GST, Easy as 1-2-3: Generation Skipping Transfer Tax

Author: Jeffrey D. Scibetta

Originally published in October 2021

Copyright © 2021 Knox McLaughlin Gornall & Sennett, P.C.

Background

Purposes of the GST

• To limit multi-generational tax planning
• To collect estate tax at every generational level

Examples of How Estate Tax could be avoided if there were no GST Tax

• Direct skip transfers
• Example #1 – GP makes gift to GC
• Example #2 –GP makes a gift to a trust solely for one or more GC

Gifts to a Trust for the benefit of Child and Grandchild

• Example #3 – Distribution from the Trust to GC
• Example #4 – Death of Child (leaving only GC to receive distributions)

Application GST Tax

• To combat avoidance of the Estate Tax, GST Tax is imposed on various types of transfers made to “skip persons”
• What are “Skip Persons”?
• Definition #1 – Persons who are 2 or more generations below the transferor;
• Definition #2 – Persons who are 37-1/2 years younger than the transferor

Significance of the GST

• The GST Tax is imposed at the highest federal estate tax rate, so it is a tax you typically want to avoid whenever possible.
• It is therefore important to know how to avoid it or minimize its impact

Recognizing Generation Skipping Transfers

• Who is the “Transferor?”
• Who is the “Transferee?”
• Is the Transferee a “Skip Person?”
• If so, then does an Exclusion or Exception apply?
• How to Allocate GST Exemption?

Definitions

“Transferor”

In General – The “transferor” is typically the individual to/for whom the transferred property was most recently subject to federal estate or gift tax.

• Example #1 –Gift of Property – In the case of a gift, the transferor is the donor
• Example #2 – Testamentary Transfer – In the case of a testamentary transfer, the transferor is usually the decedent

Exceptions (Where Transferor Changes)

• Exception #1 – Holder of a (General) Power of Appointment
• Exception #2 – QTIP Trust (Surviving Spouse)

“Skip Persons”

In General – There are two (2) different types of “skip persons”

• “Skip Persons” Based on Family Relation
• “Skip Persons” Based on Age

“Non-Skip” Persons – Any person who is not a “skip person” is a “non-skip person”.

“Skip Person” Rule – for Lineal Descendants

• Any natural person who is at least 2 or more generations below the generation of the transferor is a “skip person”
• Example #1: Gift from Grandparent to Grandchild
• Example #2: Gift from Uncle to Grand Nephew/Niece

“Skip Person” Rule – Based on Age

• Persons born within 12-1/2 years of the transferor are assigned to the same generation as the transferor
• Persons who are born between 12-1/2 years and 37-1/2 years of the transferor are assigned to the first generation after the transferor
• Then there is another generation for every additional 25 years
• So all persons who are 37-1/2 years or more younger than the transferor are 2 or more generations younger than the transferor and are therefore considered “skip persons”

Special Rules for Spouses & Others

• Spouses are always considered of the same generation as the transferor.
• Spouses of lineal descendants are always assigned to the same generation as the descendant to whom they’re married.
• Siblings are always considered of the same generation as one another, regardless of age or the basis for the relationship (biological, half blood or adopted)
• People who are adopted or related by half-blood are treated the same as full blood relations

Trusts treated as “Skip Persons”

• A trust can be a “skip person,” and in such an instance, the GST tax may be imposed on transfers to trusts.
• A trust is treated as a skip person if all of the interests in the trust are held by persons who are skip persons.
• Example: Grandparent gives property to a trust that benefits only grandchildren (or more remote descendants)
• A trust is not treated as a skip person if there are any persons holding an interest in the trust who is not a skip person
• Example: Grandparent gives money to a trust that benefits both children and grandchildren

Predeceased Parent Exception

• If at the time of the transfer, the transferor’s child is deceased, and a transfer is then made to a grandchild, then the grandchild gets to “step up” and be treated as if the grandchild is really a child. Under these circumstances, the GST tax would not apply.
• In order for the exception to apply, the parent must have already been deceased on or before the time of transfer.
• So the predeceased parent exception would not apply to a transfer into a trust to benefit a child and then a grandchild if the child dies after the transfer is made to the trust.
• The predeceased parent exception can under certain circumstances apply to nieces or nephews.
• If a transferor has no children or grandchildren of his or her own, then the predeceased parent exception can apply to a grandniece or grandnephew. The grandniece or grandnephew would be treated the same as a niece or nephew if the grandniece’s or grandnephew’s parents are already deceased when the transfer is made to them. Under these circumstances, the GST tax will not apply.

