Because of the operation of the inclusion ratio, it is beneficial to arrange for transfers to trust to have an inclusion ratio of either 0.0 or 1.0. Let’s assume that a terminally ill elderly client wishes to put $3 million into trust for the benefit of her only child during the child’s lifetime, with the remainder to her grandchildren upon her child’s death. During the child’s lifetime, the child shall be entitled to all income, and an independent trustee will be able to make discretionary payments of principal to the child. Indeed, principal will be distributed from time to time to the child. The entire $1.5 million GST tax exemption is then allocated to the trust. IRC Section 2642 provides that the trust will have an “inclusion ratio” of .5. During the lifetime of the child, the child receives $1.5 million in distributions, plus all of the income. Further assume that $2.0 million remains in the trust.
Upon the death of the child, there will be a Taxable Termination, so that .5 of the principal payable to the grandchildren will be subject to the GST tax, since .5 is the amount of the inclusion ratio. Thus, of the $2.0 million distributed to the grandchildren, $1.0 million will be subject to GST tax at a rate of 47%, thereby resulting in a tax liability of $470,000.
However, the client of the Montgomery County estate lawyer could have completely avoided the GST tax by having created two separate trusts. The first trust would have been funded with $1.5 million, to which the entire $1.5 million GST tax exemption would have been allocated (the “GST Exempt Trust”). The GST Exempt Trust would have an inclusion ratio of 0.0. The second trust would have been allocated no GST tax exemption, and therefore it would have an inclusion ratio of 1.0 (the “GST Non-Exempt Trust”). The GST Exempt Trust would contain a provision saying that no distributions shall be made to child from that trust until the GST Non-Exempt Trust was exhausted, and thus the entire $1.5 million of distributions to the child would come from the GST Non-Exempt Trust. The entire GST Exempt Trust, worth $2 million on the child’s death, will pass to the grandchildren without any further estate, gift, or GST tax.
Thus, when utilizing transfers to inter vivos trusts, it is best to be sure that the inclusion ratio is either zero to one. When working with an already established trust that has an inclusion ratio of between zero and one, the planner should investigate the option of severing the trust so that there are two separate trusts -- one with an inclusion ratio of zero and the other with an inclusion ratio of one.