Basics of Generation-Skipping Transfer Tax, Parts V, VI, and VI-A
A strong foundation for stronger understanding of the GST tax
Since publishing my last article, a lot has changed in my world. The changes warrant a separate post, but I have continued to develop the video series on the basics of generation-skipping transfer tax. In the midst of developing the next few installments in this series, I had the privilege of doing something I had not done in over a year - teaching part of the estate planning course for CFP candidates through the College for Financial Planning. This strengthened my resolve to continue developing content that bridges the beginner-to-intermediate gap, while also exposing some gaps in the way I had been developing this course (which I believe I have now corrected).
That being said, I am behind in providing this written supplement to the most recent videos. So, without further adieu, let’s dive into each part.
Part V: Intro to Allocating GST Exemption
When we left off last time, I had introduced the GST exemption amount in Part IV, with the core lessons being (1) it is the same as the estate/gift tax basic exclusion amount but (2) cannot be preserved through portability if unused by a deceased spouse.
This Part V is about what to do with this GST exemption. The answer? You allocate it, for reasons which will develop clarity over the next few videos. But, the answer is not quite that simple. We have two mechanisms upon which we can rely. First, there is automatic allocation, to direct skips and to a special type of transfer - the indirect skip - which comes up in Parts IV and IV-A. Second, you have the ability to elect out of automatic allocation, and instead to manually allocate GST exemption to some of all of these types of transfers.
Allocation, as we will find out, directly controls the rate of tax that applies to a generation-skipping transfer. Depending on how much GST exemption is allocated, the current GST tax rate can be anywhere between 0% - 40%.
For the bulk of the discussion on allocating GST exemption, we will look at it through the lens of transfers during life. There will be a different discussion for transfers at death, which we will explore later on.
One of the macro-level policy decisions here that distinguishes the GST tax from the gift tax is this element of choice. You can choose whether or not you want to use your GST exemption for lifetime transfers during life, even if doing so would cause GST tax to later be paid. However, there is no such election for the gift tax. You are forced to use your gift tax applicable credit for lifetime gifts, until it is used in full. As to why you might want to pay gift or GST tax out of pocket, this is a good way to reduce the size of your gross estate, but you do not get this choice as long as applicable credit remains.
And, interestingly, while the gross estate is increased by the amount of any gift tax paid within 3 years of death under IRC 2035(b), there is no such rule for GST tax paid within 3 years of death. However, one of the key lessons in this part is the gift tax treatment of GST tax. Under IRC 2515, for a direct skip, the amount of the gift (and thus the gift tax) is increased by the amount of GST tax paid. So, if the direct skip occurs within 3 years of death, the GST tax acts to increase the gift tax that is ultimately pulled back into the gross estate. (We will later cover whether there is a loophole here for indirect skips).
Notwithstanding the seemingly illogical election to pay gift or GST taxes, the interesting news is that you need not actually file a gift tax return to take advantage of automatic allocation. Later, we will learn what types of transfers qualify for automatic allocation without filing, but this is a unique feature of the GST tax - it is designed to not ding the transferor unless absolutely necessary. I bring this up not to encourage non-compliance with gift tax reporting, because the value of the transfer for automatic allocation purposes remains in flux so long as the period for assessing gift tax remains open.
But, many practitioners choose to use manual allocation (which warrants its own separate discussion), and manual allocation does require the filing of a gift tax return. It also requires the attachment of two written statements to the gift tax return - an election out statement, and a notice of allocation. It also requires the preparer to check the box in Schedule A, Parts 2 and 3, Column C of Form 709 (the gift tax return) to elect out of automatic allocation. I talk a bit more about this process and the pitfalls thereof in this article and this article.
Part VI: Indirect Skips
Bringing in the gift tax return, this Part VI compares the gift tax return definition of “indirect skip” to the Code definition of this same term. But, in Part VI-A, I provide what I think is a better definition - a transfer involving both skip persons and non-skip persons. 9,999 times out of 10,000, this type of a transfer will involve a trust, and we will even later see that the definition of inclusion ratio assumes that a trust is involved.
That aside, this video walks through some of the parts of the gift tax return involved in allocating GST exemption, especially for indirect skips, while the next part (Part VI-A) supplements this Part by further illustrating the core problem we are trying to solve - timing.
What do I mean? Well, let’s say you create an irrevocable dynasty trust during life and gift property to the trust. Your “descendants” are beneficiaries of this trust. However, in the class of descendants, you have only children living - not grandchildren - but future-born grandchildren are included as trust beneficiaries. So, at some point in the future, skip persons will become trust beneficiaries. This is what we know as “GST potential.”
Unless and until we have (1) living skip persons, and (2) trust property passing to these skip persons, we have no way of knowing how much property passes to skip persons. So, the GST tax could kick in well into the future, even after the transferor is deceased. How will we know how much GST tax is paid then?
This is where allocation of the GST exemption comes in. Indirect skips are unique in that the GST tax liability is deferred. Contrast this with direct skips, where the GST tax liability (if any) is always payable concurrent with the gift tax (for lifetime transfers) or the estate tax (for transfers at death). And, since the ticket to entry for the GST tax is a corresponding gift or estate tax, or use of gift or estate tax applicable credit, this means that sales (to the extent of adequate consideration received) are not subject to GST tax.
In this Part, we tee up some concepts which will be tacked in due time - GST trusts, and the estate tax inclusion period (ETIP). These are the wrenches thrown in the allocation works, as you cannot just assume that any indirect skip trust qualifies for allocation of GST exemption. In the case of a trust that is not a GST trust, you lose automatic allocation. In the case of a trust subject to an ETIP, you lose both automatic and manual allocation until the ETIP ends.
Assuming you have a GST trust with no ETIP, this video briefly introduces some of the parts of Form 709, the gift tax return, which come into play in allocating GST exemption. We will examine these in greater detail later.
Part VI-A: Indirect Skips, Re-Explained
To tackle my perfectionism, I have a one-take rule for videos. I don’t cut, redact, or add to videos once I have recorded them. But, on occasion, I discover that entire videos have missed the mark. This is one of those occasions, where I took the liberty of re-explaining a concept - indirect skips - in a way that would allow you to more meaningfully grasp the concept.
Circling back to the timing issue, this video discusses the problem of deferred benefits from a trust for (yet unborn) skip persons. Recall that to have a GST tax, you must have property deemed to pass from a transferor (in this case, the grantor of a trust) to an individual that is a skip person by virtue of generation assignment, or difference in age, when compared to the transferor.
Given that the GST tax liability is deferred, how do we plan today for a tax that might not kick in for many years? The answer lies in the allocation of GST exemption. What we will find out is that a dollar-for-dollar allocation of GST exemption to an indirect skip by the transferor at the time of transfer will prevent the GST tax from ever applying to both the initial value of the trust, and the future growth of the trust. The GST tax rate refers back to the last time that the trust was subject to gift or estate tax, because at that time GST exemption could have or should have been allocated if available to the last transferor.
(Of course, the transferor can shift over time - we will later explore how.)
In the next Part, we will discover how the problem may be even bigger than we thought at first glance. (Hint: could a future increase in the estate tax rate apply to the GST tax on a trust, even if a lower rate was in place when the trust was funded?)
Conclusion
GST tax can be challenging, but I hope these bite-sized nuggets aid in your understanding. Stay tuned to this newsletter, and to my YouTube channel, to see the latest updates as I post new parts. If you enjoy this format, more courses are in the works.
And, if you are interested in contributing an article or video, I am always looking for co-collaborators - feel free to reach out. You can find my e-mail in the videos embedded in this article.