“GST Trust”

In general, a “GST Trust” is any trust that could give rise to a generation skipping transfer with respect to the Transferor.

Although there are certain exceptions listed in the Internal Revenue Code, generally a GST Trust is any trust that could have a taxable termination or taxable distribution (both defined below).

Technically, a GST Trust is any trust that could have a taxable termination or taxable distribution and does not fall within any of the enumerated exceptions (discussed later in this outline).

Types of Generation Skipping Transfers

Types of Transfers Subject to GST Tax

• Direct Skips (IRC §2612(c))
• Taxable Terminations (IRC §2612(a))
• Taxable Distributions (IRC §2612(b))

Direct Skips

Technically, a “direct skip” is defined as any transfer to a skip person in which the transfer is subject to federal estate tax or federal gift tax.

From a practical standpoint, a “direct skip” is a direct transfer to a skip person, so long as that the transfer is otherwise taxable for estate or gift tax purposes.

• Example #1 – Direct Skip: Grandparent (GP) makes a direct gift of $100,000 during lifetime to his grandchild (GC).
• Example #2 – Direct Skip: Grandparent (GP) dies and makes a bequest in his Will of $100,000 to his grandchild (GC).

A transfer to a trust is a “direct skip” if all of the beneficiaries of the trust are skip persons.

• Example #1 – Direct Skip to a Trust: Grandparent (GP) gives $1 Million to a trust and the only beneficiaries of the trust are his 3 grandchildren, GC1, GC2 and GC3.
• Example #2 – Direct Skip to a Trust: Grandparent (GP) gives $1 Million to a trust. GP’s grandson (GS) is the lifetime beneficiary of the trust and at his death, the principal passes to GS’s 3 children (GGC1, GG2 & GGC3).
• Example #3 – Direct Skip to a Trust: Grandparent (GP) gives $1 Million to a trust. The beneficiaries of the trust are all more than 40 years younger than GP.

Taxable Terminations

A “taxable termination” is any termination of an interest in a trust unless one of the following three (3) exceptions applies.

• Exception #1 – The transfer is subject to federal estate tax or gift tax at the time of the transfer; OR
• Exception #2 –There is still a “non-skip person” (i.e., someone of the same generation or within 1 generation of the transferor) who still has an interest in the trust following the termination; OR
• Exception #3 – After the transfer, it is not possible for there to be a transfer from the trust to a skip person.

A “termination” of an interest in a trust can occur as a result of death, passage of time, release of a power, or otherwise.

Examples of Taxable Terminations

• Example #1: Grandparent (GP) gives $1 Million to a trust. Under the terms of the trust, the trust will benefit GP’s son (S) during his lifetime, and at S’s death, the remaining funds will continue in trust beneficiaries for the benefit of GP’s three (3) grandchildren, GC1, GC2 & GC3. At S’s death, there is a taxable termination, because the only remaining trust beneficiaries are all skip persons.
• Example #2: Grandparent (GP) gives $1 Million to a trust. The trust is a “sprinkle trust,” meaning that it authorizes the trustee to exercise his or her discretion to distribute income or principal among any of GP’s son (S) or his grandchildren. GP’s son (S) effectively disclaims any and all interest in the trust shortly after it’s created, leaving only the grandchildren as beneficiaries. S’s disclaimer triggers a taxable termination because following the disclaimer, all of the trust beneficiaries are skip persons.

Examples of the “Exceptions” (“Non-Taxable” Termination)

• Exception #1 (Example) – Grandparent (GP) transfers $1 Million to a trust. The beneficiaries of the trust are GP’s son (S) and each of GP’s grandchildren (GC1, GC2 & GC3). GP’s son (S) is trustee and he holds a testamentary general power of appointment over the trust assets. S then dies. S’s general power of appointment over the trust assets causes the trust assets to be subject to estate tax at S’s death. Therefore the termination of S’s interest in the trust is not a taxable termination, even though all of the remaining beneficiaries are skip persons.
• Exception #2 (Example) – Grandparent (GP) transfers $1 Million to a trust. The beneficiaries of the trust include GP’s son (S) and daughter (D) and GP’s 3 grandchildren (GC1, GC2 & GC3). S dies. S’s death does not cause a taxable termination, because there is a non-skip person (D) who still holds an interest in the trust following the termination of S’s interest in the trust,
• Exception #3 (Example) – Grandparent (GP) transfers $1 Million to a trust. The beneficiaries of the trust include GP’s son (S) and 3 charitable organizations. S is the lifetime beneficiary of the trust. The charities are the remainder beneficiaries. S dies. S’s death does not cause a taxable termination, because following the termination of S’s interest in the trust, it is not possible for there to be a transfer to a skip person from the trust.

