Basics of Generation-Skipping Transfer Tax, Parts VII, VIII, and IX
A strong foundation for stronger understanding of the GST tax
The next three installments in my video series, Basics of Generation-Skipping Transfer (GST) Tax, build on the prior fundamentals of indirect skips and allocating GST exemption. This article serves as an overview of these three installments, but I would encourage you to listen to the videos for a more comprehensive analysis (with examples in some cases).
Part VII: Applicable Rate and Inclusion Ratio
So far, I have explained this theoretical idea that allocation of GST exemption can exempt not just the initial value of an estate or gift tax transfer that is treated as a generation-skipping transfer, but also subsequent growth and income. In this video, I explain how.
Allocation of (or failure to allocate) GST exemption creates a fraction called the applicable fraction, the numerator of which is the GST exemption allocated, and the denominator of which is the taxable value of the property (net of the charitable deduction, and any estate or death taxes actually paid from the property that was transferred).
Once we have this fraction, we can determine the inclusion ratio. This is simply one minus the applicable fraction. If the applicable fraction is a perfect 1/1 fraction, we end up with a zero inclusion ratio. If no GST exemption is allocated, we end up with a 0/1 applicable fraction, leading to an inclusion ratio of one. Either way, the inclusion ratio is always between zero and one.
Finally, this leads us to our applicable rate, which is simply the maximum federal estate tax rate at the time of a generation-skipping transfer, multiplied by the inclusion ratio. The result? If you have a zero inclusion ratio, you have a 0% applicable GST tax rate, meaning that the trust (or direct skip) is effectively exempt from GST tax.
For a direct skip, this is an instantaneous, one-time determination. However, for a trust, the inclusion ratio tends to stay static unless or until additional property is added to the trust in a transfer subject to gift or estate tax reporting, or until another person is deemed the transferor.
This is significant, because it means that any deferred generation-skipping transfer (be it a taxable distribution or taxable termination) won’t be subject to GST tax, even if the trust grows, so long as the trust maintains its zero inclusion ratio. But, it does mean that any future increase in the maximum federal estate tax rate can increase the GST tax applicable rate.
There is one interesting note to close out, for estate and gift taxes paid out of pocket. When gift tax is paid out of pocket on a generation-skipping transfer, the value of the transfer for GST tax purposes is increased by the gift tax paid, whereas any estate tax paid from the generation-skipping transfer will decrease the value of the transfer for GST tax purposes.
Later, we will discuss inclusion ratios between one and zero, and what can be done in these situations, but that brings us to the significance of the deferred generation-skipping transfers just mentioned.
Part VIII: Taxable Terminations and Taxable Distributions
The theme of most of the videos has been the fact that GST tax liability is often deferred until a skip person receives a benefit from a trust. The technical terms for these deferred benefits are taxable distributions and taxable terminations.
The taxable distribution arises when there is a distribution of income, or principal, or both to a skip person. The value is the FMV of principal at the time of the distribution, along with the amount of income, multiplied by the inclusion ratio. Now, if you were thinking this could create a double-tax on distributable net income (DNI) distributed to a skip person, note that there is an itemized deduction for GST tax on a taxable distribution of income under IRC 164(a)(4). The inclusion ratio, however, does not affect the income tax payable by the skip person.
If there is any GST tax on a taxable distribution, it must be reported and paid by the skip person who receives it. (Note that the trustee’s payment of GST tax attributable to the taxable distribution increases the amount of the taxable distribution subject to GST tax, creating a circular calculation). The skip person files IRS Form 706-GS(D), which is due by April 15 (plus extensions) of the year following the year of the taxable distribution. The trustee also provides Form 706-GS(D-1) to the beneficiary, which is similar to a K-1 for GST tax purposes, providing the amount of the distribution and the tentative value (value of distribution times inclusion ratio).
Note that taxable distributions from a trust with an inclusion ratio of zero do not have to be reported, even if the skip person receives Form 706-GS(D-1).
The other form of deferred transfer, taxable terminations, can be a bit more tricky. Simply put, this is an event wherein the interests of all non-skip persons in a trust have terminated. As a result, at such time the only remaining beneficiaries are skip persons, meaning that the amount passing to skip persons can then be determined. A taxable termination can come up in a variety of ways - passage of time under the terms of the trust, the death of a non-skip person, or even at the election of a non-skip person (such as a release of a trust interest). There could also be a taxable termination for only a portion of a trust, such as a share of a common trust carved off for a deceased child’s descendants.
