Back to Basics
The Role of Generation Skipping Transfer
Taxes in Everyday Estate Planning
Presentation for The Chicago
Estate Planning Council,
May 25, 2010
Jason S. Ornduff
Thompson Coburn LLP
55 E. Monroe Street, 37th Floor
Chicago, Illinois 60603
(312) 580-2227
jornduff@thompsoncoburn.com
© 2010 Thompson Coburn LLP
Disclosures/Disclaimers
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The Trinity of the GST Tax
System
• Transferor
– Person who has disposed of property (or spouse if gift split)
– Person who exercises, releases or lets lapse a taxable power over
property
Transferor
• Property Interest Being Transferred
– Direct Skips
– Taxable Terminations
– Taxable Distributions
Property
Interest
• Skip Person Transferee
– Natural person 2 or more generations below that of transferor
– Trust whose interest is held only by skip persons or that cannot
make distributions other than to skip persons
© 2010 Thompson Coburn LLP
Skip Person
Generation Assignment
Everyone in the world is assigned to a generation in relation to
the transferor:
Transferor’s Generation: spouse, siblings (and spouses), first
cousins (and spouses), unrelated persons no more than 12.5
years younger
One Generation Below: children (and spouses),
nephews/nieces (and spouses), children of first cousins (and
spouses), persons more than 12.5 but not more than 37.5 years
younger
Two Generations Below: grandchildren (and spouses),
grandnephews/nieces (and spouses), grandchildren of first
cousins (and spouses), persons more than 37.5 but not more
than 62.5 years younger (even younger is next generation
down)
© 2010 Thompson Coburn LLP
A GST Love Story
Vickie Lynn Marshall (a/k/a
Anna Nicole Smith) and
former husband J. Howard
Marshall (63 years older
than her)
Before Marriage: Anna is a
skip person (not related to
Marshall and more than
37.5 years younger)
After Marriage: Anna is not a
skip person (moves up to
the generation of her
husband, despite age
difference)
© 2010 Thompson Coburn LLP
Predeceased Ancestor Rule
In general, death in intermediary generation causes
persons from lower generation to move up (if death
is before transfer)
Transferor
Living Child
Grandchildren
(skip persons)
© 2010 Thompson Coburn LLP
Grandchildren
(move up)
Deceased Child
Grandchildren
(not skip persons)
Types of GSTs
•
•
•
Direct Skips
– Outright gifts (during life or at death) to skip persons
Taxable Terminations
– Termination of interest unless:
(A) Immediately after termination non-skip person has
interest, or
(B) At no time after termination may a distribution be
made to a skip person
Taxable Distribution
Distribution of property from a trust to a skip person
(except when this can be a direct skip or a taxable
termination)
© 2010 Thompson Coburn LLP
Types of GSTs (cont.)
Direct Skips: Main issue arises when elderly person leaves a bequest
at death to a non-related person more than 37.5 years younger
(neighbor, friend, caregiver)
Taxation of GSTs
Direct Skips:
Tax exclusive (tax paid by
transferor on Form 706, Sch. R,
or Form 709, Parts 2 and 3 and
Sch. C)
Taxable Distributions:
Tax inclusive (tax comes out of
transfer – reported by trustee (on
Form 706-GS(D-1), reported and
paid by recipient (on Form 706
GS(D))
Taxable Terminations:
Tax inclusive (tax comes out of
transfer – reported and paid by
trustee on Form 706-GS(T))
© 2010 Thompson Coburn LLP
Calculation of GST Tax
GST Tax = Taxable Amount (TA) x Applicable Rate
Applicable Rate = Maximum Federal Estate Tax Rate (45%) x
Inclusion Ratio
Inclusion Ratio = 1 – Applicable Fraction
Applicable Fraction = GST Exemption Allocated to Transfer
(GSTE)/Fair Market Value of Transfer (FMV)
GST Tax = TA x [45% x (1 - (GSTE/FMV))]
© 2010 Thompson Coburn LLP
The GST Exemption
• GST Exemption is a necessary component since you need to
know the Applicable Fraction to calculate the tax owed, if any
• Was $3.5 million in 2009, there is no GST tax in 2010 and it
goes back to $1 million (adjusted for inflation) in 2011 if
EGTRRA expires)
• Applies to both lifetime and testamentary transfers
• Large GST Exemption is the main reason only 197 out of
38,373 estate tax returns in 2008 reported GST tax owed (.5%
of returns filed)
© 2010 Thompson Coburn LLP
Automatic/Elective GST Exemption
Allocations
Automatic Allocations
1.
