31 Jan 2024 Solving Generation-Skipping Transfer Tax Problems
Authored by RSM US LLP, January 31, 2024
Published in Probate & Property Volume 38, Number 1, ©2024 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
The intricacies of estate planning often bring to light a range of complex tax considerations, including the generation-skipping transfer tax (GSTT). Understanding the implications associated with the imposition of the GSTT is crucial when reviewing an estate plan, as it can significantly affect the distribution of wealth and the preservation of family assets.
The allocation of a transferor’s generation-skipping tax (GST) exemption protects transfers from the GSTT. The inclusion ratio of a trust, calculated under IRC § 2642(a), determines the portion of the trust assets that is subject to GSTT. The 40 percent flat GSTT is imposed on three triggering events: (1) a direct skip with no remaining GST exemption available under section 2612(c), (2) a taxable distribution from a trust with an inclusion ratio other than 0.000 under section 2612(b), and (3) a taxable termination of a trust with an inclusion ratio other than 0.000 under section 2612(a).
A zero inclusion ratio means 0% of the trust assets are subject to GSTT.
A one inclusion ratio means 100% of the trust assets are subject to GSTT.
Other than 0.000 or 1.000
‘Mixed inclusion ratio’
An inclusion ratio other than zero or one means that a fraction of the trust assets is subject to GSTT. A trust with an inclusion ratio other than 0.000 or 1.000 is a good candidate for a qualified severance.
Below, we delve into five common GST exemption allocation problems that may arise when reviewing the GST status of a trust. We then provide suggested remedies to mitigate potential unintended consequences.
Problem 1: Trust with an Unintended Mixed Inclusion Ratio Due to Unreported Transfers Made Prior to Automatic Allocation Rules
Section 2632(c) enacted a deemed allocation of a transferor’s GST exemption to certain lifetime transfers to indirect skip GST trusts (GST Trust) after December 31, 2000. Before that date, GST exemption had to be manually allocated to transfers other than direct skips on a timely filed gift tax return. If clients made gifts to a GST Trust (under section 2632(c)(3)(B)) before and after December 31, 2000, and did not consider the GST exemption implications, they may have a trust with a mixed inclusion ratio.
For example, a client funded a life insurance trust in 1998 that is a GST Trust. The client has never reported transfers to this trust on a gift tax return because a Form 709 was not required. All gifts made to the trust were below the annual exclusion and were present interests because the beneficiaries had the right to withdraw the entirety of each transfer. The client made the transfers listed below.
Value of current
No GST exemption allocation
No GST exemption allocation
No GST exemption allocation
Automatic allocation of transferor’s GST exemption
The transfers made in 1998, 1999, and 2000 are not protected from the GSTT. For 2001 and future years, an automatic allocation of the transferor’s GST exemption occurred, and the portion of the trust related to those transfers is protected from the GSTT. The failure to file gift tax returns to manually allocate GST exemption to the 1998, 1999, and 2000 transfers to this trust resulted in a mixed inclusion ratio. This means that a portion of the trust assets are not protected from the GSTT. This situation may be remedied, however, by the relief provided in Rev. Proc. 2004-46.
Remedy 1: Timely Manual Allocation Relief under Rev. Proc. 2004-46
In any situation where an error or oversight may have occurred, by either the client or prior advisors, it is recommended to start by having a conversation. This conversation should be focused on your clients’ intentions for the trust. Do they think that non-skip persons will deplete the trust before it ever benefits skip persons? If so, they may not be concerned with the mixed inclusion ratio and instead may be concerned with the potential waste of their GST exemption in 2001. If they do think the trust will benefit skip persons, the conversation will shift to how to protect the trust from the GSTT.
