Last-Minute Estate Planning for 2009: Focus on the GST

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EXECUTIVE SUMMARY

• Congress enacted the generation-skipping transfer tax to prevent avoidance of the estate or gift tax through bequests or gifts that skip a generation. The GST subjects generation-skipping transfers to an additional tax that approximates the gift or estate tax that would have been due had a generation not been skipped.

• Transfers to a “skip person” are potentially subject to the GST. A skip person for these purposes is anyone assigned to a generation more than one generation below that of the transferor (donor or decedent).

• A lifetime GST exemption is allowed for transfers that would otherwise be generation-skipping transfers. Under the provisions of EGTRRA, the GST exemption is tied to the estate tax exemption amount—$3.5 million in 2009.

• Due to the upcoming changes in the GST rules, planning should be done in 2009 in order to best allocate a taxpayer’s available GST exemption to any transfers that are potentially subject to the GST that may or are expected to occur in 2010 or after.

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This article focuses on estate planning opportunities relating to the generation-skipping transfer tax¹ (GST) that practitioners and taxpayers should consider for implementation in 2009. Admittedly, the GST affects a relatively few high-net-worth individuals; however, for those who are affected, the impact can be severe. In many cases, these severe consequences can be mitigated or avoided entirely by means of careful estate planning.

The article is organized into four main sections. The first section briefly reviews the treacherous landscape in which estate planners find themselves in 2009 and beyond. The second section reviews fundamental GST rules and planning principles. In the third section, issues relating to the allocation of GST exemption to trusts are addressed. The final section considers several GST planning opportunities, the viability of which may or may not extend beyond 2009. This section addresses planning opportunities relating to both newly formed and existing trusts.

GST and Estate Planning in Uncertain Times

In 2010, the estate tax and the GST are scheduled to be repealed—but only for that one year, 2010. After 2010, the entire set of rules put in place by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)² sunsets, and the transfer taxes revert to the system that was in place prior to EGTRRA. In his budget proposal for fiscal 2010, President Obama signaled his intent to continue the estate tax as it exists in 2009—presumably meaning the maximum marginal transfer tax rate will be 45% and the exemption amount for the estate tax will be $3.5 million. However, the 134-page budget proposal is light on details, so we are left to assume that, when the budget proposal states “the estate tax is maintained at its 2009 parameters,”³ this also pertains to the GST. Further, this is just the initial budget proposal. As the fiscal 2010 budget moves toward conference, practitioners can only speculate whether the estate tax and the GST will make the final cut.

For several reasons, 2009 is a critically important year for estate planners. First, the amount of the GST exemption is at its historic high of $3.5 million. Second, the value of financial assets is at a low not seen for a decade or more.⁴ Finally, the form the GST will take after its one-year repeal in 2010 is uncertain. One possibility is that the GST will revert to its parameters under permanent (pre-EGTRRA) law. The most dramatic aspect of this possibility is that the GST exemption will revert to an inflation-adjusted $1 million. Combined with the return of the 55% maximum estate tax rate in 2011, advisers would be hard pressed to explain to their clients why they had not taken advantage of the GST planning opportunities in 2009. Even if the GST returns in 2011 as incarnated in 2009, hopefully the economic recovery will be underway by then, which will mean that trust values will have somewhat recovered from the lows of 2009. As trust values recover, the efficiency of GST exemption allocations is reduced.

Overview of the GST

The purpose of the GST is to “backstop” the gift and estate tax. The intent of the gift and estate tax is to subject wealth to taxation as it passes from generation to generation. Obviously, if a taxpayer makes gifts or bequests in such a way that a generation is skipped, an otherwise taxable transfer is avoided. Before the enactment of the GST,⁵ this approach was a viable strategy for mitigating the impact of the estate tax. However, the GST subjects such generation- skipping transfers to an additional tax that approximates the gift or estate tax that would have been due had a generation not been skipped. Because a single transfer is being subjected to two transfer taxes— i.e., the gift or estate tax and the GST—the tax burden on the transfer can seem punitive. Indeed, the effective tax rate on a generation- skipping transfer can exceed 100% when both transfer taxes are considered.