2.
3.
Deemed allocation to
lifetime direct skips and
lifetime indirect gifts
subject to gift tax (after
12/31/00)
No need to make election
on gift tax return (but
must expressly opt out of
automatic allocation in
timely filed gift tax
return)
At death, automatic
allocation first to
testamentary direct skips,
then to trusts
© 2010 Thompson Coburn LLP
Elective Allocations
1. Must report gift on timely
filed return and allocate
GST exemption to it
2. Instructions for how to
make election found in
Treas. Reg. 26.2632-1(b)(4)
3. Late allocation can be made
(but value of transfer at
time of election, not
transfer, is value at issue)
4. Retroactive allocation
allowed in limited
circumstances
Correcting Allocation Mistakes
• Mistakes are made to GST exemption allocations (or opting
out of them) all the time
• Section 9100 Relief
– Must apply for private letter ruling (streamlined procedure
in certain circumstances)
– IRS makes decision (if yes, retroactive to time of transfer)
• Five circumstances IRS considers
1. Relief request comes prior to IRS discovery
2. Election not made due to circumstances beyond taxpayer
control
3. Despite reasonable diligence, taxpayer unaware of
necessity
4. Taxpayer relied on written advice of IRS
5. Tax professional error (most common reason given in
request)
© 2010 Thompson Coburn LLP
Calculation Examples
Example 1 – Direct Skip
Facts: Grandfather died in 2009, leaving outright gift of $3.5
million to grandchildren (parents alive). Grandfather had
previously used $700,000 of GST exemption (so $2.8 million
of exemption left).
Taxable Amount:
Applicable Fraction:
Inclusion Ratio:
Applicable Rate:
GST Tax:
© 2010 Thompson Coburn LLP
$3.5 million
4/5 ($2.8 million/$3.5 million)
1/5 (1 – 4/5)
9% (45% x 1/5)
$315,000 ($3.5 million x 9%)
Calculation Examples
Example 2 – Taxable Termination
Facts: Grandfather died in 2009, leaving gift in trust of $10.5
million for benefit of son, outright to his grandchildren at
son’s death. Grandfather has not previously used GST
exemption (so $3.5 million of exemption is left). Son dies a
year later, and trust is worth $11 million.
Taxable Amount:
Applicable Fraction:
Inclusion Ratio:
Applicable Rate:
GST Tax:
© 2010 Thompson Coburn LLP
$11 million
1/3 ($3.5 million/$10.5 million)
2/3 (1 – 1/3)
30% (45% x 2/3)
$3.3 million ($11 million x 30%)
Calculation Examples
Example 3 – Taxable Distribution
Facts: Same facts as Example 2, except distributions can be made
to grandchildren during the life of son as son appoints by
special power. As a result, a $10,000 distribution is made to
grandson.
Taxable Amount:
Applicable Fraction:
Inclusion Ratio:
Applicable Rate:
GST Tax:
*
$10,000
1/3 ($3.5 million/$10.5 million)
2/3 (1 – 1/3)
30% (45% x 2/3)
$3,000 ($10,000 x 30%)*
This example points to the problem of trusts with inclusion ratios of between 0
and 1. Had there been two trusts, one with $3.5 million and the full GST
exemption, the other with $7 million and no exemption, the first trust could
make GST tax-free distributions to the grandchildren and the other could
make distributions to the son.