The mixed inclusion ratio issue is related to the transfers made in 1998, 1999, and 2000 in which automatic allocation rules did not apply, leaving the transfers susceptible to GSTT exposure. The solution to this problem is Rev. Proc. 2004-46, which provides a special rule for pre-2001 present interest gifts under the annual exclusion. It allows taxpayers to go back and file gift tax returns as if they are making a timely manual allocation using date of transfer values. To take advantage of this relief, the client should file gift returns for 1998, 1999, and 2000 to allocate the available GST exemption following the other reporting requirements outlined in the revenue procedure. After filing those returns, the trust will have an inclusion ratio of 0.000. By taking advantage of this remedy, the client limits the amount of GST exemption needed to allocate to fully protect the trust and potentially saves a significant amount of GSTT if assets do benefit skip persons.
If the client does not take advantage of this revenue procedure or the gifts made do not qualify for this method, there are other remedies available, such as relief under section 9100 (see Problem 2 below), a late allocation of GST exemption (see Problem 3 below), or a qualified severance (see Problem 5 below).
If the client did not intend for the trust to be GST exempt, additional remedies are available, such as a private letter ruling (PLR) to request relief to make a timely opt-out election under section 9100 (see Problem 2 below) or a qualified severance (see Problem 5 below).
Problem 2: Inadvertent Automatic Allocation of Transferor’s GST Exemption; No Affirmative Opt-out Election Made
Sometimes when filing a gift tax return, the preparer may fail to make an affirmative GST election. If a trust formed after 2000 is a GST Trust, the transferor’s available GST exemption will be automatically allocated to transfers made to the trust. In the alternative, if a trust is not a GST Trust, no GST exemption would be allocated to transfers made to the trust unless made manually. Automatic allocation rules were enacted as a safety net to protect trusts from exposure to GSTT. The rules themselves, however, may cause unintended consequences. If you have a trust that is a GST Trust but will never benefit skip persons, an automatic allocation of the transferor’s GST exemption to that trust could be a waste of the transferor’s exemption.
For example, a taxpayer and spouse filed 2012 gift tax returns that reported a $1 gift to a grantor- retained annuity trust (GRAT). They relied on their prior tax professional to make an opt-out election on the 2012 gift tax returns to prevent the automatic allocation of their GST exemption after the estate tax inclusion period (ETIP). The professional failed to do so. The trust is a GST Trust and there is a remote chance it could benefit skip persons. The clients expect that their child, a non-skip person, will fully deplete the trust. The trust does not need to be protected from the GSTT. The GRAT value at the end of the ETIP is $10,240,000.
In 2021, the GRAT matured, and no opt-out election was made at the end of the ETIP on the 2021 gift tax returns. The taxpayer and spouse elected to split gifts in 2012 and 2021. Because no opt-out elections were made, $5,120,000 of the taxpayer’s and $5,120,000 of the spouse’s available GST exemptions were automatically allocated to the trust. The trust ultimately goes outright to their child, so the automatic allocation was a significant waste of the transferors’ available GST exemptions.
Remedy 2: Private Letter Ruling to Request Timely Election Relief Under Section 9100
To rectify the failure to make an election for GST purposes, we can look to section 9100 for relief. Section 9100 relief grants an extension of time to make certain regulatory elections. If relief is granted, it provides the same effect as if an opt-out election had been made timely. Under Notice 2001-50, extensions of time for GST purposes may be granted under Treas. Reg. § 301.9100-3. To take advantage of the 9100 relief for failure to make a GST election, the taxpayer must request relief through a private letter ruling (PLR) from the IRS. This type of relief can be costly. The standard cost for a PLR in 2023 is $12,600, plus an additional $3,800 for an identical spousal letter for gift-splitting purposes. The related legal and accounting fees would be even more significant.
Generally, the IRS will grant relief if the taxpayer shows she acted reasonably and in good faith. Also, the IRS considers whether the government would be prejudiced by granting the relief. In this example, the IRS grants the relief. The taxpayer files an amended 2012 gift tax return to make the opt-out election and attaches the PLR. The election will be treated as if it were made timely on the 2012 gift tax return, preventing the automatic allocation of the transferors’ GST exemption at the end of the ETIP in 2021. This will result in saving $5,120,000 of each of the transferors’ GST exemptions.