What makes this tricky is the definition of an interest in a trust. We only analyze this from the perspective of the non-skip person(s) whose interests are terminating, but generally the definition includes either a discretionary or mandatory right to receive income. If two (similar or different) interests of non-skip persons terminate simultaneously for a trust or the same portion of a trust, you only have one taxable termination.
A taxable termination is reported by the trustee on IRS Form 706-GS(T), by April 15 of the year following the year of the taxable termination. The GST tax payable (if the inclusion ratio is greater than zero) is the value of the trust principal at the time of the taxable termination, times the inclusion ratio. Accrued but undistributed income could presumably be included in this calculation, but may not be included where a non-skip person’s estate retains the right to receive income and actually receives it.
There are some ordering rules to note in this analysis. When analyzing generation-skipping transfers, transfers that fit multiple categories are assigned in this order of priority:
direct skips;
taxable terminations; then
taxable distributions.
So, for example, if you have what appears to be a taxable termination, but it generates gift or estate tax liability (before taking into account the applicable credit) at the time, it could instead be a direct skip from the individual who incurs the gift or estate tax. Similarly, if you have a distribution of all remaining trust income and principal from a trust to a skip person, it would appear that this is a taxable distribution, but the effect of the distribution (terminating all interests of non-skip persons) would instead make it a taxable termination.
Part IX: GST Trusts under IRC Section 2632
When it comes to allocating GST exemption, whether automatically or manually, it is easy to assume that any indirect skip trust is eligible. Indeed, even where no skip persons are living when a trust is funded, the inclusion of after-born skip persons in any class of beneficiary is enough to create “GST potential” such that GST exemption can be allocated to the trust.
But, in order to have automatic allocation, the trust has to meet the definition of GST trust. This definition, found in IRC 2632(c)(3)(B), applies to indirect skip transfers to trusts which have the spirit of providing meaningful future interests to skip persons. This Code Section sets forth 6 types of trusts which will not qualify as GST trusts. I won’t list them here, but there are a few types of transfers to highlight.
One, any charitable lead trust or charitable remainder trust won’t be classified as a GST trust. Thus, if GST exemption can be allocated (which depends on the ETIP rule to be later discussed), you cannot rely on automatic allocations for these types of trusts. Later, we will discuss the calculation of GST exemption allocations for charitable lead annuity trusts (CLATs).
Two, we will later learn about the ETIP rule and how it relates to estate inclusion for a grantor or grantor’s spouse. But, it is important to note that the ETIP rule does not extend to a situation where any portion of a trust could be included in the gross estate of a beneficiary if the beneficiary were to die immediately after the trust is funded.
Obviously if a skip person was the beneficiary who could be subject to such gross estate inclusion, we could have a generation-skipping transfer. But, if a non-skip beneficiary is subject to this rule (called out in IRC 2632(c)(3)(B)(iv), the entire trust would not be a GST trust (even if only a portion is includable in the non-skip person’s gross estate). Why? Because eventually that non-skip person would be the transferor, and would allocate their own GST exemption, meaning that any prior allocations are wasted if there are no taxable distributions or taxable terminations in the interim. (Interestingly, the grant of a general power of appointment for a non-skip person can prevent a taxable termination, and this is a strategy often used for trusts that have an inclusion ratio of more than zero).
It is easy to read this and assume that a Crummey withdrawal right would disqualify a trust from automatic allocation of GST exemption, but that is not the case. Why? Because there is a special carve-out in the flush language of 2632(c) which treats a Crummey withdrawal right (up to the gift tax annual exclusion amount) as not being includable in the gross estate of a non-skip person, and assumes that the right will not be exercised, in each case solely for purposes of the classification of the trust as a GST trust. (I will later discuss Crummey rights against the GST tax annual exclusion in Part XI of this series).
The primary lesson here, however, is that a failure to timely allocate GST exemption (such as through a gift tax return) could potentially be saved through the automatic allocation rules, but only if the trust is a GST trust. The secondary lesson is that, where GST allocation may be timely, you are allowed to manually allocate GST exemption to a trust that is not a GST trust - but doing so may not be an efficient use of the exemption if most or all trust benefits go to non-skip persons.
Conclusion
The mechanics and strategy behind allocation of GST exemption can have effects that extend far into the future. While the automatic allocation rules seem to cover a variety of circumstances, they do not create a perfect backstop.