Exemptions from the GST

There are two important exemptions from the GST. First, a gift that does not exceed the gift tax annual exclusion⁶ ($13,000 in 2009) is usually sheltered from the GST.⁷ Similarly, exempt gifts for educational or medical purposes under Sec. 2503(e) are also exempted from the GST.⁸ In addition, a lifetime GST exemption is allowed for otherwise generation-skipping transfers. Under the provisions of EGTRRA, the GST exemption is tied to the estate tax exemption amount—$3.5 million in 2009.⁹ Under (pre-EGTRRA) permanent law, the GST exemption was an inflation-adjusted $1 million.¹⁰

Generation-Skipping Transfers

Transfers that are potentially subject to the GST are transfers in which the recipient is a “skip person,”¹¹ which is anyone assigned to a generation more than one generation below that of the transferor (donor or decedent). Thus, one’s child would not be a skip person but one’s grandchild (or lower generation) would. The rules for determining generation assignment also address collateral relationships (e.g., nephew versus grandnephew), in-law relationships, and unrelated individuals. ¹² It is possible for a person to be assigned to more than one generation for GST purposes—e.g., a grandnephew who has been adopted by the transferor. In this case, it is the youngest generation that applies. Thus, an adopted grandnephew would still be a skip person because the biological relationship trumps the legal (adoptive) relationship.¹³

Three types of transfers are subject to the GST—direct skips, taxable terminations, and taxable distributions.14 In most cases, a direct skip involves a transfer directly from a donor or decedent to a skip person. A transfer in trust where all beneficiaries of the trust are skip persons is also considered a direct skip. A key element of a direct skip is that the transfer is subject to either the gift or estate tax.¹⁵

With respect to property held in trust, a taxable termination occurs when all interests in the trust property shift to members of a skip generation.¹⁶ For example, the terms of a trust hold that the primary beneficiary is the trustor’s child (not a skip person). In the event that the primary beneficiary dies before the trust is terminated, the primary beneficiary’s interest in the trust will pass to his or her issue by right of representation. In that event, regardless of whether the trust actually terminates upon the death of the primary beneficiary, a taxable termination occurs for GST purposes because all interests in the trust pass to a skip generation (i.e., the trustor’s grandchild).¹⁷ In a direct skip or a taxable termination, the transferor (i.e., the donor in the case of a gift, the decedent’s estate in the case of a bequest, or the trust in the case of a taxable termination) is responsible for paying the GST.¹⁸

The third type of transfer subject to the GST is a taxable distribution, which is defined as any distribution by a trust to a skip person that is not considered to be either a direct skip or a taxable termination.¹⁹ For example, a trust might have beneficiaries in both nonskip and skip generations. A distribution to a skip person from such a trust would be a taxable distribution. In contrast to the other transfers subject to the GST, in a taxable distribution the transferee is responsible for paying the GST.²⁰

Predeceased Parent Rule

The insightful reader might be thinking that it is hardly fair to subject a transfer to the GST when the generationally out of order death of a child causes the transfer. For example, if all one’s children have died, no lineal descendants except grandchildren (i.e., skip persons) are alive. Consequently, without resorting to more distant relatives, there is no choice but to make transfers to skip persons. Indeed, the GST does provide for situations such as predeceased parents.²¹ In the case of predeceased parents, the grandchild whose parent has died moves up one generation and is no longer considered a skip person; however, there are important limitations to the applicability of the predeceased parent rule. First, that rule applies only to lineal descendants of the transferor’s parents—i.e., children, grandchildren, etc., and nieces, grandnieces, etc.²² More distant collateral relatives (i.e., cousins) are not eligible. Further, the nonskip person’s parent must be deceased at the time that a transfer subject to either the gift or estate tax occurs.²³ Thus, a direct skip will always fit within the parameters of the predeceased parent rule. However, a taxable termination or taxable distribution will benefit from the predeceased parent rule only if the parent had already died when the property was transferred to the trust.²⁴

