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What Is GST and Why Do I Care?
In this edition of Gift Planner's Digest, Kansas City, Missouri attorney Scott Blakesley provides an introduction to the basic concepts of generation skipping transfer planning and why it needs to be considered in a well designed charitable gift plan.
The areas of planned giving and estate planning have a tendency to overlap on a fairly regular basis. To be an effective estate planner, it is important to understand the concepts involved in planned giving. Likewise, to be an effective donor advisor, it is important to understand the concepts involved in estate planning. Without some level of understanding of the estate planning rules of the game, a gift planner might get into a discussion with donors and their advisors where it seems like everyone else is talking in some mysterious language-using strange and unusual terms like GST, CLAT, CRUT, QTIP, etc.
This article addresses one of these "mysterious" areas of estate planning that is often referred to as GST (Generation Skipping Transfer). Actually, this area involves the concept of planning over several generations, and is based on the reality that estate planning (and indeed, planned giving) cannot focus on a single client/donor or a single generation. Estate and gift planners always need to be aware of how actions of prior generations will affect the current generation, and how the actions of the current generation will affect future generations. The proper term for this kind of planning is probably something like "multiple generation planning" (or "past, present, and future"). However, the terms generation skipping and GST are used quite often because of the specific tax rules that operate to control multiple generation plans (and because planners are always looking for shorter ways to refer to ideas).
The Federal Generation Skipping Tax
The current federal Generation Skipping Transfer Tax (GST Tax) came into existence with the Tax Reform Act of 1986 (the original 1976 version was repealed retroactively). Basically, the federal estate tax is designed to impose a tax on the right to transfer assets at death, and the federal gift tax is designed to make sure the estate tax is not avoided through lifetime giving. Similarly, the federal GST Tax is designed to make sure that taxpayers do not avoid the estate and gift tax through the use of long-term trusts, and to ensure there will be a tax paid at each generation.
The primary target of the GST Tax is the typical generation skipping trust (sometimes called a GST Trust or Dynasty Trust), which provides distributions for the benefit of a child for life with the remainder continuing on for the grandchildren (or more remote descendants). Under the current estate tax rules, the trust assets would not be taxed at the child's death because the child does not have sufficient powers over the trust to cause the assets to be included in the child's estate. In this context, the reference to generation skipping does not mean that the economic benefits of the trust "skip" the children, but simply that the estate transfer tax is "skipped" at the death of the children. The GST Tax was established to prevent this type of tax "skipping" (at least above certain limits, as described below).
In the case of the typical GST Trust, the GST Tax would be imposed at the death of the child, when the assets continue for the grandchildren (but only if the assets of the trust are not otherwise subject to estate tax at the child's death). The GST Tax also applies to direct transfers to grandchildren that would otherwise avoid the GST Tax because no trust is involved.
Rate and Specific Application
When the GST Tax applies, the rate of tax is a flat rate equal to the maximum estate tax rate (currently 55%). [IRC § 2641] However, unlike the estate and gift tax, there are no lower rate brackets applicable to the GST Tax.
Specifically, the GST Tax is applied in each occurrence of a Direct Skip, Taxable Termination, or Taxable Distribution.
- A Direct Skip occurs whenever a transfer is made to a "skip person" with no intermediate benefit to a nonskip person. A skip person is anyone assigned to a generation that is two or more generations below the transferor's assigned generation (the most common example of a skip person is a grandchild). A trust can also be a skip person if all the beneficiaries are skip persons.
- A Taxable Termination occurs through a trust when the interest of a nonskip person terminates and there are no more nonskip persons still holding an interest. For example, upon the death of a child/beneficiary if, after the child's death, the only beneficiaries are grandchildren.
- A Taxable Distribution occurs whenever a distribution is made from a trust to a skip person. However, a taxable distribution does not occur if the event can be classified as a direct skip or a taxable termination.
