By by Martin M. Shenkman, CPA, MBA, JD
The following discussions are relevant for year end 2010 planning, and in 2011 for determining how to report 2010 transactions on gift tax returns.
TRA sets a $5 million GST tax exemption, and a zero percent GST tax rate for 2010. TRA made these changes retroactive to January 1, 2010. Thus, the GST rules apply to all 2010 transfers for GST purposes, but the GST tax rate (the applicable rate) on GST transfers is zero under Code Sec. 2641(a).
A GST transfer might have been a large gift to a grandchild, or a transfer to a dynasty trust. Thus, for GST transfers, all the rules that existed in 2009 and many prior years, will continue to apply without pause:
· Through 2009 under the law that existed prior to the 2010 repeal.
· In 2010 under this special rule.
· Through 2011-2012 under the general TRA extensions.
· For 2013 .... Well, we'll have to see. The TRA changes sunset, so 2013, just like 2011, is "up in the air" until Congress acts. If Congress opts not to act, then 2013 will be the pre EGTRRA rules.
The opportunity to make GST transfers (e.g., gifts to grandchildren and other skip persons) before the end of 2010 may still be worthwhile for some. The zero percent rate and some of the surprising beneficial affects of 2010 rules on GST planning may have created significant benefits for some wealthy taxpayers. However, the timing of the TRA being so late in the year, the complexity of the law, and the difficulty of planning and implementing rush year end GST planning, will have made it quite difficult if not impossible for many taxpayers who might have wished to take advantage of these benefits to be able to do so. However, the prospect of a $5 million gift and GST exemption in 2011 rather than the paltry $1 million some feared, may eliminate the motivation for such transfers for many clients.
Some of the background on what occurred with the GST tax in 2010, when repeal was in existence, may prove helpful to understanding the GST consequences of 2010 planning, and then the preparation of gift tax returns addressing GST exemption for 2010, which will be filed in 2011.
The GST tax was initially repealed for 2010 by EGTRRA. IRC Sec. 2664. That Code Section provided: "§ 2664 Termination. This chapter shall not apply to generation-skipping transfers after December 31, 2009." If a transfer was made in 2010 using any of the three types of taxable GST transfers discussed above (direct skips, taxable terminations, and taxable distributions) no GST tax would have been incurred in 2010. What remained uncertain prior to the TRA was what GST tax treatment would be afforded to transfers to trusts in 2010 that were in a later year (when the GST tax would have presumably been again effective) subject to either a taxable termination or taxable distribution. Although the transfer into the trust would have been exempt from GST in 2010 there was concern that a taxable distribution from that trust to a grandchild (skip person) in 2012 would have triggered GST tax. Prior to the TRA, there were no mechanisms to allocate GST exemption to protect such a transfer from future GST tax. The EGTRRA sunset rules treated the Code as if EGTRRA never occurred. This meant that the GST automatic allocation provisions (to automatically allocate GST exemption to an indirect skip) would not apply during or after 2010. There was also the concern that even if a transfer to a trust was exempt from GST tax in 2010 (before the TRA), the later distributions after 2010 would be subject to GST tax as a taxable distribution. This risk was resolved by the TRA as a result of the application of the step-down (move down) rule of IRC Sec. 2652(a). This concept is key to the 2010 year end GST planning many clients undertook. This is discussed in more detail below.
TRA Sec. 301(a): "...each provision of law amended by subtitle ... E of title V of EGTTRA is amended to read as such provision would be read if such subtitle had never been enacted." The EGTRRA repeal of the GST tax for 2010 is repealed. Just like in grammar school math, a double negative is a positive, a repeal of a repeal is real. So, the GST tax rides again! This means that the GST will generally apply retroactively, for all of 2010.
TRA Section 302(f): "Effective Date.-Except as otherwise provided in this subsection, the amendments made by this section shall apply to estates of decedents dying, generation-skipping transfers, and gifts made, after December 31, 2009."
Code Sec. 2631. GST exemption.
(a) General rule. For purposes of determining the inclusion ratio, every individual shall be allowed a GST exemption amount which may be allocated by such individual (or his executor) to any property with respect to which such individual is the transferor.
(b) Allocations irrevocable. Any allocation under subsection (a), once made, shall be irrevocable.
(c) GST exemption amount. For purposes of subsection (a), the GST exemption amount for any calendar year shall be equal to 1 the basic exclusion amount under section 2010(c) for such calendar year.