Computation of the GST

The GST due is determined by multiplying the taxable amount (e.g., value of direct skip) by the applicable rate. The applicable rate is derived by multiplying the highest federal estate tax rate (45%) by the inclusion ratio. The inclusion ratio reflects the extent to which there is GST exposure for the transfer. For example, a $1 million transfer to which $250,000 of GST exemption was allocated would have an inclusion ratio of 75% (i.e., 1 minus (250,000 ÷ 1,000,000)).²⁵

The following examples illustrate the impact of the GST in both a gift and a bequest situation. The facts of each example will assume a worst-case scenario for both the gift or estate tax and the GST. “Worstcase scenario” refers to the fact that the transferor has exhausted all exemptions from both the gift or estate tax and the GST, and the 45% maximum transfer tax rate applies to transfers.

Example 1: G makes a generationskipping gift of $1 million. The GST on the gift would be 45%, or $450,000. Likewise, the gift tax rate would be 45%. The GST is added to the taxable gift to determine the gift tax base.²⁶ Accordingly, the gift tax would be 45% of $1,450,000, or $652,500. In this example, the combined transfer tax (gift tax and GST) is $1,102,500—an effective tax rate in excess of 110% of the gift value.

Before illustrating the GST in an estate situation, an important conceptual difference between how the GST is assessed in a gift situation versus in an estate situation needs to be reviewed. In a gift situation, the GST due is paid using property other than that gifted. That is, the GST in a gift situation is described as being “tax exclusive.” On the other hand, in an estate situation, Sec. 2603(b) provides that unless the trust instrument specifically provides otherwise, the GST is to be paid out of the property bequeathed—described as being “tax inclusive.” So what the transferee in a bequest subject to this treatment receives is a net-of-GST value, not full value, even though the GST is computed on full value.

Example 2: D leaves H a $1 million bequest. If the GST on the bequest were $450,000, H would receive the net value of $550,000. In order for H to actually receive $1 million, an amount larger than $1 million (i.e., an amount equal to the desired bequest plus the GST due) would have to be bequeathed. If the “normal” 45% GST rate were applied to this larger bequest, the impact of the GST in a bequest situation would be much more severe than in a similar gift situation.

To address this discrepancy, the GST rate that applies to a direct skip bequest is modified as follows: 45% ÷ (1 + 45%) = 31.03448%.²⁷ For a net bequest of this sort to result in $1 million being received by the transferee (heir or beneficiary of the estate), the pre-GST bequest would need to be $1,450,000.²⁸ Applying the 31.03448% GST rate for a bequest, the GST due is again $450,000. The 45% estate tax on $1,450,000 is $652,500, resulting in a combined transfer tax of $1,102,500, the same as in an equivalent gift situation.

Allocation of GST Exemption to Transfers in Trust

If, when a trust is funded, the primary beneficiaries include skip persons, the need to allocate the GST exemption to the trust is obvious, although if trust beneficiaries include both nonskip and skip persons, the allocation of the GST exemption will exhibit inefficiencies to the extent that the exemption will apply equally to transfers from the trust to both nonskip and skip persons. For this reason, a useful strategy of GST planning involves the creation of multiple trusts, each of which is endowed with but a single relevant tax attribute, such as being GST exempt (i.e., having a zero inclusion ratio). The trust document will allow distributions to skip persons to be made from the GST-exempt trust to the extent possible. In this way, GST exemption is not “wasted” on nonskip persons.²⁹

Difficulties arise when a skip person is a contingent beneficiary. If a trust is formed for the benefit of a nonskip person, no GST exemption need be allocated. But if that nonskip person dies and his or her interest passes to the next generation (i.e., skip persons), the need to allocate the GST exemption arises. Under pre- EGTRRA law, a so-called late allocation of GST exemption was not possible in such a circumstance. The death of the nonskip beneficiary triggers the taxable termination, presumably before any allocation of GST exemption can be made. The following example will illustrate the dilemma that this situation presents.

