The wide-ranging changes to U.S. tax law contained in the Tax Cuts and Jobs Act of 2017 (P.L. 115-97, the act) have created opportunities for clients whose net worth is expected to remain below the federal estate and gift tax exemption amounts. In particular, practitioners may wish to analyze the federal generation-skipping transfer tax (GST) treatment of existing irrevocable trusts in order to confirm each trust’s inclusion ratio and, if appropriate, take affirmative steps to allocate GST exemption to partially exempt trusts.
The act as signed into law on Dec. 22, 2017, significantly increased the federal gift tax lifetime exemption and federal generation-skipping transfer tax exemption amounts from $5.49 million in 2017 to approximately $11.2 million in 2018, although the precise amount is still not finalized. These amounts are indexed for inflation and absent legislative action, will sunset on Dec. 31, 2025, and revert back to pre-act levels (indexed for inflation in 2026). The federal gift tax exemption is currently unified with the federal estate tax exemption. With the advent of portability, a married couple in 2018 can effectively give away, during life or at death, amounts exceeding approximately $22 million before incurring federal estate or gift tax. Because no similar portability election is available for unused GST exemption, many practitioners are taking a “use it or lose it” approach to this newfound, increased GST exemption.
One important first step is to determine the amount of GST exemption that a client has already used, either by affirmative or automatic allocation. The rules governing automatic allocation of GST exemption to trusts are complex. I.R.C. Section 2632(c) provides that GST exemption will be automatically allocated to transfers made after Dec. 31, 2000, to a “GST trust” without the need for any affirmative action by the taxpayer. A “GST trust” is broadly defined as any trust that could have a generation-skipping transfer unless one of the exceptions contained in I.R.C. Section 2632(c)(3)(B) applies at the time of the transfer. This appears to include one common iteration of the irrevocable life insurance trust (ILIT), where Spouse 1 creates an irrevocable inter vivos trust for the benefit of Spouse 2, and after Spouse 2’s death the property is held in further trust for children and for a child’s own children in the event that a child dies before the termination of child’s trust. I.R.C. Section 2632(c) was originally enacted to aid taxpayers who transferred property to irrevocable trusts that were intended to be generation-skipping but, for one reason or another, inadvertently did not allocate the needed GST exemption to the transfer. However, in practice this wide-sweeping definition of what constitutes a “GST trust,” and therefore a trust to which GST exemption will be automatically allocated, has ensnared many trusts that were not intended to be GST exempt. As a result, unless one of the exceptions applied to each transfer made to the trust, some amount of GST exemption was automatically (albeit inadvertently and in some situations, unknowingly) allocated to the trust.
The exceptions are nuanced and focus upon several factors including the ages of the trust’s beneficiaries at the time of the transfer, the trust’s total value in a given year, and the value of accumulated hanging Crummey withdrawal powers possessed by beneficiaries. Thus, the required analysis is highly fact-intensive, so the determination of whether one of the exceptions applies to a transfer (and therefore, whether GST exemption was automatically allocated) may, and often does, change from year to year.
One exception in particular can be troublesome for trusts in which beneficiaries possess hanging Crummey powers. A trust will not be considered to be a GST Trust, and therefore GST exemption will not be automatically allocated, if any portion of the trust property would be included in a non-skip person’s gross estate (other than the transferor) if the nonskip person (other than the transferor) were to die immediately after the transfer. This would seem to include any trust that provides children (nonskip persons) with Crummey withdrawal powers over property contributed to a trust created by a parent, and the Crummey powers are designed to not lapse fully (i.e., will “hang”) at the end of each year. If a Crummey power holder dies before her withdrawal right fully lapses, the value of her withdrawal right is includible in her gross estate for federal estate tax purposes. Realizing that the death of any Crummey power holder could potentially prevent the allocation of GST exemption with unintended results, the Internal Revenue Code limits the application of this exception to situations where the total value of property subject to a Crummey power (hanging and current) exceeds the federal gift tax annual exclusion amount for that particular year. Unfortunately, many ILITs with hanging Crummey powers will still run afoul of this exception, although not necessarily in every year, resulting in a trust that is not fully exempt or nonexempt for GST purposes.
For example, presume that grantor creates an irrevocable trust for the benefit of spouse and child, and the trust agreement provides that upon any contribution made to the trust, child has the right to withdraw an amount equal to the lesser of the amount of the contribution or the federal gift tax annual exclusion amount available for child, and on Dec. 31, of that year child’s withdrawal power will lapse up to an amount equal to the greater of $5,000 or 5 percent of the trust’s value. In 2016 (the year the trust was created), grantor contributed $14,000 to the trust and did not file a gift tax return reporting the transfer or electing GST allocation treatment. The child’s withdrawal right was $14,000, and on Dec. 31, 2016, the child’s withdrawal right lapsed by $5,000, so that $9,000 of the withdrawal right hangs. This particular exception would not be triggered because the child’s total withdrawal right did not exceed the federal gift tax annual exclusion amount ($14,000 in 2016), the trust would be a GST trust and GST exemption would be automatically allocated to the transfer. Assume that in 2017, the grantor contributed another $14,000 to the trust. The child’s total withdrawal right as of the date of transfer was $23,000 ($9,000 hanging withdrawal right plus $14,000 current withdrawal right). Because the value of the child’s total withdrawal right exceeded the federal gift tax annual exclusion ($14,000 in 2017), the exception was triggered and the trust will not be considered to be a GST trust at the time of the 2017 transfer; therefore, GST exemption would not be automatically allocated to the transfer.
Many similar trusts that hold life insurance policies with moderate premiums that build cash value may experience a bell curve of GST exemption allocation if the grantor contributes cash to the trust annually to pay premiums. The beneficiaries’ hanging Crummey powers can accumulate slowly for the first several years after the trust’s creation (resulting in the automatic allocation of GST exemption), until the aggregate value of the hanging powers hits a tipping point that exceeds the federal gift tax annual exclusion amount (stopping the automatic allocation of GST exemption). Then, the hanging Crummey amounts eventually lapse as the insurance policy’s cash value grows in value to the point that 5 percent of the trust’s value is greater than $5,000 (resulting again in the automatic allocation of GST exemption to future transfers).
Of course, one way to avoid the need for this complex analysis is to timely file a federal gift tax return for the year in which a contribution is first made to the trust and make an affirmative election to opt-in or opt-out of the GST exemption automatic allocation rules for that trust. Other options must be explored for already existing trusts.
The act creates a potential “spring cleaning” opportunity for clients who have created irrevocable trusts. Such clients may wish to file a 2018 federal gift tax return with two goals. First, a return can be filed to stop any inadvertent hemorrhaging of GST exemption by making an election to opt-out of the I.R.C. Section 2632(c) automatic allocation rules. Second, it may be appropriate for some clients to use a portion of their newly doubled GST exemption to make a late allocation to any trusts that were intended to be fully exempt from GST tax but are suspected to be only partially exempt. With careful navigation of the automatic allocation rules and proactive (albeit late) allocation of GST exemption, many trusts can soon look sparkling new.
Melissa L. Dougherty is a director in the Pittsburgh office of Cohen & Grigsby and focuses her practice in estate and trust planning for high net worth individuals. She can be contacted at (412) 297-4686 or firstname.lastname@example.org.