The generation-skipping transfer (GST) tax is imposed on certain transfers that skip generations, to ensure that property is subject to transfer tax at each generational level. The tax is imposed at the rate equal to the highest federal estate tax rate at the time of the transfer. Each individual is allowed a GST exemption that may be allocated to a transfer so that it will be exempt from GST tax.
Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 1 the GST tax was scheduled to be repealed entirely for 2010. The GST tax was retroactively reinstated for 2010 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the Tax Relief Act), 2 but Congress provided that the GST tax due on GSTs made in 2010 is zero. It did so by making the applicable rate determined under Sec. 2641(a) zero for GSTs made after December 31, 2009, and before January 1, 2011. 3
All generation-skipping transfers are taxed at the “applicable rate” (a flat rate equal to the maximum federal estate tax rate in effect at the time of the generation-skipping transfer) multiplied by the “inclusion ratio.” 4 The inclusion ratio is determined by subtracting the “applicable fraction” from one. 5 The applicable fraction is defined as the fraction with:
- A numerator equal to the GST exemption allocated to the trust; and
equal to the
value of the
the trust less:
- Any federal estate tax and state death taxes chargeable to the trust and actually recovered from the trust;
- The amount of any charitable deduction allowed under Sec. 2055, Sec. 2106, or Sec. 2522 with respect to the transfer; and
- In the case of a direct skip, the value of the portion of the transfer that is a “nontaxable gift.” 6
Example 1: In 2009, T transferred $100,000 to a newly created irrevocable trust providing that income is to be accumulated for 10 years. At the end of 10 years, the accumulated income is to be distributed to T’s child, C, and the trust principal is to be paid to T’s grandchild, GC. T made an affirmative allocation of $40,000 of her GST exemption to the trust on a timely filed gift tax return for 2009. The applicable fraction of the trust is 2/5 ($40,000 ÷ $100,000), or 0.40, and the inclusion ratio is 3/5 (1 − 2/5), or 0.60. In 2019, if the maximum federal estate tax rate is 55%, 7 the GST tax rate applicable to the trust is 0.33 (0.55 × 0.60). 8
The applicable fraction for a trust is recomputed when property is added to an existing trust. 9 The numerator of the recomputed applicable fraction generally is the sum of:
- The amount of GST exemption currently being allocated to the trust (if any), plus
- The value of the “nontax portion” of the trust.
The denominator of the recomputed applicable fraction generally is the value of the trust principal immediately after the occurrence of the recomputation event. 10 The nontax portion of the trust is determined by multiplying the value of the trust principal immediately before the recomputation event by the then-applicable fraction. 11
Example 2: T transfers $1 million to a newly created trust and allocates $1 million of GST exemption to the transfer. Thus, the applicable fraction of the trust at that time is 1, and the inclusion ratio is zero. T subsequently transfers $250,000 to the trust. Just before the addition, the value of the trust is $1,200,000. The nontax portion of the trust at the time of the addition is $1,200,000 (applicable fraction of 1 × $1,200,000). If T has no more GST exemption to allocate to the trust, the new applicable fraction will be 0.828 ([0 + $1,200,000] ÷ [$1,200,000 + $250,000]) and the new inclusion ratio will be 0.172 (1 − 0.828).
Transfers to Trusts
Many donors create trusts solely for the benefit of grandchildren and more remote descendants. These trusts are considered skip persons because the beneficiaries are in a generation two or more below the generation of the donor. 12 Transfers to these trusts are treated as direct skips. In the past, a donor’s available GST exemption automatically was allocated to an inter vivos direct skip, unless the donor elected out by paying the GST tax with the filing of the gift tax return. As a general rule, the donor’s GST exemption was allocated to all the transfers to such a trust so that the trust’s inclusion ratio was zero.