The reference to the "basic exclusion amount" is the new TRA term which has been set at $5 million. The above provisions sunset for tax years after 2012 as provided in EGTRRA as amended. The amendments to EGTRRA were the TRA.
IRC Sec. 2632 Special rules for allocation of GST exemption.
(a) Time and manner of allocation.
(1) Time. Any allocation by an individual of his GST exemption under section 2631(a) may be made at any time on or before the date prescribed for filing the estate tax return for such individual's estate (determined with regard to extensions), regardless of whether such a return is required to be filed.
(2) Manner. The Secretary shall prescribe by forms or regulations the manner in which any allocation referred to in paragraph (1) is to be made.
(b) Deemed allocation to certain lifetime direct skips.
(1) In general. If any individual makes a direct skip during his lifetime, any unused portion of such individual's GST exemption shall be allocated to the property transferred to the extent necessary to make the inclusion ratio for such property zero. If the amount of the direct skip exceeds such unused portion, the entire unused portion shall be allocated to the property transferred.
(2) Unused portion. For purposes of paragraph (1) , the unused portion of an individual's GST exemption is that portion of such exemption which has not previously been allocated by such individual (or treated as allocated under paragraph (1) or subsection (c)(1)) .
(3) Subsection not to apply in certain cases. An individual may elect to have this subsection not apply to a transfer...
The concept of the automatic allocation rule is important to understand for the 2010 last minute GST planning techniques some clients sought to take advantage of. In section 2632(b)(1) of the Code, GST exemption is automatically allocated to direct skip transfers. For the 2010 year end GST planning to work optimally, an election out of the GST automatic allocation rules should be made on the 2010 gift tax return filed in 2011.
Code Sec. 2641. Applicable rate.
(a) General rule. For purposes of this chapter, the term "applicable rate" means, with respect to any generation-skipping transfer, the product of-
(1) the maximum Federal estate tax rate, and
(2) the inclusion ratio with respect to the transfer.
(b) Maximum Federal estate tax rate. For purposes of subsection (a), the term "maximum Federal estate tax rate" means the maximum rate imposed by section 2001 on the estates of decedents dying at the time of the taxable distribution, taxable termination, or direct skip, as the case may be.
TRA Sec. 302(c) provides: "Modification of generation-skipping transfer tax. In the case of any generation-skipping transfer made after December 31, 2009, and before January 1, 2011 [i.e., in 2010], the applicable rate determined under section 2641(a) of the Internal Revenue Code of 1986 shall be zero."
Thus, regardless of the estate tax rate being 35% the applicable rate on 2010 GST transfers is zero.
Implication of GST Statutory Changes
The statutory language quoted above appears to imply that the TRA reinstates the GST exemption as of January 1, 2010, with a $5 million exemption and a zero percent tax rate. TRA Sec. 301(c).
While at first blush, it appeared that the retroactive application to all of 2010 was intended to ease the burden on estates, nothing in the Act would prevent allocation of the new $5 million GST exemption to gifts to a GST trust funded in 2010. In light of this significantly increased GST exemption for 2010, then all transfers in 2010 would need to be re-evaluated, the terms of trusts analyzed, and decisions made as to what positions to take (e.g., whether to elect out of the GST automatic allocation rules). That would prove to be quite a windfall for many taxpayers, and a rather unexpected and substantial cost to the federal fiscal budget. Be careful, the gift exclusion in 2010 remains only $1 million, so a large transfer to take advantage of favorable GST rules could trigger a costly gift tax. The tax numbers might still make this quite worthwhile, but how many wealthy taxpayers would be willing to pay larger current gift tax once their $1 million exclusion is used up? Likely very few.
This is a planning opportunity unique to the waning days of 2010. Great opportunity, cool technique for the right family, but not enough time for most advisers to assimilate it, contact clients, draft trusts, and implement it. Since this is the only window of opportunity for this one shot at this type of trust, it might just warrant its own name: "2010 Grandchild Safe Trust" because it is safe from GST but it really doesn't require the use of valuable GST exemption that most such trusts in normal years (if the word "normal" could even be applied to the estate tax any longer!).
What can this special GST planning opportunity afford? Plenty. Wealthy clients can transfer any amount of funds to a trust for a grandchild. No GST tax will be due on the transfer, although once the client's gift exemption of $1 million is utilized, there will be a 35% gift tax due on transfers above that amount. This is not quite a "Get out of GST Free" card (land on "Go" collect $200"). GST and estate tax can be deferred until the death of the grandchild beneficiary. That's not a complete save, but if your client likes the motto "A tax deferred is a tax saved," this technique could defer estate and GST taxes for perhaps nearly a century if the grandchild is very young, eats his or her Wheaties, and lives a long life.