Allocation of GST exemption to a trust subject to an ETIP will not take effect until the period has ended.
GRATs generally result in a nominal taxable gift but are expected to appreciate, leaving significant assets in the trust after the ETIP. Accordingly, with GRATs, the taxpayer should generally opt-out of an automatic allocation of GST exemption on the gift tax return reporting the initial transfer. The taxpayer would then wait until the GRAT has terminated and the ETIP has ended to decide whether to make an allocation of the available GST exemption.
Problem 3: Erroneous Opt-out Election Made on a Gift to a Trust Intended to Be GST Exempt
In contrast to failing to make a GST election, making an erroneous opt-out election is another common error. Taxpayers cannot use 9100 relief if an erroneous election was made. That relief is generally available only when no election has been made and the transferor is seeking relief to make a timely election.
For example, upon reviewing your client’s prior gift tax returns, you notice an opt-out election was made for a gift of $4 million to a trust in 2021. The value of the trust assets today is $4.5 million. The trust is intended to benefit the transferor’s grandchildren, so the transferor wants to ensure that it is protected from the GSTT. Section 9100 relief is not available to undo the opt-out election.
Remedy 3: Late Allocation of Transferor’s GST Exemption
A late allocation is available for trusts that are not fully GST exempt trusts where the taxpayer wishes to allocate an available GST exemption to a trust. There are two scenarios where late allocation may be helpful: First, during an economic downturn, opting out of automatic allocation rules for higher-value transfers and making a late allocation of GST exemption based on a lower value to preserve a larger portion of the transferor’s GST exemption; second, solving our problem above, when GST exemption was not allocated on the original transfer and the transferor now wants to allocate to protect the assets from the GSTT.
The late allocation should be reported on a late gift tax return. The allocation is made based on date-of- filing values and is effective as of the date of filing. A taxpayer may elect, however, to use the first day of the filing month for the value of the allocation. Note that this election is not available for life insurance if the transferor passes away before the effective date of the late allocation.
In the example above, the taxpayer can file a late gift tax return to allocate $4.5 million of the available GST exemption to the trust to fully protect it from the GSTT. The taxpayer would also want to terminate the opt-out election on the next timely filed gift tax return and make an opt-in election. This will ensure that the available GST exemption will be automatically allocated to any future transfers to the trust, whether or not they are reported on a gift tax return.
Problem 4: Untimely Death of Non-skip Persons, Resulting in Unexpected Skip Person Beneficiaries Receiving Nonexempt Trust Assets
Generally, transferors will not allocate their GST exemptions to trusts that they expect will benefit only non-skip persons, but would instead save their GST exemption for other planning that is intended to benefit future generations. For example, in 2012, a taxpayer funded a trust for her child. The trust agreement states that the assets will be distributed outright to that child when the child reaches age 40. When the original transfer was made, of course, the transferor did not expect that the trust would benefit skip persons or be subject to GSTT.
The child predeceased the transferor in 2023 at age 30 and unexpected GSTT is due. The assets now stay in trust for the transferor’s grandchildren. At the death of the child, a taxable termination occurs and the trust is fully subject to GSTT due to its inclusion ratio of 1.000. Because the taxpayer did not allocate any of his GST exemption to the trust, the trust is liable for the GSTT even if the transferor had available GST exemption remaining.
Remedy 4: Retroactive Allocation of Transferor’s GST Exemption
A retroactive allocation under section 2632(d) provides a remedy for untimely death. It allows for GST exemption to be chronologically allocated at original date of transfer values effective the moment right before the non-skip person’s death. The generosity of this relief is amplified by the fact that the available GST exemption is higher today than it was at the time of the original transfer. Even if there was not enough GST exemption available to fully protect the trust on the original transfer, the transferor’s GST exemption available in the non-skip person’s year of death can be used.