Taxable Distributions

A taxable distribution includes any distribution from a trust (of income or principal) to a skip person (except for a direct skip or taxable termination).

Examples of Taxable Distributions

• Example #1: Grandparent (GP) transfers $1 Million to a trust during lifetime. The trust is a “spray” trust that authorizes the Trustee to distribute income and/or principal to GP’s daughter (D) or to any of his grandchildren (GC1 or GC2). The Trustee makes a distribution to one of the grandchildren. The distribution to the grandchild is a taxable distribution to a skip person.
• Example #2: Grandparent (GP) dies and his Will creates a testamentary trust for the benefit of his daughter (D) and her children (GP’s grandchildren) (GC1 and GC2). The Trustee is authorized to distribute income and/or principal to GP’s daughter (D) or to any of his grandchildren (GC1 or GC2). The Trustee makes a distribution to one of the grandchildren. The distribution to the grandchild is a taxable distribution to a skip person.

Other Types of Transfers

Indirect Skips

An indirect skip is a transfer to a trust that benefits a mix of beneficiaries – i.e., some of the beneficiaries are skip persons (such as grandchildren or more remote descendants) and some are non-skip persons (such as a spouse and/or children).

An indirect skip is not a GST transfer.

An indirect skip is defined as any transfer of property (other than a direct skip) subject to gift tax that is made to a “GST Trust.”

A “GST Trust” is any trust that could have a taxable termination or a taxable distribution.

So another way of thinking of an indirect skip is that it is a transfer to a trust that is not a direct skip but which gives rise to the possibility of a taxable distribution or a taxable termination.

Example: Grandparent (GP) transfers $1 Million to a trust that benefits GP’s son (S) and S’s 3 children, GC1, GC2 & GC3.

The transfer to the trust is not a direct skip because one of the beneficiaries (S) is within one generation of the transferor (GP).

However, a distribution by the Trustee to any of the grandchildren (GC1, GC2 or GC3) would be a taxable distribution.

Also, if S’s interest in the trust were to terminate (e.g., due to death, disclaimer, etc.), then the termination of S’s interest would be a taxable termination, because following S’s death, the only beneficiaries would be grandchildren (GC1, GC2 & GC3).

So GP’s transfer of the $1 Million to the trust is an “indirect skip”.

So basically, an indirect skip is a type of transfer to a trust that necessitates the allocation of GST Exemption to the trust in order to minimize or eliminate the impact of a taxable termination or a taxable distribution from the trust.

Non-Taxable (Gift) Transfers

“Non-Taxable Gifts” are transfers that are deemed to have an “inclusion ratio” of zero. In other words, they are not subject to the GST tax.

Types of Non-Taxable Transfers

• Directs Skip Transfers to an individual that qualify for exclusion from gift tax under IRC §2503(b) (“Annual Exclusion Gifts”) – currently $15,000 per donee per year (IRC §2642(c)(1) & (3))
• Direct Payments of Medical or Education Expenses that would qualify for exclusion from gift tax under IRC §2503(e) (IRC §2642(c)(1) & (3))
• Direct Skip Transfers to a trust that qualify for the annual exclusion from gift tax – but only if the following requirements are met: (1) Only one individual is a beneficiary of the trust during that individual’s lifetime; and (2) If the trust beneficiary dies before the trust ends, then the trust assets must be includable in the beneficiary’s gross estate for federal estate tax purposes (IRC §2642(c)(1) & (2))