Example 3: In year 1, U funded a trust in the amount of $2 million for the benefit of his nephew, N. The trust was to be terminated and its assets distributed to N at the end of a 20-year period. In the event that N dies before the trust is terminated, his interest is to pass to his issue by right of representation (i.e., equal shares to N’s children). N dies in year 15, at which time the value of trust assets has grown to $7 million. Five years later, when the trust assets are worth $8 million, the trust is terminated and its assets are distributed to N’s children.

When this trust was funded there was no clear need to allocate a GST exemption because the primary beneficiary was not a skip person. GST exposure for the trust results from N’s death, which results in a taxable termination of the trust—even though the actual termination will not take place for another five years. Once the taxable termination occurs, it is too late to allocate GST exemption to the trust.³⁰ Had U allocated the GST exemption to the trust when it was funded, only $2 million of the GST exemption would have been needed to provide 100% protection from the GST. But the need, which would not materialize for 15 years, was unknown when U funded the trust. Conversely, had U allocated the GST exemption when the trust was funded but N did not die before the trust terminated, the GST exemption so allocated would have been wasted. This predicament forms the basis for the dilemma faced by estate planners before the enactment of EGTRRA.

Under EGTRRA, this dilemma was removed by allowing a retroactive allocation of GST exemption if the death of a nonskip beneficiary creates GST exposure for the trust.³¹ Under this provision, when U becomes aware of N’s death, he can make an allocation of GST exemption to the trust, with the allocation being treated as made when the trust was funded. This retroactive allocation is made by means of a timely filed gift tax return for the year in which N died, the event that exposes the trust to the GST.³² Thus, in contrast to pre-EGTRRA law, under the provisions of EGTRRA the trustor need not speculate on whether a GST exemption will be needed when the trust is formed. Allocation of a GST exemption can be postponed until it is definitely needed and still be treated as if the allocation had been made when the trust was funded.³³

GST Planning in 2009

Prospects now seem good that the GST, along with the estate tax, will be repealed in 2010 under EGTRRA. However, what is very unlikely is that the repeal of the GST will be permanent. Republican proponents of repeal were unable to effect that change when they controlled both houses of Congress and the White House, and the Democrats are disinclined to consider permanent repeal. As mentioned above, President Obama’s budget proposal for fiscal 2010 includes a provision for the estate tax to continue in its 2009 form. However, what will actually happen with the estate tax and whether the GST will be along for the ride are unknowns right now. If other aspects of the budget negotiations become bogged down in partisan wrangling, nothing may be done about the estate tax and GST, in which case pre-EGTRRA law will return in 2011.

To sum up, if the GST is indeed repealed in 2010, taking advantage of the GST structure extant in 2009 will have been unnecessary. If the GST is reincarnated in 2011 as it is in 2009, taking advantage of the 2009 GST structure will again have been unnecessary. But if the GST is allowed to revert to its pre- EGTRRA structure after 2010, it will be too late to do in 2011 what should have been done in 2009. With this context in mind, it seems prudent to assume the worst while hoping for the best. Assuming the worst (for GST purposes) would mean that EGTRRA sunsets and the entire transfer tax system reverts to its pre- EGTRRA structure. Accordingly, the first step in deciding what to do about the GST should involve comparing the parameters of the GST in 2009 to the GST structure under pre-EGTRRA law. In this regard, there are three major factors a practitioner should consider, which are presented in the exhibit above.

Planning for Newly Formed Trusts

Funding GST trusts in 2009: Focusing on the GST rate and the amount of the GST exemption, a so-called GST trust could be funded in 2009 in the amount of $3.5 million without incurring any GST. On the other hand, that same trust funded in 2011 under the pre-EGTRRA GST structure would incur GST tax of approximately $1,155,000.³⁴ If this trust is funded by means of a gift, the GST liability would exacerbate the resulting gift tax as well because the GST is treated as a taxable gift. So counting on the GST structure of 2009 returning in 2011 but being wrong could result in as much as $2,140,250 additional transfer tax being incurred.³⁵ With this possible adverse consequence of delaying the funding of a trust for a year or two, a strong case can be made for funding a trust in 2009 rather than waiting until 2011.

