Transfers during life or at death to a "skip person" may be subject to the generation skipping transfer tax ("GST"). A transfer to a grandchild while their parent is still alive is considered a direct skip, and is subject to the GST. The philosophy behind the GST is that each generation should be subject to estate tax. Transfers that skip a generation are therefore subject to a tax that is at least as severe as the estate tax.

The GST is an onerous, flat, 50% percent tax that is imposed in addition to the regular gift and estate tax. The GST tax rate imposed is equal to the highest estate tax rate in the year of the transfer. Under EGTRRA, the GST is scheduled for repeal, as is the estate tax. A skip person is defined as a person in a generation that is two or more generations below the transferor.188 Thus, grandchildren of the transferor are skip persons. However, a transfer to the children of a deceased child will not be considered to be a generation skipping transfer. Grandchildren who are the children of a deceased child of the transferor move up a generation, and are therefore not considered skip persons.

Example: Harry is a successful business owner who wants to establish a trust for his two grandchildren, Greg and Gretchen, whose father, Sam, was killed in an automobile accident. Harry funds each trust with $1 million of securities. The GST will not apply to the transfers because Greg and Gretchen's father was dead when the trust was originally established. However, gift tax will be assessed because the transfer amount exceeds the $1,000,000 exclusion for gift tax purposes.

Fortunately, all individuals are allowed a $1 million dollar exemption ($1,060,000 in 2002, indexed for inflation) from the GST. In addition, direct skip transfers that are within the $11,000 gift tax exclusion, and gifts that qualify for tuition and medical expenses (see Chapter 9) are not subject to the GST. Thus, a grandparent can make annual gifts of $11,000 per grandchild, plus a total of $1 million dollars in additional generation skipping transfers to grandchildren during life or at death GST free.

Gifts in trust that qualify for the gift tax exclusion rarely qualify for the GST exclusion. For gift tax purposes, gifts in trust qualify as present interest gifts by virtue of the Crummey power. Gifts in trust will qualify for the GST exclusion only if:

1. no part of trust income or corpus can be distributed to anyone other than the trust beneficiary during the beneficiary's life, and
2. trust assets are included in the beneficiary's gross estate if the beneficiary dies before the trust terminates. To qualify for the GST exclusion, a trust would have to benefit a single skip person, and would have to grant a general power of appointment to the beneficiary in the event the beneficiary predeceased the grandparent.

The GST applies to "direct skips", "taxable trust distributions", and "taxable trust terminations." A direct skip is a transfer of property, subject to either the estate or gift tax, to a skip person. A taxable distribution is any distribution (other than a taxable termination or a direct skip) from a trust to a skip person. A taxable termination is the termination of the interest of a beneficiary in a trust if immediately after the termination, no non-skip person has an interest in the trust and future distributions can only be made to a skip person.

Example: If Grandmother creates a trust for the lifetime benefit of her children, and then her grandchildren upon the death of her last surviving child, a taxable termination occurs on the death of her last surviving child.

The GST is incredibly complex! Only estate planning professionals with extensive experience can be expected to understand the rules. Unfortunately, the GST cannot be ignored. Inadvertent generation skipping transfers can occur where children of the decedent die between the deaths of their parents (see below). GST planning primarily involves proper allocation of the $1 million dollar GST exemption to transferred property. Revocable living trusts must accommodate the proper allocation of the GST exemption. To maximize the GST exemptions, revocable living trusts segregate trust assets on the basis of those that are subject to GST ("non-exempt" assets) and those which are exempt ("exempt" assets). Clients are confused by the numerous references to the GST in their revocable living trust document, sometimes uttering aloud "I'm not leaving a million dollars to my grandchildren." This Chapter 20 attempts to explain the reason why GST provisions must be addressed in every revocable living trust.

TRUSTS FOR CHILDREN

Trusts commonly hold funds for the benefit of children until they are old enough to manage an outright distribution. Such trusts create a generation skipping transfer if, at the child's death, before the termination of the trust, the trust funds pass to the child's descendants.

Example: Harry creates a trust for the benefit of his son, Sam. In the event that Sam is not age 35 at Harry's death, the Trust provides that trust assets will be held and used for Sam until he attains age 35, at which time the balance of the trust assets will be distributed to Sam outright. The trust further provides that in the event that Sam dies after Harry but before attaining age 35, his share passes to his children. If Sam survives Harry but fails to live to age 35, the share that passes to Sam's children is considered a generation skipping transfer.

Another common trust provision that can result in a generation skipping transfer is a transfer in trust for the grantor's spouse followed by an outright transfer to the grantor's children at the spouse's death. Such trusts usually provide that in the event a child of grantor predeceases grantor or grantor's spouse, the share of such child passes to the deceased child's issue. A transfer to grandchildren resulting from the death of child who dies after one parent but before the other is a generation skipping transfer.

