By by Martin M. Shenkman, CPA, MBA, JD
The following is a general background discussion of GST to establish the framework for the discussions that follow.
The GST tax can apply to a broad range of property transfers, including transfers of property in trust (e.g. a gift to a trust established for a grandchild), life estates (e.g. a child has the right to income from the property for life and on the child's death a grandchild receives the property), remainder interests (e.g. a grandchild receives the property after the death of a child and the termination of the child's life estate), and so forth.
For the GST tax to apply, a taxable event must occur. IRC Sec. 2601(a). This requires a generation-skipping transfer. The simplest example is where you give your grandchild property. More technically, the GST tax applies where there is a transfer of property (or income from property) to a person who is considered to be a member of a generation at least two generations below the generation of the person making the gift.
Some basic definitions must be explained in order to discuss the complicated GST tax. These include the three events which can cause the GST tax to apply. These are a direct skip, a taxable distribution, and a taxable termination. IRC Sec. 2612.
Direct Skip: To understand the first situation which can trigger a GST, a "direct skip," the definition of a "Skip Person" must first be explained. IRC Sec. 2613. A skip person is a person who is two or more generations below the generation of the person making the gift (e.g. a grandchild or a trust for the benefit of a grandchild). A trust is also considered a skip person where no distributions can be made to non-skip persons. This concept is critical to understanding some of the last minute 2010 GST tax planning maneuvers clients have taken. A non-skip person is a person who is less than two generations below the generation of the person making the gift (e.g. a child or sibling). IRC Sec. 2652(c). When a child has died and a grandchild survives, the child will not be considered a skip person so that a transfer to the grandchild won't trigger the GST tax. IRC Sec. 2651(f). A direct skip includes a transfer of an interest in property, which is subject to the estate or gift tax, to a skip person. The GST tax for a direct skip is to be paid by the person making the transfer.
Once it has been determined that a gift is subject to the GST, the GST tax must be calculated. For tax purposes, the property is generally valued at the time of the generation-skipping transfer occurred. However, if the transfer was a direct skip and the property was included in the decedent's gross estate, the special valuation rules the estate uses will apply to the GST as well. Presumably, in 2010, if a carryover basis regime is elected, alternate valuation and other special valuation rules will not be available. When the GST transfer also triggers a gift tax, the amount of GST tax paid by the donor is treated as a further gift subject to the gift tax.
Taxable Distribution: When there is a distribution of property or money from a trust to a skip person, the GST tax may apply. If the GST tax is paid out of a trust, the amount of tax paid is treated as an additional distribution subject to the tax. The GST tax on a taxable distribution is charged against the property which was given, unless specific provisions are made for a different treatment. The transferee (e.g. grandchild) is liable to pay the GST tax.
Taxable Termination: This occurs when the interests of a beneficiary of a trust (the person entitled to receive income from a trust, such as a child) terminate as a result of a death, lapse of time, or release of a power (right). This will be considered a taxable termination resulting in a GST tax, unless: (1) Immediately after the termination a non-"Skip Person" has an interest in the property; or (2) No distribution can be made to a skip person. The GST Tax on a taxable termination is payable by the trustee of the trust. The amount of tax is calculated based on the value of all property to which the taxable termination occurred, reduced by expenses, debts and taxes.
There are also a number of methods to protect transfers that would otherwise be subject to GST tax from the tax.
GST Annual Exclusion: Although the $13,000 annual exclusion is available for the GST tax, the requirements are different then those applicable for the gift tax. Thus, a transfer might qualify for the annual $13,000 gift tax exclusion, but not for the GST tax. The $13,000 annual exclusion is only available for GST tax purposes on a direct skip transfer. This is a gift directly to a grandchild (or later generation), or in some instances to a trust for a grandchild. It doesn't apply to a taxable termination or a taxable distribution.
Transfers for Educational and Medical Benefits: Your client can gift unlimited amounts of money to pay for a grandchild's education or medical benefits as described in IRC Sec. 2503(e). These will not be subject to GST. IRC Sec. 2642(c)(2).
GST Exemption: A lifetime exemption is allowed which would permit a client to transfer up to $1 million of property, or other assets, to skip persons without triggering a GST tax through 2009. In 2010, the GST exemption is increased by the TRA to $5 million. Under the TRA it appears that an executor in 2010 should be afforded the opportunity to allocate GST exemption regardless of whether carryover basis is elected. See discussions above.
Certain Transfers: Transfers which meet the following three requirements are also excluded from GST taxation: (1) the property transferred was subject to the GST tax before; (2) the transferee (recipient) in that prior transfer was a member of the same generation as the current transferee; and (3) the transfer does not have the effect of avoiding the GST tax.
To understand the use of the GST exemption, another concept must be introduced, the inclusion ratio. The GST tax exemption percentage (the inclusion ratio) is set when you make the gift and allocate your exemption. The inclusion ratio is: [1 - the applicable fraction]. The applicable fraction, when a transferor makes a gift to a trust, is determined as follows:
One approach to addressing this potential GST tax problem is to allocate some portion of the GST tax exemption to the trust. If the donor allocates any portion of his or her GST tax exemption to the trust, that portion of the exemption is considered used, whether or not a GST tax is ever incurred. So, if your client makes the allocation, and no tax is incurred, you've wasted that portion of your exemption. Analyze all the relevant factors and estimate the likelihood of the trust incurring a GST tax in the future. This could be especially difficult because the TRA sunset of the GST exemption leaves no certainty as to what the GST exemption will be after 2012. If it appears likely that the trust will incur a GST tax, then the transferor may benefit by allocating some GST exemption to the trust. If the likelihood of a GST tax appears small, perhaps GST exemption should be preserved for other planning opportunities.
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