A further consideration may seal the deal in favor of 2009 funding. The values of financial assets (e.g., stocks, bonds, and real estate) have experienced unprecedented declines. A result of the economic turmoil in which we find ourselves is that the time has never been better to fund trusts. From the perspective of transfer taxes, historically low financial asset values allow trusts to be funded much more efficiently. Thus, considering the uncertain future structure of transfer taxes and historically low financial asset values, 2009 may be the perfect year for funding trusts.

Repeal of retroactive allocation of GST exemption: If the retroactive allocation of GST exemption is repealed in 2011, the dilemma of whether or not to allocate a GST exemption when a trust is funded returns to torment estate planners. Without a crystal ball, all that can be done is to build as much flexibility into the estate plan as possible. In this regard, trust instruments should be drafted so that a qualified severance under Sec. 2642(a)(3) would be allowed in the future. Regardless of whether the GST exemption is allocated at funding or at a later date,³⁶ a partially GST-exempt trust can be divided into two separate trusts—one fully GST exempt and the other exposed to the GST. Once the trust is divided, distributions can be fine-tuned to specific needs. That is, to the extent possible, distributions to skip persons will be made from the GST-exempt trust.

The alternative to allowing for future division of a single trust is to create a multiple-trust estate plan from the outset. There are numerous problems with this approach to estate planning. First, the plan is more expensive, more complex, and more difficult to explain to the client than a single-trust plan. Second, if one cannot be sure whether the GST will even be an issue, how can one know at what level to fund the GST-exempt trust? With a qualified severance in the estate-planning toolkit, a multiple-trust plan can be instituted when and if needed.

If there is only one nonskip beneficiary, a practitioner must take particular care to stay in touch with the client lest the estate plan be caught short by an unexpected taxable termination, after which allocation of GST exemption cannot be made. On the other hand, if there are several nonskip primary beneficiaries, the possibility of being surprised by a taxable termination is significantly lessened. A taxable termination would not occur until and unless all nonskip beneficiaries died—arguably an unlikely event. Thus, the death of any one nonskip beneficiary would signal the need to allocate exemption to the trust and begin the process of dividing the trust.

Planning for Existing Trusts

The economic and tax environment of 2009 presents at least two types of opportunities for existing trusts. One involves additional funding of existing GSTexempt trusts. The second involves the allocation of (additional) GST exemption to existing, partially GST-exempt trusts, without additional funding.

Additional funding opportunity: The first type of opportunity is a variation on the theme of the previous section that dealt with funding new trusts. With financial asset values down and the GST exemption up, existing GST-exempt trusts can be “funded up” in a manner that maintains the trust’s zero inclusion ratio for GST purposes.

Example 4: T funds a GST trust with $2 million in early 2006. The $2 million GST exemption allowed in 2006 was allocated to the trust, resulting in a zero inclusion ratio for GST purposes—i.e., the trust is 100% GST exempt, regardless of future changes in the value of trust assets. With the arrival of 2009, the GST exemption increases to $3.5 million. The increase in the amount of the GST exemption presents T with the opportunity to transfer an additional $1.5 million worth of property to this trust.

With the additional allocation of GST exemption, this trust is able to maintain its GST-exempt status—again, regardless of where trust values go in the future. Of course, the gift or estate tax that may result from such a transfer in trust should not be forgotten.

Allocation of GST exemption to partially GST-exempt trusts: Throughout the past decade, the amount of the GST exemption has been increasing. Prior to 2004, the GST exemption was $1 million, adjusted annually for inflation since 1998. Under EGTRRA, the exemption amount increased to $1.5 million in 2004, to $2 million in 2006, and to $3.5 million in 2009. The preceding section discussed making additional transfers to a GST-exempt trust as the GST exemption increased. However, in the case of a trust that is less than fully GST exempt, additional GST exemption can be allocated to such a trust without making additional transfers. Again, it is unknown whether the GST exemption that estate planners will find in 2011 will be $3.5 million or the inflation-adjusted $1 million under pre-EGTRRA law (or something else). Assuming the worst, the prudent estate planner should consider allocating any unused GST exemption to such trusts before the end of 2009.

