 2015 Instructions for Form 706-GS(D-1) United States Generation-Skipping Transfer Tax Return for Terminations, IRS.Gov (2015), https://www.irs.gov/pub/irs-pdf/i706gsd1.pdf (last visited January 28, 2016).
8 U.S. Internal Revenue Service, 2015 Instructions for Form 706-GS(T) United States Generation-Skipping Transfer Tax Return for Terminations, IRS.Gov (2015), https://www.irs.gov/pub/irs-pdf/i706gst.pdf (last visited January 28, 2016).