Examples of Non-Taxable Transfers

• Example #1 – Direct Skip to an Individual. Grandparent (GP) gives $15,000 apiece to each of his/her 3 grandchildren. The direct skips to each of the 3 individuals is for less than the annual exclusion amount (currently $15,000 per year) under IRC §2503(b). Accordingly, the transfers to each of them are therefore “non-taxable” for GST tax purposes (IRC §2642(c)(1) &(3))
• Example #2 – Direct Payment of Medical or Educational Expenses. Grandparent (GP) pays $50,000 of college education expenses for one of his grandchildren by making payment directly to the college that the grandchild is attending. Because the payment for educational expenses was made directly to the college, it would qualify for exclusion from gift tax pursuant to IRC §2503(e). The payment is therefore “non-taxable” for GST tax purposes (IRC §2642(c)(1) & (3))
• Example #3a – Direct Skip to a (Qualifying) Trust. Grandparent (GP) transfers $15,000 to a trust. The only beneficiary of that trust is GP’s grandchild (GC1) during her lifetime. She is entitled to all of the trust income and principal while she is alive. Furthermore, under the terms of the trust agreement, if GC1 dies before the trust is terminated, then any amount of money remaining in the trust is payable to her estate. The transfer to the trust is therefore “non-taxable” for GST tax purposes (IRC §2642(c)(1) &(2))
• Example #3b – Direct Skip to a (Non-Qualifying) Trust. Grandparent (GP) transfers $15,000 to a trust that benefits three (3) of his grandchildren (GC1, GC2 & GC3). Under the terms of the trust, the trustee can “sprinkle” income and/or principal among any of the three grandchildren during their lifetime. The trust does not meet the requirements for the exception. The transfer to the trust is therefore “taxable” for GST tax purposes, and as such will necessitate allocation of GST Exemption to avoid imposition of GST Tax (IRC §2642(c)(1) &(2))

“Excluded” Transfers

Certain types of transfers are excluded from the definition of a “generations skipping transfer” and are therefore not subject to GST tax.

Types of Excluded Transfers

• Transfers which, if made during lifetime by an individual, would not be treated as a taxable gift by reason of IRC §2503(e) (i.e., payments made directly to a medical or educational institution to pay for another person’s educational or medical expenses) (IRC §2611(b)(1))
• “Previously Taxed Transfers” – Transfers that meet each of the following requirements: (1) The transferred property was already subjected to GST tax; (2) The transferee in the prior transfer (that was subjected to GST tax) was of the same generation as (or a lower generation than) the transferee in the current transfer; and (3) The transfers do not have the effect of avoiding GST tax with respect to any transfer (IRC §2611(b)(2))

Examples of Excluded Transfers

• Example #1 – Direct Payment of Medical of Educational Expenses from a Trust. Grandparent (GP) creates a trust to help pay for any health care or educational expenses incurred by any of his children or grandchildren. Under the terms of the trust, the trustee is allowed to make direct payment to a health care provider or educational institution in order to benefit any of his children or grandchildren. The trustee then makes a payment of $50,000 from the trust directly to the college that one of the grandchildren is attending in order to pay for that grandchild’s college expenses. The payment to the college is an excluded transfer (IRC §2611(b)(1))
• Example #2 – “Previously Taxed Transfers.” Grandparent (GP) creates a trust to benefit his son (S) and his grandchildren (GC1, GC2 & GC3). Under the terms of the trust agreement, the trustee has discretion to distribute income and principal to S during S’s lifetime. At S’s death, the trust will be administered for the benefit of the grandchildren (GC1, GC2 & GC3). When S dies, all of the remaining beneficiaries (GC1, GC2 & GC3 are “skip persons” and so S’s death results in a taxable termination. The taxable termination causes the remaining trust balance to be subject to GST tax. If the trustee thereafter distributes trust assets to one of the grandchildren (GC1), the transfer to that grandchild (GC1) is not subject to GST tax (IRC §2611(b)(2))

The GST Exemption

What is the GST Exemption?

As the name implies, the GST exemption provides relief from the GST tax. If the GST exemption is allocated to a generation skipping transfer, it will reduce or possibly even avoid altogether imposition of GST tax. From a purely mechanical standpoint, it operates to reduce the tax rate that would otherwise apply to a generation skipping transfer.

Why is there a GST Exemption?

The purpose of the GST tax is to combat perceived abuses of the estate and gift tax system through transfers that skip generations. However, from a practical standpoint, families need to have a certain amount of wealth before they can afford to make transfers that skip generations for the purpose of avoiding tax. The purpose of the GST tax is not to tax small transfers by grandparents to a grandchild. It is instead intended to target dynastic accumulations of wealth through the use of trusts and other generation skipping techniques.