This discussion considers situations in which either the trustor is still alive and able to file a timely gift tax return or the trustor dies in 2009 and his or her executor can make the appropriate allocation of GST exemption on the trustor’s estate tax return.³⁷ As the amount of the GST exemption increases, the increased but unused exemption can be allocated to an existing trust in order to decrease the trust’s exposure to the GST (i.e., to decrease the trust’s inclusion ratio).³⁸ With the value of financial assets at historic lows, the efficiency of allocating additional GST exemption is enhanced. The following paragraphs illustrate the impact on an existing trust’s GST exposure when trust values are increasing and examine what happens in a more representative downward-trending market.

Example 5: T funded a $5 million trust on October 9, 2007. T’s $2 million GST exemption was allocated to this trust, resulting in an inclusion ratio of 60%. That is, wherever the trust’s value goes, that value will be 60% exposed to the GST. In 2009, the GST exemption increases to $3.5 million, making available an additional $1.5 million of GST exemption. Despite the difficult market conditions since late 2007, the trust’s assets have increased 50% in value—i.e., from $5 million to $7.5 million. Because of its 60% inclusion ratio, the trust values are exposed to the GST to the extent of $4.5 million (60% of $7.5 million). In 2009, T can allocate to the trust the additional $1.5 million GST exemption that is available in 2009. With the allocation of an additional $1.5 million of GST exemption in 2009, the trust’s exposure to the GST is reduced from 60% to 40%.³⁹

This example presents a somewhat unrealistic fact pattern in that the trust values appreciated sharply between 2007 and 2009. More realistic would be a situation in which trust values followed the direction of most financial markets and declined significantly during this period. This otherwise dire financial context does offer an opportunity to improve a trust’s level of protection from the GST.

Example 6: As in the previous example, on October 9, 2007, T funds a trust with $5 million and allocates her $2 million GST exemption to the trust, resulting in a 60% inclusion ratio. The trust value tracks with the Dow Jones Industrial Average, which by February 1, 2009, had fallen by some 43.5% from its all-time high 16 months earlier. Accordingly, trust values fell from $5 million when funded to $2,824,259. Before allocating additional GST exemption in 2009, the inclusion ratio was still 60%, which means that the trust has GST exposure to the extent of $1,694,555 (60% of $2,824,259). The allocation to the trust of the additional $1.5 million of GST exemption allowed in 2009 leaves only $194,555 of trust value exposed to the GST—that is, an inclusion ratio of about 6.9% (i.e., $194,555 ÷ $2,824,259).

The point of this example is that even in a devastatingly dire financial market, a silver lining can be found. The depressed values of financial markets, and therefore trust values, offer an opportunity to position GST-exposed trusts much more favorably for the time when markets recover.

Estate Planning in 2010

Assuming that the estate tax and the GST are repealed in 2010, that year will likely see a tremendous amount of estate planning activity, including trust formation. For those “lucky” enough to die in 2010, testamentary trusts, as well as living trusts that become irrevocable upon the death of the trustor, will not have to worry about either the estate tax or the GST.⁴⁰ For inter vivos trust formation, the maximum gift tax rate is scheduled to fall to 35% from its current 45%.⁴¹ So regardless of what steps are or are not taken in 2009, 2010 may present another opportunity to undertake very productive estate planning—again, assuming that Congress does not disturb the scheduled changes to the gift and estate taxes and the GST.

Conclusion

Practitioners should consider several estate planning actions for implementation in 2009. The repeal of the estate tax and the GST in 2010 seems more and more likely. President Obama’s proposed budget for fiscal 2010 has indicated that the estate tax that will return in 2011 will be the same as in 2009, but the future, as always, is uncertain. Anything can happen between now and then—whichever “then” one cares to consider. All one can be sure about is the status of the law right now. It is in this spirit that the suggestions offered here are made. What is certain is that there are few months left in 2009. Waiting to see what the estate planning landscape will be in 2010 and beyond is, at best, a hazardous strategy.