The allocation must be made on a timely filed gift tax return for the year of the non-skip person’s death, including extensions. In this example, the taxpayer would need to make a retroactive allocation of the available GST exemption to the trust by April 15, 2024 (or October 15, 2024, if extended). The allocation will be effective immediately before the child’s death using the value of the original 2012 transfer to the trust. The allocation is effective before the taxable termination. If the transferor had adequate GST exemption to fully protect the trust, there would be no GSTT liability related to the taxable termination after the retroactive allocation.
Note that distributions made to skip persons before the retroactive allocation are not affected by the retroactive protection from the GSTT. Because the allocation is effective immediately before the child’s death, any prior GSTT triggering events were still subject to the GSTT. The retroactive allocation will protect distributions made to skip persons after the death of the non-skip person. There may also be further complications related to trusts that have been modified or have been decanted into new irrevocable trusts before the untimely death.
Problem 5: Mixed Inclusion Ratio with Respect to an Indirect Skip Trust That Will Benefit Both Skip and Non-skip Persons
Trusts that benefit both non-skip and skip persons with a mixed inclusion ratio can expose trust assets to unnecessary GSTT. In addition, it may be expensive and time-consuming to manage the related GSTT compliance when distributions are made to skip persons from such trust.
For example, a trust with an inclusion ratio of 0.500 makes a $100,000 distribution to a skip person beneficiary. The beneficiary would be liable for GSTT of $20,000 (inclusion ratio of 0.500 x $100,000 distribution x 40% GSTT). The trustee would be responsible for filing Form 706-GS(D-1) to inform the beneficiary of the information needed for the beneficiary to file Form 706-GS(D). To avoid these consequences, a trustee may be interested in exercising a qualified severance under section 2642(a)(3)(B).
Remedy 5: Qualified Severance to Sever Trust into (i) a GST Exempt Trust with an inclusion ratio of 0.000 and (ii) a GST Nonexempt Trust with an Inclusion Ratio of 1.000
To solve the problems associated with a mixed inclusion ratio trust that has both skip and non-skip beneficiaries, the trustee may desire to sever the trust. A qualified severance is the division of a single trust with a mixed inclusion ratio into two or more identical but separate trusts, one of which is GST exempt (inclusion ratio of 0.000) and one of which is not (inclusion ratio of 1.000). Logistically, the trusts must receive a fractional share of the total value of assets equal to the fraction of the single trust before the severance. The trust and the severance must meet all the criteria required under section 2642 and Treas. Reg. § 26.2642-6(d), including being allowed by the trust agreement, being effective under local law, and having the same succession of interest to beneficiaries. The trustee must establish a date of severance, and funding must occur within 90 days of the effective date of the severance. The qualified severance also must be reported on Form 706-GS(T). The trustee would be responsible for filing Form 706-GS(T).
Once the severance has been properly executed, it is recommended that the GST nonexempt resulting trust (inclusion ratio of 1.000) make distributions to and be depleted by the non-skip person beneficiaries because it is not protected from GSTT. The GST exempt trust (inclusion ratio of 0.000) should make distributions to and be set aside for the benefit of the skip person beneficiaries because it is protected from GSTT. In our example above, after the severance, the trustee could make future distributions to the skip persons out of the GST exempt trust. By doing so, the beneficiaries would not be liable for GSTT because the inclusion ratio of the exempt trust is 0.000.
To ensure a smooth and least-complicated approach to the GSTT, it is crucial to initiate discussions on GSTT planning early in your client’s lifetime. Including discussions around GSTT is imperative when developing or revising a client’s estate plan. This will include conducting periodic and comprehensive reviews of the client’s gift tax returns to ensure that the elections made and the GST exemption allocated align with the client’s estate plan and expectations.
It is vital to incorporate discussions on planning for existing trusts and strategize the optimal utilization of the transferor’s available GST exemption within these planning conversations. By consistently integrating discussions around GSTT into your planning conversations, you will provide substantial benefits and value to your clients and their families.
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This article was written by Carol Warley, Amber Waldman, Rachel Ruffalo and originally appeared on 2024-01-31.
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