So Congress provided a dollar amount that is not subject to the GST tax. However, that dollar amount (of the GST exemption) has changed over the years.

Amount of GST Exemption

The GST Exemption is currently equal to the amount of the “Applicable Exclusion” (or exemption) from Federal Estate and Gift Tax. For the year 2021, the amount that is exempt from Federal Estate and Gift Tax (and therefore from GST Tax) is currently $11.7 Million.

The GST Exemption is also indexed for inflation and therefore it generally increases over time. However, the current exemption amount is historically quite high. So it is entirely possible (perhaps even likely) that the amount that is exempt from both Federal Estate & Gift Tax and from GST Tax will be decreased in the future.

Significance of GST Exemption

• How GST Exemption affects GST Tax. The GST Exemption is significant because it reduces the amount of GST tax that will be imposed on a transfer that would otherwise be subject to GST Tax.
• If NO GST Exemption is allocated. If property is transferred (directly or indirectly) to a skip person, then the transfer will be subject to GST tax unless GST Exemption is allocated to the transfer.
• If GST Exemption equals the amount transferred. If GST Exemption is allocated to a transfer, then the transfer will not be subject to GST Tax if the amount of the GST Exemption allocated to the transfer equals the value that was transferred to the skip person. (That is true for any type of GST transfer – direct skip, taxable termination or taxable distribution).

Examples – Allocated GST Exemption

• Example #1 – Direct Skip to a Person. Grandparent (GP) gives $500,000 to a grandchild (GC). GP allocates $500,000 of GST Exemption to the transfer. The transfer is NOT subject to GST Tax.
• Example #2 – Direct Skip to a Trust. Grandparent (GP) gives $500,000 to a trust that benefits two grandchildren (GC1 & GC2). GP allocates $500,000 to the trust. The transfer to a trust that benefits only “skip persons” (grandchildren) would ordinarily be subject to GST tax. However, because GP allocated GST Exemption equal to the amount transferred to the trust, the transfer to the trust is NOT subject to GST Tax.
• Example #3 – Taxable Distribution. Grandparent (GP) gives $500,000 to a trust that benefits one child (C1) and one grandchild (GC1). GP allocates $500,000 of GST Exemption to the trust. The trust then distributes $200,000 to the grandchild (GC1). The distribution to the grandchild would otherwise be a taxable distribution subject to GST Tax. However, because the amount of GST Exemption allocated to the trust ($500,000) equals the amount transferred to the trust ($500,000), the distribution from the trust to GC1 is entirely sheltered from GST Tax. There is therefore NO GST Tax on the distribution to GC1.
• Example #4 – Taxable Termination. Grandparent (GP) gives $500,000 to a trust that benefits his son (S) and two grandchildren (GC1 & GC2). GP allocates $500,000 to the trust. S then dies. S’s death would otherwise trigger a taxable termination subject to GST Tax. However, because GP allocated GST Exemption equal to the amount transferred to the trust, the termination of S’s interest in the trust (as a result of S’s death) does NOT trigger GST Tax.

Impact of Allocated GST Exemption upon Appreciated Trust Assets

• Application to Future Appreciation. If GST Exemption is allocated to a transfer to a trust, then the allocated GST Exemption applies not only to the value transferred but also to any future appreciation in value (or earnings) from the trust assets.
• Leveraging Potential. Consequently, the GST Exemption can be extremely valuable because of the way in which it can be “leveraged” to also shelter future growth or earnings from entrusted assets.

Examples – Application of GST Exemption to Appreciated Trust Assets

• Example #1 – Appreciated Trust Assets. Grandparent (GP) transfers $3 Million to a trust that benefits his daughter (D) and his three grandchildren (GC1, GC2 & GC3). GP allocates $3 Million of GST Exemption to the transfer. The trust then grows dramatically in value to $15 Million. Daughter (D) then dies, so that the only remaining trust beneficiaries are the grandchildren (GC1, GC2 & GC3). D’s death would otherwise trigger a taxable termination. However, because GP allocated GST Exemption ($3 Million) equal to the amount transferred ($3 Million) to the Trust, no GST Tax is imposed on the termination of D’s interest in the trust.
• NOTE: Even though GP only allocated $3 Million of GST Exemption to the trust, GST Exemption covered the entire amount in the trust. So it effectively sheltered a far greater amount ($15 Million) than the amount transferred to the trust.
• Example #2 – Appreciated Trust Assets. Grandparent (GP) transfers $3 Million to a trust that benefits his daughter (D) and his three grandchildren (GC1, GC2 & GC3). GP allocates $3 Million of GST Exemption to the transfer. The trust then grows dramatically in value to $30 Million. The Trustee then distributes $5 Million to each of the grandchildren. If no GST Exemption had been allocated to the trust, then the distributions to each of the grandchildren would have been taxable distributions subject to GST Tax. However, because GP allocated GST Exemption ($5 Million) equal to the amount transferred ($5 Million) to the trust, no GST tax is imposed on the distributions from the trust.
• NOTE: Even though GP only allocated $3 Million of GST Exemption to the trust, GST Exemption covered the entire amount in the trust. So it effectively sheltered a far greater amount ($15 Million) than the amount transferred to the trust.

