A/B Formulas and GST Tax - An Odd Combo
Making sense of trust divisions at death where GST tax exemption is to be allocated
Many wills and trusts that are set up to optimize estate tax planning for married couples call for the creation of two separate trusts at the death of the first spouse to die. One trust, often known (interchangeably) as a family trust, bypass trust, or credit shelter trust is established to use the remaining estate tax applicable exclusion (minus lifetime taxable gifts) of the first spouse to die. The second trust, often known as a marital trust or QTIP trust, is set up to qualify for the unlimited estate tax marital deduction and is thus funded with the remaining assets not allocated to the family trust. (Where the surviving spouse is not a U.S. citizen, the marital trust may be set up as a qualified domestic trust, or QDOT).
For purposes of this article, I will use marital trust and family trust. And, unless otherwise noted, I will always refer to the applicable exclusion amount, applicable credit amount, and GST exemption of the first spouse to die.
While the usual formula (colloquially called an “A/B formula”) and its permutations are not part of this discussion, this split between the two trusts is accomplished using some formula based on estate tax values of assets. The goal of the formula is to create zero estate tax at first death, using a combination of the remaining estate tax applicable exclusion and the estate tax marital deduction. In some cases, the split is made by funding the marital trust with the minimum marital deduction amount needed to zero out estate tax, with the balance to the family trust. In other cases, the split is made by funding the family trust up to the maximum amount that uses the estate tax applicable credit without generating additional estate tax, with the excess to the marital trust.
For more on this issue, I have included some videos at the end of the article. But, the common formula is not the end of the road. Why? Because the estate tax applicable exclusion is not the only transfer tax exemption available. There is also a generation-skipping transfer (GST) tax exemption to consider. Depending on the amount of this exemption, especially compared to the remaining estate tax applicable exclusion, a portion of either the family trust or marital trust may not be exempt from GST tax. For estate plans containing an A/B formula under which both the family and marital trusts are created, there are three possible permutations we will cover:
Exempt family trust, nonexempt marital trust
Exempt family trust, nonexempt family trust, nonexempt marital trust
Exempt family trust, exempt marital trust, and/or nonexempt marital trust (depending on qualification for QTIP election).
Before exploring these permutations, it is important to note that some estate plans with tax planning provisions now eschew the traditional A/B funding formula in favor of an optional funding of a family trust structure through a spousal disclaimer or Clayton QTIP election. I will cover this type of plan (often called a portability plan or disclaimer plan) in another article.
Also, I would be remiss if I did not mention that a high applicable exclusion amount (especially for a remarried widow with ported DSUE from a predeceased spouse) means that a marital trust may not always be created under an estate plan with an A/B formula. In such a case, the family trust may be the only trust created. And, the family trust will be entirely GST exempt unless the remaining GST exemption is less than the taxable estate being funded into the family trust.
This brings us to our central question, which must be answered before we look at the three permutations introduced above - is there a disparity between the remaining estate tax applicable exclusion, and the remaining GST exemption?
Usually, this only happens if there has been lifetime gifting by the first spouse to die (usually to one or more trusts), a prior portability election followed by remarriage, or gross estate inclusion of assets transferred during life under Code Sections 2035-2038, 2040, or 2042. We will look at each of these outcomes in turn.
OUTCOMES CREATING DISPARITIES IN TRANSFER TAX EXEMPTIONS
Prior Gifting
A decedent’s gifting history can create a disparity between the remaining applicable exclusion amount, and the remaining GST exemption.
In cases of direct gifts in excess of annual exclusions to non-skip persons or to non-elected trusts, this can create more GST exemption than remaining applicable exclusion. Why? Because no GST exemption may be applied to direct gifts to non-skip persons, and election out of automatic allocation can mean no GST exemption is applied to trusts. The latter case would usually be found where there is a transfer to a trust subject to an ETIP, such as a GRAT or QPRT, or to a trust that is not a GST trust. Another case could arise where there is an election out of automatic GST exemption allocation, but at a later date, the gift tax value of the transferred property is increased.
The outcome would be:
On the other hand, usually where trusts are involved, it is possible that GST exemption could be used at a faster rate than for gift transfers. How? Usually this situation arises where Crummey powers are created for living skip persons, which do not qualify for a zero inclusion ratio. This can be especially pronounced for trusts like ILITs, which have an annual premium funding obligation coupled with hanging Crummey powers.
The outcome would be:
Long story short, if there is any lifetime gifting, there is a chance that this disparity could arise. This could be the case even if no gift tax returns are actually filed because, for example, GST exemption might be automatically allocated to Crummey powers that are not taxable gifts. It is possible, but not a given, that one dies with an applicable exclusion and GST exemption that are equal.
I would also be remiss if I did not mention that, the applicable exclusion and GST exemption have not always been unified. This could be a factor in creating a disparity.
