Previously, this author has written about the potential pitfalls of forgoing an actual estate plan and instead relying upon portability under the 2010 Tax Relief Act to achieve a client’s wealth transfer goals.
In light of the fact that we currently are burdened with a Congress so entrenched in party politics that it was almost willing to do nothing when the debt ceiling crisis arose last year, it may be a good time to examine another area of the law in which reliance upon statutes, or a simple ignorance of the law, has seemingly dominated the manner in which many attorneys practice: the generation-skipping transfer tax (GSTT).
This problem stems in large part from provisions implemented as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and could come back to bite many a practitioner during the next few years.
The GSTT has the reputation of being somewhat complicated and esoteric and many attorneys I have encountered don’t truly understand its nuances.
In its most basic terms, the GSTT is a complementary tax to the federal estate and gift taxes. It is imposed upon transfers to individuals who are more than one generation below the transferor (“skip person”) and are also subject to the estate or gift tax. As with the estate and gift tax, each individual is allowed to make transfers free from the GSTT up to an exemption amount that is currently equal to the federal unified credit equivalent of $5 million. In a similar, but not identical, fashion to the gift tax, an individual is allowed to make certain transfers free of the GSTT up to an annual exclusion amount that is currently $13,000.
Transfers that may trigger the GSTT come in two broad categories: direct skips and indirect skips. A direct skip is exactly what the name implies, a transfer made directly to a person who is more than one generation below the transferor. An indirect skip is generally a transfer made to a trust in which both skip persons and nonskip persons are beneficiaries. The GSTT is assessed against indirect skips at the time that there are only skip persons remaining as beneficiaries of a trust or a distribution is made to a skip person.
The majority of the problems that may arise involve allocation of a transferor’s GSTT exemption to a trust and the subsequent tax implications. The GSTT imposed upon an indirect skip is somewhat unique in that only a portion of the assets distributed to skip persons is taxed based on the trust’s “inclusion ratio.” The inclusion ratio is one less the fraction determined by dividing the exemption allocated to the trust over the value of the assets transferred. By way of example, if I transfer $100 to a trust and allocate only $50 worth of exemption, the GSTT will be imposed upon half of all of the distributions to skip persons from that trust. As one can see, a failure to properly allocate the GSTT exemption coupled with a significant appreciation in asset value could lead to significant tax implications.
At this point, the reader is no doubt wondering how Congress, a reliance on statutes and the EGTRRA will lead to issues involving the GSTT. The answer is simple. Prior to the EGTRRA, the GSTT exemption was automatically allocated to direct skips and upon an individual’s death. In all other instances, an allocation needed to be made affirmatively on a tax return. The EGTRRA changed this by providing that the GSTT exemption would also be automatically allocated to lifetime transfers into trust that may result in potential indirect skips. It is this automatic allocation that has caused many practitioners to pay little attention to the allocation of the GSTT exemption and simply rely upon the statute for the last decade. The combination of a Congress reluctant to take action and the fact that the EGTRRA sunsets on December 31 means that practitioners should become more aware of what’s potentially in store for them in 2013 and beyond.
Probably the biggest change that many attorneys will need to make will be to begin filing Form 709 for all gifts made to trusts that may eventually make distributions to skip persons. While this is a good practice for attorneys when making any sort of gift that may be subject to the gift tax, many attorneys have grown sloppy and do not take this step. For the past 10 years, attorneys have been able to avoid problems because of the automatic allocation to trusts. Practitioners failing to file the return are asking for trouble. One prime example of the above is the use of “Crummey powers” to fund an irrevocable life insurance trust. Crummey powers take advantage of the annual gift tax exclusion, so no gift tax is due; however, the GSTT annual exclusion does not apply to a trust with more than one beneficiary. This results in the need to allocate the GSTT exemption despite the fact that there is no taxable gift. The EGTRRA forgave this ignorance by automatically allocating the GSTT exemption to the transfers. Once the automatic allocation is gone, if Form 709 is not filed to make the allocation, all distributions to a skip person are potentially 100 percent subject to the GSTT.
Another area of concern created by the EGTRRA is the ability to sever a trust into two separate trusts. Prior to this provision, once an allocation was made, the trust’s inclusion ratio was set. The ability to sever is a useful tool in the event that the GSTT exemption is allocated to a trust in an amount that does not zero out the inclusion ratio. The EGTRRA granted the trustee the power to split the trust into two identical trusts, one that was 100 percent exempt from the GSTT and another that was completely subject to it.
This allowed the trustee to strategically manage the two trusts to minimize the amount of distributions subject to the GSTT. Many attorneys seemingly relied upon this as an escape hatch that could be used if the allocation of the GSTT exemption was not made correctly. Because this won’t be available, in the future, even greater care should be taken to make appropriate allocations of the GSTT exemption, or consider splitting trusts before allocating the exemption.
The EGTRRA’s sunset will remove several of the statutory provisions upon which practitioners rely. However, there is one provision mentioned earlier that could still be relied upon and may lead to undesirable results: the automatic allocation of the exemption at the individual’s death. Under this provision, any portion of an individual’s GSTT exemption that is not allocated during lifetime or by his or her personal representative is automatically allocated first to his or her direct skips and then to any trusts that may give rise to the GSTT. At first, the reader may think that this is a solution to the problems set forth above. However, there are a number of drawbacks to letting the statute make your allocations.
First, when these allocations are made to an inter vivos trust, the allocation is for the present value of the trust, not the value on the date of funding. This means that an individual would be throwing away the GSTT exemption if the trust’s assets have appreciated.
Second, the automatic allocation first allocates exemption to all direct skips and then to any trusts. If there is not enough exemption left, it is allocated on a pro rata basis to all of the trusts. This is a problem because there are definitely situations in which it would be better to pay some GSTT at present on a direct skip as well as times when an allocation should be made to one trust over another so that it is 100 percent exempt, e.g., a trust where the assets are likely to be used up by a nonskip person beneficiary shouldn’t receive allocation. By relying on the statutory allocation, a practitioner is running the risk that his or her clients may be unnecessarily paying GSTT.
Moving forward, practitioners should, at the very least, be more mindful of the GSTT, consistently file Form 709 for all transfers that may be subject to gift tax, make sure that trust documents allow for a split of a trust so that trusts with a zero inclusion can be created, and set forth allocation directives in wills and testamentary trusts to ensure that the automatic allocation rules don’t cause issues with an otherwise sound estate plan. This minimal amount of effort will create the potential for enormous savings for future generations.
Peter J. Bietz is an associate with High Swartz in Norristown, where he focuses his practice on estate planning, business transactions and tax-related matters. He is a graduate of Boston University School of Law and earned an LL.M. in taxation from Villanova University School of Law in 2009. He can be reached at firstname.lastname@example.org.