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EditorNotes

Michael Hoffman is a professor of taxation at Nova Southeastern University’s H. Wayne Huizenga School of Business and Entrepreneurship in Ft. Lauderdale, FL. For more information about this article, contact Prof. Hoffman at hoffmanm@huizenga.nova. edu.

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Notes

¹ Sec. 2601 et seq.

² Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

³ See note 1 in Table S-5 of the proposed budget, which states, “In continuing the 2001 and 2003 tax cuts, the estate tax is maintained at its 2009 parameters” (Office of Management and Budget, “A New Era of Responsibility”121 (2009)).

⁴ As this article was being written, the Dow Jones Industrial Average lingered around 8,000. On its way up, the Dow passed the 8,000 mark in July 1997.

⁵ As enacted in the Tax Reform Act of 1976, the GST was easily circumvented. The current GST resulted from the Tax Reform Act of 1986, P.L. 99-514.

⁶ Sec. 2503(b).

⁷ Sec. 2642(c)(1). Extension of the gift tax annual exclusion to the GST is applicable to direct skips. However, in the case of an indirect skip (i.e., a gift in trust), it is possible that the transfer will be subject to the GST even though not resulting in a taxable gift for gift tax purposes because of the annual exclusion. The details of this possible difference in treatment are beyond the scope of this article. The conditions that must be satisfied for a nontaxable gift in trust to qualify as nontaxable for GST purposes are found in Sec. 2642(c)(2).

⁸ Sec. 2642(c)(1).

⁹ Sec. 2631.

¹⁰ The reader may wish to become acquainted with the rules relating to deemed (automatic) allocation of GST exemptions to lifetime direct skips (Sec. 2632(b)) and lifetime transfers to GST trusts (Sec. 2632(c), added by EGTRRA). If these automatic allocations are not desired, the transferor must opt out by means of a timely filed gift tax return (Regs. Secs. 26.2632- 1(b)(1)(i) and 26.2632-1(b)(2)(iii)). Finally, if a transferor dies without having allocated his or her entire GST exemption, Sec. 2632(e) provides for the allocation of unused GST exemption in a prescribed manner. This automatic allocation can be avoided by affirmatively allocating GST exemption to transfers on a timely filed estate tax return (Regs. Sec. 26.2632-1(d)(1)).

¹¹ See Sec. 2613.

¹² See Sec. 2651.

¹³ Sec. 2651(f)(1). Absent a conflicting biological relationship, adoptive relationships are treated no differently than biological relationships (Sec. 2651(b)(3)(A)).

¹⁴ See Secs. 2611 and 2612.

¹⁵ Sec. 2612(c)(1).

¹⁶ Sec. 2612(a).

¹⁷ If a trust has more than one nonskip primary beneficiary, the death of one primary beneficiary would not trigger a taxable termination. It is not until all interests in the trust have passed to a skip generation that a taxable termination occurs.

¹⁸ Secs. 2603(a)(2) and (3).

¹⁹ Sec. 2612(b).

²⁰ Sec. 2603(a)(1).

²¹ Sec. 2651(e).

²² Sec. 2651(e)(2).

²³ Sec. 2651(e)(1)(B).

²⁴ In the case of a decedent, the definition of “transferor” for GST purposes in Sec. 2652(a)(1)(A) is dependent on where the estate tax is imposed. To the extent that a qualified terminable interest property (QTIP) election was made under Sec. 2056(b)(7) when a trust was funded, trust value is included in the gross estate of the income-beneficiary spouse. Taken in conjunction with the predeceased parent rule of Sec. 2651(e), what would otherwise have been a taxable termination is instead treated as a direct skip (i.e., from the estate of the income-beneficiary spouse to the remainder beneficiary of the QTIP trust), which makes the event eligible for the predeceased parent rule.

²⁵ Secs. 2641 and 2642.