So if a taxpayer wanted to make a transfer to grandchildren, in the waning days of 2010 they could do so in trust (for some period of time, in late 2010, before the TRA bomb fell, it was believed that transfers would have to be outright to adult skip persons). The gift to the trust would use up some of the taxpayers $1 million gift tax exclusion (remember, it increases to $5 million in 2011) but would avoid any GST tax since the GST tax rate is zero. For wealthy taxpayers who have remaining gift exclusion in 2010, but whose estates warrant aggressive GST planning, this might afford an interesting planning opportunity.
For the planning to succeed, only skip-persons can be beneficiaries of the trust. So, if Grandpa were forming the trust, only Grandchild, not Son, could be beneficiary. The reason for this is that the trust itself will be characterized as a skip person for GST purposes if only skip-persons are beneficiaries. IRC Sec. 2613(a)(2).
The transfer of assets into this type of trust should not be subject to GST tax under TRA Sec. 301(c)'s zero percent rate, only gift tax. On the 2010 gift tax return filed in 2011, for this client, the return should reflect that the client does not want the GST automatic allocation rules to apply to gifts to this trust (i.e., the client will opt out of the automatic allocation rules). The move down rule of 2652(a) will assure that even absent an allocation of GST exemption, the later distributions from this 2010 trust would not be subject to GST tax as taxable distributions. Here's how:
Under IRC Sec. 2652(a)(1) if a transfer is subject to tax under Chapter 12, a new "transferor" is established for the transfer. The statute provides: "An individual shall be treated as transferring any property with respect to which such individual is the transferor."
Treas. Reg. Sec. 26.2652-(a) Transferor defined. (1) In general. Except as otherwise provided in paragraph (a)(3) of this section, the individual, with respect to whom property was most recently subject to Federal estate or gift tax, is the transferor of that property for purposes of chapter 13. An individual is treated as transferring any property with respect to which the individual is the transferor. Thus, an individual may be considered a transferor even though there is no transfer of property under local law at the time the Federal estate or gift tax applies.
For GST purposes on the transfer of property to the trust (skip person) the transferor of the gift property is assigned to the first generation above the highest generation of any person who has an interest in the trust following the transfer. This is often referred to as the "step-down" rule. The application of this rule prevents the GST tax from being applied to transfers for which the GST tax was already imposed. In the context of 2010 year end planning, if Grandpa transferred assets to a trust for Grandchild, these concepts would apply as follows. The highest generation of a person with an interest is Grandchild. The first generation above Grandchild is Child. Thus, the designation of the transferor for the gift has "stepped-down" from the Grandparent to the Child. In "normal" years the transfer to this specially designed skip-person trust would itself have triggered a GST tax or use of the client/transferor's limited GST exemption. In 2010, the same would occur, except as a result of: (1) the GST tax is zero so no tax will be incurred; and (2) the client/ transferor's GST exemption will affirmatively not be allocated against the gift to the trust.
It may be feasible to apply these concepts so that assets can be taken from an existing trust that benefits multiple generations. "May" may not be simple to ascertain and will require some careful analysis of the terms of a trust, the dynamics of the various beneficiaries involved, and more. This might include a bypass trust formed under the will of a deceased spouse that was structured to benefit the surviving spouse, children and descendants and for which GST exemption was never allocated (this arcane concept is explained later). Grantor Retained Annuity Trusts (GRATs) and Charitable Lead Trusts (CLTs) may have been created to benefit children, since they were not efficient vehicles for transferring wealth to grandchildren or other "skip persons" that might trigger GST implications. Assets in these non-GST exempt trusts might benefit from this late 2010 planning oddity. But, be sure to address the election out of the automatic GST allocation rules when you file gift tax returns for the 2010 year.
The distributions from this existing trust could be reported for tax purposes as if they were subject to the GST tax in 2010. There is no cost to do so, because the GST tax rate is zero. These distributions could be transferred into new trusts for the grandchildren. The existing trust language might even permit this type of distribution in further trust. This might then permit that trust to be exempt from further tax. Structuring such transfers in trust, avoids the concerns many taxpayers had about the planning ideas that had been floated by tax practitioners during 2010 about making outright distributions from trust to adult grandchildren. If this interpretation is correct, it would seemingly permit taxpayers to have their GST tax cake, and protection and control too.
