Basics of Generation-Skipping Transfer Tax, Parts X, XI, and XII

A strong foundation for stronger understanding of the GST tax

In my last write-up of my video series on the basics of generation-skipping transfer (GST) tax, I discussed some foundational concepts around the allocation of GST exemption, how it affects the GST tax rate for events within a trust in the future, and when it can be automatically or manually allocated.

The next three parts drill down on some of the concepts introduced in the previous article.

Part X: The Estate Tax Inclusion Period (ETIP)

Previously, we learned that GST exemption can only be automatically allocated to a trust so long as two conditions are met. One, as discussed in Part IX, the trust must be classified as a GST trust. Two, as I introduced but did not explain in Part IX, the trust cannot be subject to an estate tax inclusion period, or ETIP.

What is an ETIP? It is a period that applies to a trust that is funded during a transferor’s life. This period applies so long as the trust assets would be included in the gross estate of the transferor, or the transferor’s spouse, if either were to die.

The significance of an ETIP is that GST exemption cannot be applied to a trust, either automatically or manually, during an ETIP. Most often, you see this arise with a term-certain trust such as a GRAT or QPRT where a grantor retains an interest.

But, there is a twist. GST exemption gets automatically applied to a trust subject to an ETIP at the end of the ETIP, assuming it is then classified as a GST trust. This can be a bad outcome, for one main reason - the amount of GST exemption allocated is based on the FMV of trust assets at the end of the ETIP. The goal of a successful GRAT or QPRT is to use time-value discounting to remove assets and their future growth from the gross estate. But, you lose this discounting for GST tax purposes due to the ETIP rule.

For this reason, it is common to not allocate GST exemption to the remainder of a term-certain trust such as a GRAT or QPRT because, if the trust is successful, the exercise of making the trust GST-exempt requires the use of more GST exemption than basic exclusion amount.

We cannot stop there, however. A common mistake in gift tax reporting is the failure to elect out of automatic allocation of GST exemption at the end of an ETIP. Fortunately, you get two bites at the apple to do so - one at the funding of the trust subject to an ETIP, and the other at the end of the ETIP. To take either bite at the apple, you must file a gift tax return.

I explain more about the procedure for doing so in this article.

The ETIP rule has some crossover with the rules on classifying a trust as a GST trust, with one common thread - the question of whether the trust would be included in the gross estate of someone other than a skip person.

While the ETIP rule applies only to the transferor or the transferor’s spouse, we will discuss below that a QTIP trust is usually not subject to the ETIP rule. Similarly, the ETIP rule does not apply to transfers that may be included in the gross estate under IRC Section 2035 - this has special application for ILITs.

On the other hand, the GST trust rule considers whether a non-skip person beneficiary other than the transferor or transferor’s spouse may be subject to gross estate inclusion. This typically arises where the beneficiary has a general power of appointment. But, there is a carve-out which states that a Crummey power will not count in determining whether or not a trust is a GST trust. However, there is no such exception for an ETIP - so, for example, spousal Crummey powers are often limited to the greater of $5,000 or 5% of the spouse’s share of contributed assets so as to avoid an ETIP. Nonetheless, we must recognize the limitations of Crummey powers in GST tax planning.

Part XI: GST Tax Treatment of Crummey Withdrawal Rights

Much like the gift tax, the GST tax has an annual exclusion for gifts of present interests to skip persons. This exclusion is currently $17,000 per donee. The lifetime gift tax applicable exclusion, and GST exemption, are only used to the extent a gift to a particular donee exceeds the annual exclusion or does not qualify for the annual exclusion (or some other deduction).

Central to the analysis of both annual exclusions is the present interest requirement, which requires the donee to have the immediate right to the possession or enjoyment of transferred property. Most gifts in discretionary trusts fail to meet this requirement, so rights of withdrawal (as introduced by case precedent in Crummey v. Commissioner and this colloquially known as “Crummey” rights) are designed to manufacture a present interest by giving trust beneficiaries a temporary window of time to withdraw their proportionate share of contributed assets, up to the gift tax annual exclusion amount.

As noted above, the spousal Crummey withdrawal right may be limited to $5,000 or 5%, so as to avoid an ETIP. But, where things get hairy is where skip persons hold a Crummey withdrawal right. Why? Because the Crummey case cited above is a gift tax case. In the case of GST tax, qualification for the annual exclusion is driven by IRC Section 2642(c).

Notably, only a direct skip qualifies for the GST tax annual exclusion. While a skip person’s Crummey power appears to be a direct skip on its face, this Code Section imposes additional requirements for transfers in trust. These requirements cause Crummey rights for skip persons to differ from Crummey rights for non-skip persons with regard to the treatment upon lapse.

The question of the gift tax treatment of a lapse of a Crummey power warrants its own separate discussion, but the central premise is that the grant of a Crummey power shifts transfer tax ownership from the donor, to the holder of the power. Usually, the treatment of the power upon lapse does not affect the donor’s qualification for the gift tax annual exclusion. But, the treatment upon lapse does affect the donor’s qualification for the GST tax annual exclusion. Long story short, if the lapse results in a deemed gift by the skip person to another beneficiary, there is no qualification for the GST tax annual exclusion.