²⁶ The purpose of adding the GST due to the taxable gift is to ensure that the treatment of the GST for the purpose of computing the gift tax is equivalent to the treatment of the GST for the purpose of computing the estate tax. With this adjustment, the GST due is included in the tax base for the gift or estate tax.

²⁷ Line 6, Part 1, Schedule R-1 of Form 706, United States Estate (and Generation- Skipping Transfer) Tax Return, effects this modification by dividing the amount subject to GST by 3.222222. The fraction 1/3.222222 translates to a tax rate of 31.03448%. If the trust instrument provides for GST to be paid from property other than that constituting the bequest, the normal 45% GST rate would be used.

²⁸ The figure of $1,450,000 can be arrived at in two ways. The easiest is to simply combine the $1 million with the $450,000 GST due in a gift situation. In the alternative, one can divide $1 million by the complement of the bequest GST rate (i.e., 1 – 31.03448%), which also results in the $1,450,000 pre-GST figure.

²⁹ Sec. 2642(a)(3) allows a trust to be divided into two or more trusts if permitted by the trust instrument or local law. The purpose of such a qualified severance would be to create two trusts, one of which would have an inclusion ratio of zero while the other would have a 100% inclusion ratio. In this way, distributions can be tailored to specific needs—e.g., fully GST-exempt distributions to skip persons and no GST exemption wasted on distributions to nonskip persons.

³⁰ If U became aware of N’s impending death and immediately recognized the GST implications of that death, he could have filed a gift tax return for the purpose of making a late allocation of GST exemption. The late allocation of $3.5 million GST exemption to a $7 million trust would provide 50% protection from the imposition of GST.

³¹ Sec. 2642(d).

³² If U dies, his executor can allocate any remaining GST exemption to N’s trust. If N is still alive, this would be a late allocation; if N died in the same year as U, this would be a retroactive allocation.

³³ If U dies and the due date for his estate tax return passes without the allocation of GST exemption to N’s trust, N’s death would result in an unavoidable taxable termination.

³⁴ For this calculation, assume that the inflation-adjusted GST exemption under permanent law would have grown to $1.4 million by 2011.

³⁵ $2,140,250 is computed as follows: GST of $1,155,000 plus $350,000, the extra 10% gift tax (55% in 2011 vs. 45% in 2009) on the excess of the $3.5 million transfer, plus $635,250, the 55% gift tax on the GST due.

³⁶ Remember that if the retroactive allocation of GST exemption does not return in 2011, any allocation of exemption to a trust will have to be made before the transfer that triggers GST (e.g., a taxable termination) occurs.

³⁷ Allocation of the GST exemption must be completed by the due date of the transferor’s estate tax return, including extensions (Sec. 2632(a)(1)).

³⁸ See, e.g., the instructions to Form 709, United States Gift (and Generation- Skipping Transfer) Tax Return, p. 11.

³⁹ Sec. 2642(d)(4). Before the additional allocation of GST exemption, $3 million of the trust’s $7.5 million value was sheltered from GST—i.e., 40% nontaxable based on the allocation of $2 million GST exemption to a $5 million transfer in trust. The allocation of an additional $1.5 million of GST exemption increases the nontaxable value to $4.5 million—i.e., 60% of the trust value is protected from the GST and the trust now has a 40% inclusion ratio.

⁴⁰ Of course, with the repeal of the estate tax come the complicated modified carryover basis rules of Sec. 1022(a). A 2010 estate will be allowed a $1.3 million basis increase under Sec. 1022(b)(2)(B) and a $3 million basis increase for bequests to the decedent’s spouse under Sec. 1022(c)(2)(B). But properly allocating these basis increases requires a clear picture of the decedent’s adjusted basis, which was seldom an issue under the fair market value rule of Sec. 1014. Further, battles between beneficiaries and executors and among beneficiaries are likely to ensue because beneficiaries are unlikely to be happy with their allocated portion of basis increase. Further consideration of this matter is beyond the scope of this article.

⁴¹ Sec. 2502(a), as revised by EGTRRA.