Who Can Allocate GST Exemption

The only person who can allocate GST Exemption to a transfer is the transferor (in the case of a gift) or the transferor’s executor (in the case of an estate).

The identity of the transferor is therefore critical.

It is also important to understand that who the transferor is can change.

A change in identity of the transferor with respect to a trust changes who can who can allocate GST exemption and it also changes whose allocated GST exemption can continue to protect the trust from GST Tax.

Once a new transferor is determined with respect to any property, any previous allocation of GST exemption is lost and only the new transferor can allocate GST exemption to the property.

• Example – Change in Transferor. Transferor (T) creates a trust for the benefit of his wife (W) and his son (S). When W and S are both deceased, the trust balance passes to T’s grandchildren. W is given the power to withdraw the entire trust balance during her lifetime. T transfers $1,000,000 of GST Exemption to the trust. W’s withdrawal power is a general power of appointment and causes her (W) to be treated as the new transferor. T’s allocation of GST exemption to the trust is “wasted”.

Computation of Tax

Applicable Rate

The GST Tax Rate applied to a transfer is called the “applicable rate.” The applicable rate = the maximum federal estate tax rate multiplied by the “inclusion ratio.” The Maximum Federal Estate Tax Rate in 2021 is currently 45%.

Inclusion Ratio

If a transfer is subject to GST tax, then the amount of GST tax imposed will be determined by reference to a formula known as the “inclusion ratio.” The inclusion ratio is determined by how much of the Transferor’s GST Exemption is allocated to the transfer.

Inclusion Ratio Formula: The Inclusion Ratio = ONE minus the “Applicable Fraction”

Applicable Fraction. The Applicable Fraction = GST Exemption Allocated to the Transfer DIVIDED by the value of the transferred property

What does the Inclusion Ratio mean?

• An inclusion ratio of ZERO means that the transfer is effectively exempt from GST tax. NO GST tax will be imposed on the transfer.
• An inclusion ratio of ONE means that the transfer will be entirely subject to GST tax.
• An Inclusion Ratio of BETWEEN ZERO AND ONE means that the transfer is partially subject to GST tax.

Examples of How the Inclusion Ratio Works

• Example #1 – Inclusion Ratio of ZERO:

Grandparent (GP) gives $1 Million to her grandchild (GC).

GP allocates $1 Million to the transfer.

Inclusion Ratio = 1 – ($1 Million /$1 Million) = 1 – 1 = 0

Applicable Rate = Max Federal Estate Rate (45%) x Inclusion Ratio (ZERO) = 0% Tax.

• Example #2 – Inclusion Ratio of ONE:

Grandparent (GP) gives $1 Million to her grandchild (GC).

GP allocates NO GST Exemption at all to the transfer.

Inclusion Ratio = 1 – (Zero / $1 Million) = 1 – 0 = 1

Applicable Rate = Max Federal Estate Rate (45%) x Inclusion Ratio (ONE) = 45% Tax.

• Example #3 – Inclusion Ratio between Zero and One:

Grandparent (GP) gives $600,000 to her grandchild (GC).

GP allocates $200,000 of GST exemption to the transfer.

Inclusion Ratio = 1 – ($200,000 / $600,000) = 2/3

Applicable Rate = Max Federal Estate Rate (45%) x Inclusion Ratio (2/3) = 30% Tax.

Planning for Inclusion Ratios

The Goal: To the extent possible, the goal in GST planning is generally to allocate GST exemption such that all trusts have an inclusion ratio of either ZERO OR ONE.