For this reason, IRC Section 2642(c) sets forth two requirements for a Crummey power to qualify for the GST tax annual exclusion (both of which apply to the property subject to the withdrawal right):

1. After the withdrawal right lapses, no income or principal attributable to the property subject to the lapsed withdrawal right can be distributed to any individual other than the skip person who held the withdrawal right; and

2. The income and principal attributable to the property subject to the withdrawal right, to the extent not distributed to the skip person, must be includable in the skip person’s gross estate at death.

So what is the key difference? Many Crummey powers lapse into a common trust for all beneficiaries, both skip and non-skip persons. To avoid a deemed gift from the powerholder to the other beneficiaries, the lapse in this context is often structured as a “hanging” power which only lapses to the extent of the greater of $5,000, or 5% of the assets which could have been withdrawn. As a result, Crummey powers tend to accumulate for perpetuity until they lapse out, with the excess being subject to inclusion in the gross estate of the powerholder.

But, the 2642(c) approach does not permit a common trust, or a shifting of a lapsed benefit to other trust beneficiaries. Instead, it requires that the property subject to the withdrawal right be held in a subtrust for the sole benefit of the skip person who held the power. It also requires, at the very least, that the skip person have a testamentary power of appointment over this subtrust.

However, this power of appointment does not have to be a general power of appointment. Why? Because the grant of a Crummey power shifts transfer tax ownership to the skip person who held that power. As a result, merely granting a nongeneral power of appointment is enough to cause gross estate inclusion, under the principles of incomplete gifts in Treas. Reg. 25.2511-2. This regulation generally provides that a gift will be incomplete, and thus included in the gross estate, if the donor retains a testamentary power of appointment. Since a lapse of a power of appointment is a deemed gift by the powerholder, this same incomplete gift rule should apply in this context.

Part XII: GST Grandfathered Trusts

If you have been around GST tax planning long enough, you have probably heard of grandfathered trusts. But, if not, this is an important topic for those who analyze and administer older trusts.

The grandfathered trust rules are found in Treas. Reg. 26.2601-1(b). Since the GST tax became effective in piecemeal fashion throughout 1985 and 1986, this rule recognized that certain irrevocable trusts should not retroactively be subject to the GST tax. So, for any trust that was irrevocable on September 25, 1985, the trust was deemed GST-exempt by virtue of a zero inclusion ratio for transfers to the trust that had occurred on or before that date. However, a trust is not a grandfathered trust if the transferor held a power that would be subject to IRC Sections 2038 or 2042 on that date.

But, actual or constructive additions to a GST grandfathered trust after that date are subject to allocation of GST exemption. It is also important to note that the automatic allocation rules were only given full effect for transfers occurring after December 31, 2000. So, for a 15+ year period, actual or constructive additions could have increased the inclusion ratio of a grandfathered trust if GST exemption was not allocated on a gift or estate tax return.

The Regulations go to great lengths to explain how the inclusion ratio is redetermined for each actual or constructive addition. It is obvious that GST exemption is allocated to a transfer based on the FMV of the property at the time of the transfer. But, for grandfathered trusts, the FMV of the other trust assets has to be redetermined at the time of the addition to determine what part of the growth contributes to the zero inclusion ratio.

For QTIP trusts, we will later learn about the reverse QTIP election which allows the GST tax treatment of a QTIP trust to be decoupled from the gift/estate tax treatment. Essentially, this decoupling allows a choice of whether the grantor spouse, or beneficiary spouse, will be treated as the “transferor” for purposes of allocating GST exemption. But, for a grandfathered QTIP trust, the grantor spouse is deemed to be the transferor. As a result, even though the beneficiary spouse may be subject to gross estate inclusion under IRC Section 2044 (or gift tax treatment under IRC Section 2519), these events will not cause the beneficiary spouse to have to allocate their own GST tax exemption to the grandfathered QTIP trust.

These regulations also have a number of rules relevant to modification and decanting of trusts. These rules determine whether a trust with a zero inclusion ratio (either due to grandfathering, or allocation of sufficient GST exemption) maintains its exempt status. In a nutshell, these rules respect the GST-exempt status of a trust post-modification so long as:

1. The time for vesting is not extended beyond the rule against perpetuities applicable to the exempt trust; and

2. No beneficial interest is shifted to a beneficiary in a younger generation than the current beneficiaries of that interest.

The merger and division of trusts has some other special rules, especially as relates to severing trusts, that we will later explore. These rules get quite complicated.

Conclusion

GST tax is, and will continue to be, a tricky subject. But, the subjects covered so far should give you the foundation to determine the GST tax status of a number of trusts that are funded during life. A lot of the topics to be covered in later articles will tie up loose ends, while introducing some narrow concepts that may not apply as often but nonetheless are important to know.

[And, as a quick promotional note, I do what I do because I love speaking and teaching. If you have a programming need for your bar association, estate planning council, FPA chapter, conference, marketing event, or training event, please reach out if you are interested in having me speak.]