For gifts that are direct skips made to trusts in 2010, the donor may not have wanted to allocate GST exemption to the transfer. No GST tax would be due on the gift so the donor may well have elected out of the automatic allocation of GST exemption. Even though the original GST made in 2010 was not subject to GST tax, it is possible that GST tax would be due later. If, for example, the donor’s grandchildren and great-grandchildren are beneficiaries of the trust, there would be a GST subject to GST tax when distributions are made to great-grandchildren in the future (a taxable distribution) or upon the termination of the interests of all the grandchildren (a taxable termination).
The subsequent GST occurs because of the operation of the so-called move-down rule of Sec. 2653(a). The move-down rule provides that, when there is a GST and the property is held in a trust, the trust will be treated as if the transferor were assigned to the first generation above the highest generation of any person who has an interest in the trust immediately after the transfer.
This rule is used to apply the GST tax provisions to subsequent transfers from the trust. For example, if a donor transferred property to a trust for the benefit of his or her grandchildren and great-grandchildren in 2010, the GST occurred upon the transfer. The GST tax with respect to that transfer is zero. The donor then moves down to the generation of his or her child for purposes of applying the GST tax to future transfers from the trust. Any subsequent distributions to the donor’s grandchildren are not GSTs because the grandchildren are no longer skip persons based on the donor’s new generational as signment. Any distributions to the donor’s great-grandchildren, however, would be subject to GST tax because they are skip persons with respect to the donor, even with the donor’s new generational assignment.
If a trust that is a skip person is created in 2010 and the only transfers to it are made in that year, it is easy to apply the rules. But what happens if the transfer in 2010 was to a previously existing trust that was a skip person and had a zero inclusion ratio because the donor had allocated GST exemption to all the transfers to the trust in the past? If the donor’s GST exemption is not allocated to the 2010 transfer to the trust, the 2010 transfer creates an inclusion ratio between zero and one depending on the size of the 2010 transfer compared with the size of the trust before the transfer. A similar issue occurs when future transfers are made to a trust that is a skip person created in 2010, and the donor’s GST exemption is automatically allocated to those future transfers.
Example 3: T created a trust in 2006 for the benefit of her grandchildren and great-grandchildren. T ’s GST exemption has been allocated to all transfers to the trust in previous years so that the trust has a zero inclusion ratio. In 2010, when the value of the trust is $2 million, T transfers $500,000 to the trust and elects out of the automatic allocation of GST exemption to that transfer. The applicable fraction is recomputed. The numerator is the nontax portion of the trust equal to $2 million, and the denominator is the value of the trust after the current transfer or $2.5 million. The recomputed applicable fraction becomes 0.8 ([0 + $2,000,000] ÷ [$2,000,000 + $500,000]). The inclusion ratio for the trust becomes 0.2 (1 − 0.8).
When the trust makes distributions to T’s grandchildren in the future, even though the inclusion ratio of the trust is 0.2, none of the distributions should be subject to GST tax. With respect to the inclusion ratio greater than zero, T has moved down to her child’s generation so the distribution is no longer treated as going to a skip person. Any distributions to T’s great-grandchildren would be subject to an inclusion ratio of 0.2. If the applicable rate is 55% in the year of the distribution, the GST tax would be equal to 11% of the amount of the distribution to the great-grandchildren (0.2 × 0.55).
From an administrative, as well as a tactical, perspective, it would make sense for the trustee to sever such a trust under the qualified severance procedures of Sec. 2642(a)(3). 13 A trustee may make a qualified severance of a trust at any time, and the resulting trusts are treated as separate trusts for GST tax purposes. If the trust is a discretionary trust, the trustee would then be able to make distributions from the trusts in a way that minimizes the amount of GST tax that ultimately would have to be paid.
A “qualified severance” is the division of a single trust (by any means available under the governing instrument or local law) and the creation of two or more trusts if: (1) the trust is divided on a fractional basis; and (2) the terms of the new trust provide for the same succession of interests as the original trust. If the trust has an inclusion ratio between 0 and 1, the division of the trust must be into two trusts: one with an inclusion ratio of zero (0) and the other with an inclusion ratio of one (1).