© 2010 Thompson Coburn LLP
Gifts Excluded from GST Tax
• Annual Exclusion Gifts
– Same rules apply as for annual exclusion from gift tax,
except
– Crummey powers do not work for trusts unless trust is for
one beneficiary only and trust includable in estate of
beneficiary for estate tax purposes (big issue with respect
to insurance trusts)
– Section 2503(c) Minor’s Trusts work as well (age 21
issue)
• Gifts to 529 College Savings Plans
– Considered completed gifts (annual exclusion can apply)
– Can front load gift to grandchildren (5 years in year 1)
• Qualified Medical and Tuition Gifts
– Same rules as gift tax exclusion
– Key is to make payments directly to institution
© 2010 Thompson Coburn LLP
Estate Tax Inclusion Period
• General Rule – GST exemption allocation not effective for
transferred property interests until property is no longer
subject to estate tax at transferor’s death (estate tax inclusion
period – ETIP)
• ETIP terminates when one of the following occurs:
1) Death of transferor
2) No portion of property included in transferor’s estate
(other than by reason of Section 2035)
3) At the time of a GST, but only with respect to property
involved in the GST
4) If ETIP because of power held by spouse of transferor, on
the first to occur of spouse’s death or time property would
not be included in the spouse’s estate (except for Section
2053)
• Classic ETIPs
– Grantor Retained Trusts (GRATs/GRUTs)
– Qualified Personal Residence Trust (QPRT)
© 2010 Thompson Coburn LLP
Estate Tax Inclusion Period
• ETIP Problem – assume $1 million placed in a GRAT with a
10-year term, 5% payout and 6% annual growth, residuary at
end of term to a GST trust for children and grandchildren
(April, 2010 7520 rate of 3.2% used)
– Value of gift ($422,190)
– Value of property at end of term ($1,131,808)
– If $422,190 in GST exemption is allocated to gift to start,
inclusion ratio of GST trust will be 62.7%
($422,190/1,131,808 = 37.3%) (1-37.3% = 62.7%)
– Conversely, if property earns less than payouts, GST
exemption will have been wasted
• Possible solutions: (1) wait until end of ETIP to allocate, (2)
formula allocation
– Risk of waiting – death of transferor before allocation
– Risk of formula – additional GST gifts during ETIP (what
is available to allocate?)
© 2010 Thompson Coburn LLP
Reverse QTIP Election
General
Rule:
A person who exercises, releases or lets lapse a taxable power
is the transferor for GST tax purposes
Problem: A surviving spouse has a taxable power over a QTIP marital
trust, but if she is treated as the transferor, the surviving
spouse must dip into her own GST exemption to pass QTIP
assets to skip persons or GST trusts
Solution: Reverse QTIP election
Elements: (1) made on estate tax return of first spouse to die
(2) first spouse deemed to be transferor for GST purposes
(3) applies to all property in QTIP trust (3-trust structure)
© 2010 Thompson Coburn LLP
Reverse QTIP Election
Husband ($6 million)
(has already used $1 million of
gift tax exemption for gifts to
non skip persons)
GST Credit Shelter Trust
($2.5 million)
GST QTIP Trust
($1 million)
Non-GST QTIP Trust
($2.5 million)
Wife
($3.5 million)
GST Trusts for descendants
(get $7 million)
Children
(get $1.375 million after taxes)
(broken green line) If no reverse QTIP election is made, then Wife is treated as transferor at her death,
meaning she loses the ability to give all $3.5 million of her own assets to GST trusts for descendants
© 2010 Thompson Coburn LLP
Grandfathered GST Trusts
GST tax applies to transfers made on or
after October 22, 1986, except those
made from trusts that were irrevocable
on or before September 25, 1985 and to
which no subsequent additions have
been made
TIP: When in doubt, leave
“grandfathered” GST trusts alone
Two main issues with grandfathered
GST trusts:
1) Modifications
2) Property Additions
© 2010 Thompson Coburn LLP
Grandfathered GST Trusts
Modifications
Modifications that do the following cause a GST trust to lose
its grandfathered status
1) shift of beneficial interest to a lower generation from
the current beneficiary
2) modification extends time for vesting beyond that
provided for in the original instrument
In general, changing a traditional income interest to a unitrust
or equitable apportionment scheme is not an impermissible
modification
© 2010 Thompson Coburn LLP
Grandfathered GST Trusts
Property Additions
Do not add property to a grandfathered trust (unless you
allocate GST exemption to the addition)
Issue of property addition is less about actual additions and
more about constructive additions
1) payment of debts, taxes or other expenses of a
grandfathered trust
2) exercise, release or lapse of certain powers that
constitute taxable transfers for gift or estate tax
purposes
3) nonqualified disclaimers (thus also a taxable gift)
© 2010 Thompson Coburn LLP
When Do You Do GST Planning?
