This is a post about the Generation Skipping Transfer Tax (GST). The purpose for the enactment of the GST tax was to limit the erosion of the federal estate tax base through taxpayer's use of gifts to grandchildren or more remote generations, either by way of direct gifts or gifts in trust. The GST tax accomplishes the purpose by taxing transfers that skip generations, to the extent that the transfers are not protected by the GST tax exemption. Recall that a transferor is generally the donor of a completed gift federal gift tax purposes, or a decedent for federal estate tax purposes. And, remember that a Skip Person is a term that refers to someone that is more than one generation below the generation of the Transferor. For donees, or legatees, that are not related to the transferor, they will generally be considered Skip Persons if they are more than 37.5 years younger than the transfer. A trust can be a Skip Person if either:
i) all interests in the trust are held by Skip Persons, or
ii) the only current beneficiaries are skip persons, and so long as a trust distribution cannot be made to a Non-Skip Person.
Finally, remember that a non-Skip Person is any person or trust that is not a Skip Person (which seems rather obvious).
Types of GST
There are various types of GST transfers. A GST transfer can come in the form of a "direct skip ", a "taxable termination", or a "taxable distribution", and each of them is determined in reference to a transferor. A direct skip involves the direct transfer to a skip person, either during their lifetime or at death. A taxable termination occurs when a transfer is made to a skip person on termination of the trust. And finally, a taxable distribution occurs when there is a regular distribution (of principle or income) from a trust to a skip person. A skip person is someone that is more than one generation below the generation of the transfer. For donees or legatees that are not related to the transferor, they will generally be considered Skip persons if they are more than 37.5 years younger than the transfer. A trust can be a skip person if all the beneficiaries or skip persons, and so long as a trust distribution cannot be made to a non-Skip person.
GST tax and inclusion ratio
This is a post about the GST tax exemption and the inclusion ratio. A transferors GST tax exemption may be allocated to a transfer so I was to pass completely or partially free of the GST tax. The extent to which a transfer passes without GST tax will depend upon the "inclusion ratio", which is determined by the following formula: 1.0 - (Amount GST Allocated/Amount of Transfer). To illustrate, let's assume that A makes a gift of $1 million to a trust that pays income to A’s children for their lifetimes, with principal passing on termination to A’ grandchildren. A then allocates $500,000 of A’s GST tax exemption to the trust. The inclusion ratio will be .50, arrived at as follows: 1.0 - ($500,000 divided by $1,000,000). Therefore, upon distribution of the remainder to the grandchildren, one half of each remainder distribution will be subject to GST tax (unless the parent of the grandchildren predeceased the transfer into the trust).
Methods of allocating GST
This is a post about the methods of allocating the GST tax exemption. The primary means of reporting an allocation of the GST tax exemption to a lifetime transfer is to report it on a timely filed gift tax return for the year of the transfer, in which case the allocation is effective at the value of the transferred property at the time of the transfer. However, if the timely allocation of the GST tax exemption is not made for a lifetime gift, the grantor can make a late allocation at any time prior to his or her death by filing a late gift tax return, and the personal representative of his or her estate may make a late allocation on a federal estate tax return. If a late election is filed, it is effective as of the date of filing of the allocation. Once made, the allocation is a revocable. If the full GST tax exemption is not made on or before the due date of the taxpayers federal estate tax return, the taxpayer’s remaining GST tax exemption will be automatically allocated.
Another opportunity for your Montgomery County estate lawyer is a deemed allocation as a lifetime transfer. If a taxpayer makes a lifetime gift that is the direct skip, the taxpayers remaining GST tax exemption will be allocated to that transfer in an amount necessary to get to a zero inclusion ratio. The taxpayer is given the ability to opt-out of this the deemed allocation either by paying the GST tax, or by making an election out. The election out of the deemed allocation must be made on a timely filed gift tax return. Though the election out of the deemed allocation is irrevocable once made, in the case of a direct skip to a trust, the taxpayer or the taxpayer’s executor may make a late allocation of GST tax exemption to the trust to limit the GST tax on later taxable distributions or taxable terminations. Some lifetime direct skips may be delayed because the transfer is subject to inclusion in the transferor's estate (which causes an estate tax inclusion). In that case, the direct skip doesn't occur until the end of the ETIP period.
Yet another opportunity is for indirect skips, where the deemed allocation rules also apply to certain transfers to trusts. An indirect skip is defined as a lifetime transfer of property subject to the gift tax that is not a direct skip, and that is a transfer to a GST trust. A GST trust is a trust that could have a generation skipping transfer with regard to the transfer in the future. A transfer is subject to GST tax even if the transfer qualifies for the annual exclusion under IRC section 2503(b). If a trust is classified as a GST trust under IRC section 2632(c), and it meets the other requirements, then the amount deemed allocated to the transferred property will be the amount necessary to get an inclusion ratio of zero. The taxpayer may elect out of the automatic allocation to an indirect skip on a timely file gift tax return for the calendar year of the indirect skip. The trust which does not meet the definition of a GST trust can elect to be a GST trust for particular transfer or transfers during a calendar year.
There is also the possibility of a retroactive allocation. The IRC permits retroactive allocations of the GST tax exemption in certain narrow circumstances. Retroactive allocations are distinguished from late allocations, the latter of which can be more freely made with different consequences. IRC section 2632 – D allows a tax payer to allocate unused GST tax exemption to a trust created by the taxpayer, if there a natural order of death in the tax payer/transfer is still living at that time and has unused GST tax exemption. For example, assume that a taxpayer creates an irrevocable life insurance trust for the benefit of her husband and children on January 1, 2005. The children will be entitled to principal upon the death of the spouse. The taxpayer begins to fund the trust, and decides not to allocate any GST tax exemption the trust may have because the tax pair expects all distributions of principle to be made to non-skip persons. However, in 2009, one of the taxpayer's children passes away, such that the child’s share will go to his surviving children on the spouse's death. The GST will apply to the entire amount of principal distributions to the grandchildren. To remedy the situation, IRC section 2632(d) permits a retroactive allocation in this scenario. The basic requirement for retroactive allocation is that there be an unnatural order of death of a non-skip person, and that non-skip person must: i) be a lineal descendent of a grandparent of the transferor’s current or former spouse, ii) be assigned to a generation below the generation level of the transfer; and iii) must predecease the transferor. The election will be effective immediately prior to the non-skip person's death, but the value used for purposes of determining the allocation amount will be the date the property is transferred. If the retroactive allocation is to be made where there is an open ETIP, the effect of the retroactive allocation of the GST tax exemption will be delayed until the close of the ETIP.
The final method of allocating the GST tax exemption is an allocation upon death. There are four basic types of transfers to which the GST tax exemption can be allocated at a transferors death: 1) direct skips occurring at death; 2) property held in trust but included in the transferors estate; 3) property held in trust not included in the transfer wars estate; and 4) lifetime direct skips or indirect skips made during transferor’s lifetime but transfer or died before the expiration for making a timely allocation. If there's no active allocation to a decedent’s unused GST tax exemption within these categories, it will be automatically allocated in the following order: to the nonexempt value of property that constitutes a direct skip occurring at the transfer/decedent’s death, to the nonexempt value of property held in trust with respect to which the decedent is the transfer, and which might result in a capital taxable termination or taxable distribution in the future, to the nonexempt value of property upon the disposition of cessation of use of IRC section 2032(a) property.