Example: Harry dies leaving assets in a revocable living trust for the benefit of wife, Wendy, to be used for her benefit for the balance of her lifetime. At Wendy's death, trust assets are to be distributed to Harry's children, Sam and Donna, or the issue of a child who fails to survive Wendy. If Donna survives Harry, but predeceases Wendy, the share that passes to Donna's children is a generation skipping transfer.

TRANSFEROR

Identifying the transferor of a generation skipping transfer is important because only the transferor or the transferor's executor may allocate the GST exemption. The transferor is the donor for any transferred property subject to the gift tax and is the decedent for transfers of property subject to estate tax. Transfers that qualify for the marital deduction cause the transferred property to be subject to gift or estate tax on subsequent transfers by the recipient spouse. The recipient spouse becomes the transferor when property is later included in the estate of the recipient spouse.

Example: At Harry's death, his revocable living trust divides into a family and marital trust. Harry is the transferor of the family trust because funding of the family trust is a taxable transfer (even though it is offset by Harry's unified credit). Wife, Wendy, is the transferor of the marital trust since the balance of the marital trust remaining at Wendy's death is included in her estate and therefore taxable to her. Harry can use all of his GST exemption.

REVERSE QTIP ELECTION

A special election is available to Harry's executor in the above example if the marital trust is a QTIP trust. Harry's executor may make a "reverse QTIP election," which has the effect of treating the marital Trust (for GST purposes only) as if no QTIP election was made.

The reverse QTIP election effectively treats Harry as the transferor, allowing him to allocate his full $1 million dollar GST exemption. The reverse QTIP election is made on the gift tax return (Form 709) or estate tax return (Form 706).

EARLY GST EXEMPTION ALLOCATION

The benefit of the $1 million dollar GST exemption can be maximized if used during the life of the transferor. The future appreciation of assets to which GST has been allocated is not subject to the GST.

Example: In 1999, Harry transferred $500,000 of stock to a trust for the benefit of his son, Sam, for his life, then to Harry's grandchildren. One half of Harry's GST exemption was timely allocated to the transfer on Form 709. The stock is worth $4 million dollars at Sam's death, when it passes to Harry's grandchildren. No GST is due on what would otherwise be a taxable termination since the GST exemption was allocated when the gift was made. Thus, once the exemption is allocated, any further generation skipping transfers of the exempted property remain exempt from the GST tax.

Married couples can maximize their separate $1 Million dollar GST exemptions by dividing their assets to ensure that each spouse has a revocable living trust funded with at least $1 million dollars. Further, a husband and wife may elect to split a gift, allowing the gift to be deemed to have been made one-half by each spouse. For GST purposes, each spouse is treated as the transferor of one-half of the gift, and each spouse may allocate his or her GST exemption to the respective gifts."

USE OF MULTIPLE TRUSTS TO OPTIMIZE THE GST EXEMPTION

Separate trusts inside a single revocable living trust allow the successor trustee to segregate assets that are subject to the GST from those that are not. Once separated, the GST exemption can be allocated between the trusts in such a way as to maximize the exemption. The GST exemption will be allocated to the non-exempt trust for the benefit of a skip person, while no such allocation is necessary for the exempt trust benefiting non-skip persons, since such transfers are not subject to the GST. In the parlance of the GST, the separate trusts should have an inclusion ratio of either "0" or "1." The trust with the inclusion ratio of 0 is used to provide benefits only for skip persons while the trust with the inclusion ratio of 1 is used to provide benefits for non-skip persons. Absent the segregation of assets described above, the GST exemption would be allocated to all trust assets on a pro rata basis. A trust with assets in excess of $1 million dollars would have an inclusion ratio between 0 and 1. The GST exemption would then be wasted on a distribution to a non-skip person since unprotected assets could have been distributed to a non-skip person without GST tax consequence anyway.

THE INCLUSION RATIO

The inclusion ratio is the fraction used to determine the GST tax rate applicable to a GST transfer. An inclusion ratio of 0 will result in no GST, while an inclusion ratio of 1 results in a full 50% GST. The inclusion ratio is 1 minus the applicable fraction. The numerator of the applicable fraction is the amount of the GST exemption allocated to the trust or transferred property. The denominator of the applicable fraction is the final gift or estate tax value of the property transferred.

Example: Harry transfers $6 Million dollars to a trust he establishes for his grandchildren. Harry allocates his entire GST exemption to the trust on a timely filed Form 709. The applicable fraction is $1 million divided by $6 million, or .167 (rounded to the nearest thousandth). The inclusion ratio is .833 (1 - .167). Any taxable transfer with respect to the trust will be taxed at 83.3% of the GST tax rate of 50% (e.g., 50% times 83.3% = 41.65%).

EGTRRA

The GST Tax, like the federal estate tax, is scheduled for continuing reduction and ultimate repeal by 2010. However, unless the "sunset" provision is removed, GST and the Federal Estate Tax will return with a vengeance in 2011, using rates and exemption amounts in effect in 2001. The author believes that change of some kind will certainly be enacted prior to 2010. Keep posted!