To determine if a person is or is not a skip person for GST Tax purposes, everyone is assigned to a specific generation on the basis of: 1) lineal descent (if applicable); or 2) an implied generation assignment based on each 25-year age group (for example, a person born more than 12 ½ years but less than 37 ½ years after the transferor will be deemed to be in the generation immediately below the transferor). [IRC § 2651] In the case of lineal descendants, the spouse of a descendant is deemed to be in the same generation as such descendant. [IRC § 2651(c)]
There is also the "move up rule," which provides that at the time of any transfer to a skip person, if the parent of the skip person (who is a descendant of the donor) is not living, then the transfer will not be deemed a direct skip because the skip person is "moved up" to the generation of his or her deceased parent. [IRC § 2612(c)(2)] The move-up rule does not apply if the nonskip person is only deemed to have predeceased the transferor as a result of a qualified disclaimer.
Exclusions from the GST Tax
The GST Tax does not apply to transfers made prior to September 25, 1985-so that an irrevocable trust created before September 25, 1985 is considered "grandfathered" for GST Tax purposes (distributions from the trust are generally not subject to the GST Tax). In addition, the GST Tax does not apply to any transfer under a will or revocable trust if the will or trust was executed before October 22, 1986, and the decedent died before January 1, 1987. (This is becoming less and less significant as the years roll on.) However, if additions are made to a grandfathered trust, the trust becomes partially taxable in the future except to the extent the GST Exemption (described below) is allocated to the additional transfer.
In addition, if a transfer is not subject to gift tax because it is within the $10,000 annual exclusion amount, the GST Tax will not apply. [IRC § 2611(b)(2)] However, as a result of the Technical Corrections and Miscellaneous Revenue Act of 1988 (TAMRA), this exception for nontaxable transfers is limited to transfers that are direct skips; and for this purpose, a gift to a trust will only be a direct skip if: 1) the trust is for only one beneficiary who is a skip person; 2) no one other than the beneficiary can receive distributions during the beneficiary's lifetime; and 3) if the beneficiary dies before the trust terminates, the trust estate must be included in the beneficiary's estate for tax purposes. What this means is that transfers to trusts that qualify for the gift tax annual exclusion as a result of withdrawal rights (sometimes known as Crummey Powers) will not qualify for the GST annual exclusion unless the trust also meets the requirements detailed above.
Finally, transfers made directly to education institutions (for tuition) or healthcare providers on behalf of a donee, which are therefore exempt from gift tax under IRC § 2503(e), are excluded from the GST Tax. [IRC § 2611(b)(2)]
$1,000,000 GST Exemption
One of the most important aspects of the GST Tax is the $1,000,000 GST Exemption that is available to each individual. This is commonly called the GST Exemption. (Note: As a result of recent changes in the tax laws, this $1,000,000 is indexed for inflation, and is actually $1,010,000 in 1999, but is still often referred to as the $1,000,000 GST Exemption.) Because of this GST Exemption, each person has the ability to transfer up to $1,010,000 (determined at the time the exemption is allocated) in a manner that would otherwise be subject to the GST Tax. [IRC § 2631(a)] This amount can be used for lifetime gifts, and any portion of the GST Exemption not used during lifetime will be applied to assets passing at death.
The GST Exemption can be allocated in any manner chosen by the transferor (or the decedent's personal representative). [IRC § 2632(a)] Normally, the GST Exemption will not be allocated without affirmative action of the transferor. However, the GST Exemption will be automatically applied to direct skips unless the transferor elects not to use the GST Exemption. [IRC § 2632(b)]
Any portion of the GST Exemption unused at death, and not allocated by the decedent's personal representative (sometimes called the executor), will be automatically allocated to direct skips occurring at death, and then any remaining GST Exemption will be allocated to trusts with respect to which the decedent is the transferor, and as to which taxable distributions or taxable terminations may occur.
Reverse QTIP Election. Married couples can make use of a special IRC § 2652(a)(3) election (reverse QTIP election) that allows the full use of the GST Exemption for both spouses, even if the unlimited marital deduction is utilized. Normally, assets in a Qualified Terminable Interest Property (QTIP) Marital Trust are deemed to pass from the surviving spouse (and could only utilize the GST Exemption of the surviving spouse). The IRC § 2652(a)(3) election reverses this presumption so that, for GST Tax purposes only, the QTIP Trust assets are deemed to pass from the first spouse (and therefore will utilize the first spouse's GST Exemption).