We could say do GST planning in every estate, but that is
impractical (author’s opinion only)
Consider GST planning in the following circumstances:
 High net worth clients
 Children are already wealthy
 Children cannot be trusted
 Grandchild’s needs are greater
© 2010 Thompson Coburn LLP
GST Planning - Lifetime Gifts
GST Gifting Mechanisms
 Outright Gifts
 Gifts to Section 2503(e) Minor’s Trusts
 Gifts to 529 College Savings Plans
 Qualified Medical and Tuition Gifts
 GST Trusts (lifetime and testamentary)
© 2010 Thompson Coburn LLP
GST Planning - GST Trusts
• GST Trusts (trusts with current or potential skip person
beneficiaries)
 Goal is to provide for multiple successive generations free
from estate tax to at least one of those generations
• GST trust issues
 Mandatory or Discretionary Income Payouts (tax
efficiency)
 Beneficiary/Third Party Rights
• Special v. general powers
• Trustee replacement/removal powers
• Trust protectors
 Perpetuity (Dynasty Trust) or Finite Term
 Grantor or Non-grantor Trust (tax exempt
growth during life)
© 2010 Thompson Coburn LLP
GST Planning - Use of Disclaimers
• Disclaimers and QTIP elections should be on every estate
attorney’s standard administration checklist
– These are the post-death planning devices
– Need to have a qualified disclaimer (9 months, don’t touch
asset)
• Disclaimers allow non-GST gifts to become GST gifts if the
conditions are right
– Beneficiary who does not need or want all or some of
inheritance
– Instrument or intestate law says skip persons inherit if
beneficiary dies (or disclaims)
Ideal Situation for Disclaimer: Client engaging in annual
gifting to children stands to inherit assets at death of parent
(disclaimer can accomplish in one stroke what years of annual
exclusion gifting cannot – sizeable tax free gifting)
© 2010 Thompson Coburn LLP
GST Planning – Life Insurance Planning
• Placing life insurance in a GST trust can greatly enhance
wealth for future generations
• Main problem, however, is Crummey powers that qualify gifts
for the annual gift tax exclusion for gift tax purposes, but not
for GST tax purposes
• Solutions
– One trust for each skip person (impractical for life
insurance)
– Use grandfathered GST trusts to purchase life insurance
– Allocate GST exemption to gifts
• Issues to consider
– Waiting for value of policy to decline (risk death of
insured)
– Do we apply GST exemption elsewhere (given that most
policies lapse, perhaps it is best to apply GST exemption
to other gifts)
• If using GST trust to hold life insurance, consider second-todie policy
© 2010 Thompson Coburn LLP
GST Planning – Avoiding GST
Common inadvertent GST scenario: Gift to trust for minor
child with payout at certain age and death of child before that
age, with child’s children receiving assets in trust
Best way to avoid inadvertent GST: Give all children, even
minors, a testamentary general power of appointment (can
appoint to selves, creditors, estates, creditors of estates)
* Forces inclusion in child’s estate (child becomes
transferor)
* Since testamentary, however, spendthrift concerns are
less
© 2010 Thompson Coburn LLP
EGTRRA Expiration in 2011
EGTRRA expires at the end of 2010
Effect on GST Tax:
1.
2.
3.
4.
5.
GST Exemption reverts to $1 million (indexed for inflation)
Loss of Automatic Allocations for Certain Lifetime Transfers
under Section 2632(c)
Loss of Retroactive Allocations Under Section 2632(d)
Loss of Late Election 9100 Relief Under Section
2642(b)(2)(A)
Loss of Ability to Sever Trusts into Exempt and Nonexempt
Trusts Under Section 2642(a)(3)
Nightmare Thought: EGTRRA expiration language says to deem
as if it never existed (what effect on existing GST trusts?)
© 2010 Thompson Coburn LLP
GST Spotting - Questions to Ask
• Are any beneficiaries grandchildren (or other relatives of the
same generation) or individuals more than 37.5 years younger
than the decedent?
• What rights over the trust have been given to the trust
beneficiaries (general or special powers)?
• If the trust was created and funded during life and gives
benefits to skip persons (see first question), was GST
exemption allocated to such gifts (get copies of gift tax
returns)
• Is the governing instrument older than September 25, 1985,
and, if so, did the decedent die or lose the ability to amend it
before that date as well?
© 2010 Thompson Coburn LLP
Things to Remember
• All GSTs require a skip person (no skip, no GST)
• Every GST also is subject to gift or estate tax and
use those exemptions as well
• A property interest that avoids estate tax at death is
probably a GST (the goal of the GST tax is to
impose tax at each generation)
© 2010 Thompson Coburn LLP
Things to Remember
• If the client chooses consciously to engage in GSTs,
document this decision for future generations
• Remember that GST exemption will be
automatically allocated to most lifetime GST
transfers (plan accordingly)
• Crummey powers generally will not work on the
GST tax (do you apply GST exemption?)
• When is doubt, never mess with a “grandfathered”
GST trust
© 2010 Thompson Coburn LLP