A trust that has an inclusion ratio between zero and one because of 2010 transfers can be severed into two trusts with identical terms. The trust in the example above with an inclusion ratio of 0.2 can be severed into two trusts. One trust with 80% of the trust assets at the date of the severance would have an inclusion ratio of zero. The other trust with 20% of the trust assets would have an inclusion ratio of one and a transferor who is treated as in the generation of his or her child. If the terms of the trust provide for discretionary distributions, then any distributions that would be made to the transferor’s grandchildren could be made from the trust with the inclusion ratio of one (1). The trust with the inclusion ratio of zero (0) could be preserved to the extent possible for distributions to the donor’s great-grandchildren or more remote descendants.
Suppose in the above example that the trust does not appreciate but remains at $2.5 million and that a total of $800,000 is ultimately distributed to the grandchildren and nothing to the great- grandchildren until the trust terminates. None of the distributions to the grandchildren are subject to GST tax because the distributions are not to skip persons as a result of the move-down rule. Upon the death of the last grandchild, the remaining $1.7 million is distributed to the great-grandchildren. If the trust is not severed, then there is a taxable termination upon the death of the last grandchild. If the applicable rate at that time is 55%, the $1.7 million balance in the trust is taxed at 11%. GST tax due at that time would be $187,000.
If the trust is split in a qualified severance, $500,000 would be transferred to the trust with the inclusion ratio of one (1). That trust could be exhausted with the distributions to the grandchildren, and the remaining $300,000 distributed to the grandchildren would have to come from the trust with an inclusion ratio of zero (0). Upon the death of the last grandchild, there would be a taxable termination, but there would be no GST tax due because the trust has an inclusion ratio of zero. As a result of the qualified severance, $187,000 of GST tax is saved. This is a very simplistic example with no appreciation in the value of the trust assets over the term of the trust. The amount of GST tax saved could be considerably more if the trust assets appreciate over time. In any event, it would be worthwhile to sever any trust that is a skip person if GST exemption was allocated to transfers to the trust in all years except for the transfers made in 2010.
Authors’ note: The authors would like to thank Eric L. Johnson, partner, Deloitte Tax LLP for his contributions to this article.
1 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.
2 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.
3 Tax Relief Act, §302(c).
4 Secs. 2602 and 2641; Regs. Sec. 26.2641-1.
5 Sec. 2642(a)(1) and Regs. Sec. 26.2642-1(a).
6 Sec. 2642(a)(2) and Regs. Secs. 26.2642-1(b) and (c).
7 Currently, the EGTRRA provisions as extended and modified by the Tax Relief Act are scheduled to expire at the end of 2012, and the maximum federal estate tax rate is scheduled to return to 55% beginning in 2013.
8 See Regs. Sec. 26.2642-1(d), Example (1). The authors understand that the trust is a GST trust and, thus, transfers to the trust are indirect skips to which T’s remaining GST exemption is automatically allocated. However, pursuant to Regs. Sec. 26.2632-1(b)(2)(ii), a timely affirmative allocation of GST exemption on a gift tax return of an amount that is less than the value of the property transferred to a trust will prevent the automatic allocation of GST exemption to the remaining value of the property.
9 Secs. 2642(d) and (f); Regs. Secs. 26.2642-4(a) and (b), Example (5).
10 Sec. 2642(d) and Regs. Sec. 26.2642-4(a).
11 Sec. 2642(d)(3) and Regs. Sec. 26.2642-4(a).
12 Sec. 2613(a)(2) and Regs. Sec. 26.2612-1(d)(2).
13 It should be noted that, because this provision is part of EGTRRA, as extended by the Tax Relief Act, it is scheduled to sunset at the end of 2012.
Justin Ransome is a partner and Frances Schafer is a managing director in the National Tax Office of Grant Thornton LLP in Washington, DC. For more information about this article, contact Mr. Ransome at email@example.com or Ms. Schafer at firstname.lastname@example.org.