Reason – Simplifies Planning: The reason that you want all trusts to have an inclusion ratio of either zero or one is that it simplifies GST planning for distributing money out of the trusts.

• Example – Planning for Inclusion Ratios (Zero or One):

Grandparent (GP) creates two (2) different trusts (Trust #1 and Trust #2) and transfers $1,000,000 to each Trust.

Both of the trusts (Trust #1 and Trust #2) benefit GP’s children and grandchildren.

However, GP has only $1,000,000 of GST Exemption.

GP allocates all $1,000,000 of GST Exemption to Trust #1.

Following the allocation of GST Exemption, Trust #1 has an inclusion ratio of ZERO and Trust #2 has an inclusion ration of ONE.

All distributions to GP’s grandchildren should be made from Trust #1 because it has a ZERO inclusion ratio and therefore distributions from that trust to a “skip person” (i.e., grandchild) will not

All distributions to GP’s children should be made from Trust #2. Even though Trust #2 has an inclusion ration of ONE, the children are not “skip persons” and therefore any transfers to the children will not trigger GST tax.

Allocating GST Exemption

When GST Exemption is allocated

• In General. GST Exemption can be allocated during the transferor’s lifetime (by the transferor) or following the transferor’s death (by the executor of the transferor’s estate). A transferor (or the transferor’s executor) may allocate GST exemption at any time, from the date of the transfer through the date for filing the individual’s federal estate tax return including extensions.
• Allocation during Lifetime. During the transferor’s lifetime, the transferor may “voluntarily” allocate GST exemption to a specific transfer that would (or might) otherwise be subject to GST tax. However, there are also a number of ways that the transferor’s GST exemption can be “automatically” allocated to transfers that might otherwise be subject to the GST tax. That is true both for gifts that are made outright and for gifts that are made in trust.
• Allocation at Death. Similarly, after a transferor has died, the executor of the transferor’s estate may “voluntarily” allocate GST exemption to a specific transfer that would (or might) otherwise be subject to GST tax. But the transferor’s GST exemption can also under certain circumstances be “automatically” allocated to transfers that might otherwise be subject to the GST tax.

Allocation of GST exemption during the Transferor’s Lifetime

Voluntary Allocations

How to Make the Allocation. The transferor may allocate GST exemption to property transferred during the transferor’s lifetime on a federal gift tax return (26 CFR § 26.2632-1(b)(2)(i)).

An allocation to a trust that is not a skip person is made on a Notice of Allocation form as an attachment to the gift tax return. (There is no place on the gift tax form itself to make an allocation to a transfer that is not a direct skip.) (Carol A. Harrington et al., Generation-Skipping Transfer Tax, 2nd Edition, at 4-35.)

When Allocation becomes Irrevocable. A voluntary allocation of GST exemption is irrevocable after the due date of the gift tax return, including extensions (if an extension is filed). However, until that date, an allocation of GST exemption to a lifetime transfer can be changed or revoked (26 CFR § 26.2632-1-(b)(2)(i)).

• Example #1 – Timely Revocation. Transferor (“T”) transfers $200,000 to a trust on July 1 of year 1. The due date for filing the gift tax return for that year is April 15 of year 2. On March 1 of year 2, T files a gift tax return that allocates $100,000 of GST exemption to the trust. Then on April 1 of year 2, T files an amended gift tax return that clearly indicates his intention to modify the earlier return and allocate $200,000 of GST exemption to the trust. The allocation of $200,000 of GST exemption to the trust is effective because it was made prior to the due date for filing the gift tax return.
• Example #2 – Untimely Revocation. Same facts as Example #1, except that T instead files the amended return on July 1 of year 2. The allocation of GST exemption on July 1 is not effective because it was made after the due date for filing the gift tax return.

Formula Allocation. It is possible to allocate a specific dollar amount of GST exemption but it is generally advisable to allocate by formula that makes clear the intent to allocate an amount necessary to produce an inclusion ratio of zero or as close to zero as possible (Harrington supra note 16.).

Allocation by formula is recommended because a formula allocation will automatically adjust if the IRS makes changes in value on audit or if mistakes are made, such as a failure to list all of the transfers to a trust on the gift tax return.

An example of a typical formula allocation is the following: “Donor allocates to [NAME OF TRUST] the smallest amount of GST exemption necessary to produce an inclusion ratio (as defined in IRC §2642(a)) equal to or as close as possible to zero.”