Again, the practical problems with these supposed opportunities is that they are complex. Taxpayers are wary of all of the changes in advice they've received as the estate tax repeal saga has played out; many taxpayers, other than the ultra-wealthy, will not be willing to commit resources to complex planning if they perceive the estate tax unlikely to apply to them in light of the $5 million exclusion and portability. So, the number of taxpayers who will actually take advantage of this and other 2010 anomalies might prove to be quite modest. But for those who do, the benefits might be substantial.
Planning Note: Some advisers assisted taxpayers in creating trusts in 2010 that may have provided that the maximum amount that could be passed GST exempt from that trust would flow to a sub trust that would be GST exempt, and any amount that would not be GST exempt would flow into a sub trust that would not be subject to the GST (e.g., it might be structured to be taxed in the donor/grantor's children's estate to avoid a future GST tax). It may now be possible that the gifts to such a trust would flow into the GST exempt portion, and that, on a gift tax return for the 2010 year, it may be feasible to allocate GST exemption to this trust.
Some tax advisers interpret the 2010 TRAs GST provisions to mean that no GST tax would be assessed on the funding of a trust for grandchildren in 2010. This is because the grandchild would not be characterized under the technicalities of the GST tax as "skip persons" for GST purposes. Presumably, later distributions to those grandchildren would also not be subject to GST tax. However, if distributions were made at some future date to descendants of those grandchildren, e.g. a great-grandchild, a GST tax would apply at that time. Even though the GST tax will only be 35 percent, it is still a significant cost. Also, since the TRA rules only apply for two years, a 55 percent GST tax rate might roar back in 2013!
If this interpretation of the oddities of the GST tax in the Twilight Zone of 2010 tax planning is correct, then there could be a tremendous advantage to funding grandchildren trusts in the waning days of 2010. The GST tax on the great-grandchildren could perhaps be mitigated by providing for inclusion in the grandchild's estate or by including the right to make distributions for qualifying medical and tuition expenses for the grandchildren's descendants.
Practitioners should hold off breathing a sigh of relief when the Auld Lang Syne melodies begin. The 2011 gift tax return filing season (for 2010 gift tax returns), won't be a cake walk.
Planning Note: If gifts were made in 2010, to grandchildren (or to trusts for them), to take advantage of the GST zero tax rate in 2010, great care must be taken when completing the 2010 gift tax return. Do the automatic allocation rules apply? Should the client elect out of the automatic allocation rules?
For non-tax-technicians, the GST automatic allocation rules can be explained in broad simplified terms to help understand the gift tax return filing consideration. If assets are given to a trust that could benefit grandchildren or great-grandchildren, distributions to them from that trust would be subject to GST tax. To minimize the number of taxpayers to which the GST tax applies, each taxpayer is afforded an exemption from the GST tax. TRA has increased this retroactively to $5 million to January 1, 2010 (but it appears to drop dramatically in 2013 if nothing is done). If some of the taxpayer's GST exemption is allocated to the gift of the trust, future GST can be avoided. If $1 million was given to the trust and no other gifts ever made to the trust, and $1 million of GST exemption was allocated to protect that gift, then the trust would be exempt from GST tax forever. No matter how large the trust would grow in value, and no matter to whom, how much, or when distributions were made in future years, no GST tax would apply. The GST tax rules automatically allocate this exemption in certain instances to assist taxpayers in avoiding running afoul of these complex GST allocation rules. Those automatic allocation rules might result in a waste of GST exemption if this unique 2010 Grandchildren GST Safe plan was pursued.
If this is, in fact, the result of the 2010 TRA's GST rules for 2010 practitioners completing gift tax returns, Forms 709, for the 2010 year should evaluate opting out of the automatic allocation of GST exemption to such a trust so that the favorable rules would apply without wasting GST exemption. From a practical perspective, given the lateness in the 2010 year, when the 2010 TRA was enacted, and the struggles practitioners are having interpreting the 2010 TRA, is there even time to create such tailored GST trusts for 2010?
The interpretation that trusts in 2010 could now be made GST exempt, may create problems for trusts that would have been structured as GST exempt, but which were not as practitioners assumed that no GST allocations would be feasible for 2010 trusts. So, some trusts that might otherwise have benefited from GST exemption may not, in their present form, be conducive to GST allocation. These trusts would have to be reviewed to ascertain whether actions could be taken to address these issues before GST allocation would be made.
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