ETIP Rules. No GST Exemption can be allocated to a transfer to which the transferor has retained certain rights or interests that would cause the assets to be included in the transferor's estate for estate tax purposes under IRC §§ 2036, 2037, 2038, 2041, and 2042 (but not IRC § 2035). This is known as the Estate Tax Inclusion Period (ETIP), which continues until the assets of the trust would no longer be included in the transferor's estate under the above Code sections.
Allocation to Lifetime Gifts. If an allocation of GST Exemption is made on a timely filed gift tax return (including extensions), the allocation is effective from the date of the gift (even if the value has since changed). An allocation of GST Exemption made after the due date for the gift tax return must be based on the current value of the asset (although the value at the beginning of the month may be used instead, unless the grantor has died). The Treasury Regulations also confirm that if an allocation of GST Exemption is made for an irrevocable life insurance trust, the GST Tax status of the trust continues after the grantor's death, even if the grantor dies within three years and the trust assets (the insurance policy) are included in the Grantor's estate for federal estate tax purposes.
Every trust has an inclusion ratio that determines the portion of each future distribution or termination that will be subjected to the GST Tax. [IRC § 2642] For example, an inclusion ratio of "zero" means that the trust is totally exempt from the GST Tax; an inclusion ratio of "one" means that all taxable distributions and taxable terminations will be fully subject to the GST Tax; and an inclusion ratio of ½ means that one-half of all taxable distributions and taxable terminations will result in a GST Tax.
The inclusion ratio for a trust is initially determined by calculating the portion of the transfer that is not covered by the GST Exemption, or an exclusion, and dividing this amount by the value of the entire transfer. For example, if a person transfers $1,500,000 into a generation skipping trust and allocates $1,000,000 of GST Exemption, the inclusion ratio would be:
Subsequent transfers to an existing trust may affect the trust's inclusion ratio. If sufficient GST Exemption is allocated to the subsequent transfer, the trust will retain its zero inclusion ratio. It is advisable not to make additions to an existing trust in amounts that exceed the available GST Exemption. However, if there is not sufficient GST Exemption remaining, the inclusion ratio is redetermined as follows:
- First, the nonexempt portion of the trust (prior to the new transfer) is determined by multiplying the pretransfer value of the trust assets by the existing inclusion ratio.
- Second, the value of this nonexempt portion is added to the portion of the new transfer that is not covered by a GST Exemption or exclusion.
- Third, this total of the nonexempt amount is divided by the total value of the trust estate immediately following the new transfer.
For example, if an existing trust with an inclusion ratio of 2/3 has trust assets valued at $750,000 (meaning that $500,000 is currently not covered by GST Exemption), and if an additional $500,000 is transferred to the trust, but only $250,000 of GST Exemption is allocated to the transfer, then the new inclusion ratio for the trust will be determined as follows:
The Treasury Regulations include elaborate rules as to when trusts or shares will be treated as separate for purposes of the inclusion ratio. Extreme caution is needed when, following the Grantor's death, a trust is to be divided into exempt and nonexempt trusts for GST Tax purposes. This is particularly true when the division is created by means of a pecuniary amount passing to the nonexempt trust with the remainder becoming the GST exempt trust. Generally, when such a pecuniary amount is funded, it must be done within 15 months, or carry with it appropriate interest to compensate for the delay in funding. It is also important that a trust is divided before any GST Exemption is allocated. For example, if there is a $500,000 trust that has an inclusion ratio of ½, the Regulations do not allow this trust to be divided into a $250,000 trust with a "zero" inclusion ratio and a $250,000 trust with a "one" inclusion ratio (even though such result sounds quite logical). According to the Regulations, a division of this trust would result in two $250,000 trusts, each of which would still have an inclusion ratio of ½.
General Planning Strategies
If the total value of the combined estates of a husband and wife is not expected to exceed $1,000,000, then the GST Tax will not be a direct concern. However, if children have sizeable estates, it may be beneficial to have some or all of the parents' estate put into GST Trusts, or be given to grandchildren outright, to avoid unnecessarily increasing the children's taxable estates. To the extent possible, an estate plan for the parents should consider the planning opportunities for children that may be lost once assets are distributed outright to the children.
If the total value of the combined estates of a husband and wife is over $1,000,000, but is not expected to exceed $2,000,000, then the GST Tax can be avoided, but special planning may be necessary (using the reverse QTIP election) to ensure that both spouses can use the $1,000,000 GST Exemption.
