GST Tax Carve-Outs Not Found in the Internal Revenue Code
Two little-known exceptions to the generation-skipping transfer (GST) tax rules
Intro
In determining the generation-skipping transfer (GST) tax-exempt status of a trust, the time of creating a trust matters. While many are familiar with grandfathered trusts under Treas. Reg. 26.2601-1(b), there are two other exceptions which are not often found under the Internal Revenue Code and its Regulations. These exceptions include:
Gallo Trusts
Hidden deep within Public Law 100-647, which provided technical amendments to the Tax Reform Act of 1986 (from which our current tax code, and GST tax laws, originated), we find this carve-out in Section 1014(h):
(3) TREATMENT OF CERTAIN TRANSFERS TO GRANDCHILDREN.--
(A) IN GENERAL.--For purposes of chapter 13 of the Internal Revenue Code of 1986, the term 'direct skip' shall not include any transfer before January 1, 1990, from a transferor to a grandchild of the transferor to the extent the aggregate transfers from such transferor to such grandchild do not exceed $2,000,000.
(B) TREATMENT OF TRANSFERS IN TRUST.--For purposes of subparagraph (A), a transfer in trust for the benefit of a grandchild shall be treated as a transfer to such grandchild if (and only if)--
(i) during the life of the grandchild, no portion of the corpus or income of the trust may be distributed to (or for the benefit of) any person other than such grandchild,
(ii) the assets of the trust will be includible in the gross estate of the grandchild if the grandchild dies before the trust is terminated, and
(iii) all of the income of the trust for periods after the grandchild has attained age 21 will be distributed to (or for the benefit of) such grandchild not less frequently than annually.
Long story short, direct transfers before 1990 in an amount of $2,000,000 per grandchild were permitted. This could be outright, or in trust (hence the “Gallo” trust, named after the Gallo wine family who lobbied for this exception). While this carve-out was technically not classified as a “direct skip,” note that transfers in trust often are treated as indirect skips except where the provisions of IRC Section 2642(c)(2) apply with respect to a grandchild. These requirements essentially mirror the requirements set forth above for a transfer in trust to qualify for the Gallo exception, but with the added requirements in a Gallo trust of (1) discretionary income distributions solely to the grandchild until age 21, and (2) mandatory income distributions solely to the grandchild after age 21.
Of note is the requirement that the trust assets be included in the gross estate of the grandchild if they die before complete distribution. As a result, the grandchild would become the new “transferor” for GST tax purposes under IRC Section 2652(a)(1)(A). Likewise, a release of the grandchild’s power(s) leading to gross estate inclusion during life would create a similar transferor shift for gift tax purposes. In either event, the prior GST exemption is wiped clean and the grandchild’s own GST exemption may be subject to automatic or manual allocation to the remaining or released trust property.
One must also be cautious about constructive addition rules, as seen for grandfathered trusts.
Finally, please note that while this was exempt from GST tax, it certainly wasn’t exempt from gift tax. From 1988 (when the Gallo exception was created) through 1990, the lifetime gift tax exclusion was only $600,000 with a top rate of 55%.
If you would like a bit more on the nitty gritty of Gallo trusts, I provide some insight in this video:
2010 Trusts
As part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the estate and GST taxes were given a limited shelf life. Both taxes were subject to repeal after December 31, 2009, which threw the planning world into a tizzy during 2010. While the estate and GST tax were eventually reenacted on December 17, 2010 under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”), there were some loose ends to tie up for 2010.
While there was an election for estate tax (to apply either the new law, or the lack of estate tax with limited basis step-up under IRC Section 1022), GST tax was a bit more nuanced. Section 302(c) of this Act provided:
In the case of any generation-skipping transfer made after December 31, 2009, and before January 1, 2011, the applicable rate determined under section 2641(a) of the Internal Revenue Code of 1986 shall be zero.
In terms of how we define a “generation-skipping transfer” in IRC Section 2611, this effectively meant there was a zero GST tax rate for either a (1) direct skip, (2) taxable distribution, or (3) taxable termination that occurred during the year 2010.
This did not apply indirect skips, however, which still require allocation of GST exemption. No relief was granted in 2010 to “waive” GST exemption allocations to indirect skip transfers that year. However, if an election was made to “waive” estate tax (which then used a limited basis step-up under IRC Section 1022), IRS Form 8939 had to be timely filed - including the attachment of Schedule R to that Form to allocate GST exemption if that was the intent.
Allocation at death was described in IRS Notice 2011-66.
Interestingly, however, what if we had a direct skip - whether in the form of an outright transfer to a grandchild, or a transfer in trust? Ironically, if we rehash the same general requirements >20 years after the fact, it was possible during 2010 to create a “Gallo” type of trust for one or more grandchildren of an unlimited amount - but with one major difference.
For a direct skip in trust, a structure similar to IRC Section 2642(c)(2) (plus the Gallo mandatory income distribution requirement after age 21) doesn’t have to be followed - we only need to limit the beneficiaries with an “interest” in the trust to skip persons. When defining an “interest,” we generally need only look at the beneficiaries with a present right to receive income and principal under Treas. Reg. 26.2612-1(e). In this context, the requirements of IRC Section 2642(c)(2) only apply to determine the portion of a gift that is nontaxable under IRC Section 2503 - they do not apply when simply defining a direct skip.
This made it possible to create a grandchildren-only trust, possibly with non-skip remainder beneficiaries, without forcing gross estate inclusion for the grandchildren (as would otherwise be required under IRC Section 2642(c)(2) or the Gallo rules). Of course, one would have been forced to use gift tax applicable credit (then based on a basic exclusion amount of $5,000,000) on those transfers. From a practical perspective, given that the Act was signed on December 17, 2010, one would have only had a 14-day period to create and fund such trusts unless they stumbled their way into a direct skip trust accidentally during the year (which would have been unlikely, given that the 2010 pre-Act gift tax exclusion was $1,000,000 with a 35% rate).
The risk with this type of trust, however, was unnecessary allocation of GST exemption since there is automatic allocation of GST exemption to direct skips (requiring a bit more nuanced reporting than an election out for indirect skips). To address this possibility, IRS Notice 2011-66 (cited above) also provided that a timely-filed 709 for a direct skip in trust had to indicate an intent to elect out of automatic allocation. (There was an assumption of such election out due to the zero percent rate only for direct skips not in trust.)
If you spot such a trust where there was no election out of automatic allocation on the 2010 Form 709, late election relief may be available. For an example of where this was sought, see PLR 202220009.
Conclusion
Sometimes, the Code and Treasury Regulations aren’t enough to address what has happened in the past. The GST tax has a storied history of fits and starts leading up to its current iteration, which can be confusing even for advanced practitioners. Nonetheless, we can occasionally find breadcrumbs of meaning for certain trusts and transfers such as the ones highlighted in this article.