Prior Portability Election
The portability election can be a valuable planning tool, but it has one fundamental flaw - it only preserves the unused basic exclusion, and not the unused GST exemption, of the first spouse to die. As a result, a widow might have deceased spousal unused exclusion (DSUE) amount which increases their applicable exclusion to an amount greater than their remaining GST tax exemption.
Let’s say, in such a situation, a widow remarries and creates an estate plan with a family trust/marital trust split for their new (now surviving) spouse. (In this situation, the widow would now be the first to die of a second married couple, applying DSUE from their prior marriage.) In such a situation, there could be superfunding of the family trust compared to the norm. But, the GST exemption would be used up before the applicable exclusion (basic exclusion plus DSUE) is used up.
The outcome would be:
Gross Estate Inclusion
Assets transferred by gift, sale, or exchange during a decedent’s life can be pulled back into the gross estate by operation of Code Sections 2035-2038, 2040, or 2042. In such a situation, any post-transfer appreciation in the value of the previously-transferred assets is pulled back into the gross estate. This excess additional value reduces the amount passing into the family trust, as it reduces the available applicable exclusion to be applied to assets actually available to fund the family trust. But, there may not be a corresponding reduction to available GST exemption - even with automatic allocation - because the allocation events for lifetime transfers and transfers at death are different.
The outcome would be:
THE FUNDING PERMUTATIONS
1. Exempt Family Trust, Nonexempt Marital Trust
This situation usually arises where the remaining applicable exclusion equals the remaining GST exemption. This usually is found where none of the disparity-creating events above exist.
In such a situation, the applicable exclusion and GST exemption are both allocated in tandem dollar-for-dollar to the family trust, making it an exempt family trust. The excess then funds the marital trust, and since there is no excess GST exemption, the marital trust is not exempt from GST tax.
At the surviving spouse’s death, it is expected that the surviving spouse would then allocate their own remaining GST exemption to whatever is left in the marital trust (presumably after allocation to the survivor’s own lifetime transfers and personally-owned estate).
2. Exempt Family Trust, Nonexempt Family Trust, Nonexempt Marital Trust
This situation arises where we have the following disparity:
Because there is less GST exemption than applicable exclusion, this means only a portion of the family trust becomes GST exempt. And, of course, the marital trust would be GST-nonexempt as well.
3. Exempt Family Trust, Exempt Marital Trust, Nonexempt Marital Trust
This situation arises where we have the following disparity:
Since the family trust can only be funded up to the remaining applicable exclusion, it leaves us with excess GST exemption to be applied to the Marital Trust. As a result, we end up with at least a GST-exempt marital trust. And, if the value of the marital trust funding exceeds the remaining GST exemption (after funding the family trust), we may also end up with a GST-nonexempt marital trust.
However, it is important to note that this structure is only possible with marital trusts that qualify for the QTIP election. Why? Because a marital trust can qualify for a marital deduction in two ways - one, by giving the survivor a general power of appointment, and two, by making a QTIP election. If the survivor is given a general power of appointment, the trust will not qualify for the QTIP election or the reverse QTIP election.
What is the reverse QTIP election, and why is it important in this context? Because, wherever the marital deduction is used, the balance of the marital trust has to be included in the survivor’s gross estate. This usually creates an ETIP, the outcome of which is that the first spouse to die cannot allocate their own GST exemption to the marital trust.
However, in the case of a QTIP trust for which a QTIP election is made, this ETIP outcome can be avoided by making a “reverse QTIP” election as permitted by Code Section 2652(a)(3). This allows the first to die to allocate their own GST exemption to create an exempt marital trust, and it also prevents the survivor from having to allocate their own GST exemption to the exempt marital trust at their death (even though the exempt marital trust is still included in the survivor’s gross estate under Code Section 2044).
Long story short, this permutation is not possible where the survivor has a general power of appointment over the marital trust.
CONCLUSION
In estate plans for married couples creating a family trust and, maybe, a marital trust under an A/B funding formula at first death, allocation of GST exemption can create a lot of confusion. But, it is important to know which permutations are available and how they are affected by disparities between the remaining applicable exclusion and the remaining GST exemption.
One thing to note here is that, absent a disclaimer or some other post-mortem planning (which are more emblematic of an estate plan without an A/B funding formula), you will usually only end up with exempt and nonexempt shares of either the family trust or the marital trust, but not both.
There is a lot more to say on this topic, especially as involves the selection of assets to fund the exempt and nonexempt shares. There is some common ground, as both the A/B funding formula and GST exemption allocation formula may operate off a “fairly representative” standard. This means you must allocate assets to shares in a way that post-death (or post-valuation) appreciation or depreciation ends up equalized between all shares. But, this is a topic that could take up several articles.
In the meantime, stay tuned for the next installment where we explore how allocation of GST exemption works in plans that forego the rigid A/B funding formula in favor of a disclaimer trust, full/partial QTIP election, Clayton QTIP trust, portability election, and/or forced payment of estate tax at first death.