If the total value of the combined estates of a husband and wife substantially exceed $2,000,000, then more sophisticated GST planning should be discussed, including the use of the GST Exemptions during life.
To the maximum extent possible, it is important to make sure that each trust is either fully exempt or fully nonexempt; otherwise, it will be impossible to make the most efficient use of the exempt trusts. If a trust has an inclusion ratio of something other than one or zero, there is no efficient method to make distributions, because either: 1) a distribution is made to a skip person that will result in the payment of some GST Tax; or 2) a distribution will be made to a nonskip person that will result in wasting a portion of the GST Exemption previously allocated.
Generally speaking, trusts with inclusion ratios of one should be used for nonskip persons (or be included in the estates of nonskip persons) and trusts with a zero inclusion ratio should be used for skip persons or accumulated for future generations. Once the trusts have been carefully divided into exempt and nonexempt, distributions should be made to nonskip persons out of nonexempt trusts and distributions should be made to skip persons out of exempt trusts.
Charitable Giving as Part of a GST Plan
Because the typical goal of a GST plan is to provide additional assets to family members for several generations, charitable distributions are not usually a part of a typical GST Trust arrangement. However, individuals who have established (or expect to establish) GST Trusts for their descendants will often be the same individuals who will conclude that there may be sufficient assets to share with charities. The wealthiest individuals are usually the ones who include GST Trusts as part of their estate plans, and they are also the most likely to be able to afford to include significant portions for charity as part of their plans.
For this reason alone it is important for charitable gift planners to understand and appreciate the importance of GST planning, and the various rules that apply. It is not uncommon to find wills and revocable trusts that include a clause that provides for some or all of the amounts in excess of the available GST Exemptions to be set aside for charity. Furthermore, in some GST Trusts, the beneficiaries may be given fairly broad powers to determine the eventual recipients of the assets at the beneficiary's death, and this might include the potential for distributions to be made to charity.
Charitable Lead Trusts and the GST Tax
One specific situation where charitable giving and GST planning come together is through a Charitable Lead Trust (CLT). A CLT is a tool that is well suited for use as part of a multiple generation estate plan when the parents also have a desire to provide a benefit to charity. Effective use of the GST Exemption with a CLT can result in significant benefits to the family while providing a source of income to the charity for a period of years. However, when it comes to the GST Tax, the Lead Unitrust has a distinct advantage over the Lead Annuity Trust.
For a Lead Unitrust, the inclusion ratio for the trust is established at the creation of the trust. The value of the transfer (and hence the amount of GST Exemption needed to maintain a zero inclusion ratio) is only the present value of the remainder interest, taking into consideration the years of payments to be made to charity. Therefore, the entire future value of the trust estate will be exempt from the GST Tax even though a relative small portion of the GST Exemption was required to attain the zero inclusion ratio.
For a Lead Annuity Trust, the rules are a little more complicated. The GST Exemption is still allocated when the trust is created, but the inclusion ratio is not determined until the end of the payments to charity. A growth factor is applied to the amount of the GST Exemption based on the federal discount rate used to value the lead and remainder interests at the time the trust is created. The value of the trust assets at the end of the lead period is compared to the artificially increased GST Exemption, and the resulting fraction is the inclusion ratio for the continuing trust. Generally, if the trust estate grows faster than the assumed federal rate, the Annuity Lead Trust will not be fully exempt at the end of the lead interest, and if the trust estate does not grow as fast as the federal rates predict, some of the GST Exemption will have been wasted. In any event, there is no certainty as to the GST Tax status of an Annuity Lead Trust until many years in the future.
Estate planning and charitable giving are not independent concepts or approaches. The key to an effective charitable giving plan requires coordination with the donor's overall estate plan. For many donors, GST planning may be a part of the estate plan and therefore something that the gift planner must understand and appreciate. This article summarizes the basic concepts and considerations involved in planning for and around the GST Tax, but there is much more that could be said. This is one area where the inexperienced and/or untrained professional should not venture without the guide of an expert who has been there many times before. But, hopefully, you now have some general information that will permit you to participate in the discussions and provide a roadmap to the mysterious land of GST.
The author welcomes your questions and feedback. Please send your email to Mr. Blakesley at: sblakesley@BSMWL.com