Timely Allocation of GST exemption. If GST exemption is allocated during the transferor’s lifetime on a timely filed federal gift tax return, then the property to which the exemption is allocated will be valued as of the date of the transfer.

• Example – Timely Allocation of GST exemption. Transferor (“T”) transfers $200,000 to a trust on December 1 of year 1. T thereafter allocates $200,000 of GST exemption to the trust on April 1 of year 2. Even though the trust may actually be worth $300,000 by April 1 of year 2, it is valued at only $200,000 for GST purposes. Therefore, T only needs to allocate $200,000 of GST exemption to the trust to obtain an inclusion ratio of zero.

Late Allocation of GST exemption. If GST exemption is not allocated on a timely filed gift tax return for the year of the transfer, then the allocation will be a “late allocation.” Accordingly, the property to which GST exemption is allocated will be valued on the date the allocation is made rather than on the date of the transfer.

• Example – Late Allocation of GST exemption. Same facts as the last example, except that T does not allocate GST exemption until July 1 of year 2, when the trust is worth $400,000. (Assume that the due date for filing the gift tax return was not extended.) The trust will be valued at $400,000 for GST tax purposes. Accordingly, T will need to allocate $400,000 of GST exemption to the trust to obtain an inclusion ratio of zero.

Retroactive Allocation of GST exemption

Explanation of the Concept. As noted above, a transferor is generally only allowed to allocate GST exemption to a generation skipping transfer based on the value of the property at the time of the transfer by reporting the transfer and allocating the GST exemption on a timely filed gift tax return (or by application of the automatic allocation rules). If the gift tax return filing deadline has already passed, then the general rule is that an allocation of GST exemption is at that point a “late allocation” and is effective only from the date of the late allocation. Therefore, the inclusion ratio for the transfer is determined by reference to the value of the transferred property at the time the late allocation is made. If the transferred property has increased in value between the time of the transfer and the late allocation, the result is that the transferor will need to allocate more GST exemption to the transfer to avoid or minimize GST tax. However, there is a statutory provision in the Internal Revenue Code that grants an exception to the general rule and allows a “retroactive” allocation of the transferor’s GST exemption if certain “non-skip” persons predecease the transferor (IRC §2632(d)).

Rationale. The rationale for the exception is that the transferor presumably did not expect his child (or other non-skip person) to predecease him or her (i.e., the transferor) and that the transferor might not have allocated GST exemption to the transferor for that reason. The exception can therefore be used to avoid or minimize an unanticipated imposition of GST tax (Harrington supra note 16 at 4-37).

Retroactive Allocation Rule. The rule applies with respect to non-skip persons dying after December 31, 2000. If the non-skip person at issue died after that date, then the transferor is allowed to make a “retroactive” allocation of GST exemption to a previously made transfer to a trust if:

• A current or future beneficiary of the trust is a non-skip person;
• The current or future beneficiary of the trust is a lineal descendant of the transferor’s grandparent (or the grandparent of the transferor’s spouse);
• The current or future beneficiary of the trust is assigned to a generation below the generation of the transferor; and
• The current or future beneficiary of the trust predeceases the transferor (IRC §2632(d); see also Harrington supra note 16 at 4-38).

If the above requirements are met and if the transferor retroactively allocates GST exemption on a timely filed gift tax return for the year of the non-skip person’s death, then the allocation will be treated as having been effectively made in the year the property was transferred (before the death of the non-skip person). Consequently, the original gift tax value of the transfer will be used to determine the inclusion ratio. In other words, the allocation will be treated as if it had been timely made during the year the GST transfer was made and therefore less GST exemption will be needed to make the inclusion ratio zero or as close to zero as possible (assuming that the property has appreciated in value since the time of the transfer) (IRC §2632(d); see also Harrington supra note 16 at 4-39).

The provision may therefore apply with respect to the death of a child, niece or nephew, or a first cousin once removed.

• Example – Retroactive Allocation. Transferor (“T”) makes a gift to a trust of $2.5 million in 2010. The primary beneficiary of the trust is T’s child (“C”), who is currently 25 years old. The trust provides that one-half (1/2) of the trust balance is distributable to C at age 30 and the balance is distributable to C at age 35. If C dies prior to withdrawing the entire amount from the trust, the trust will be maintained for the benefit of C’s descendants under similar terms. T does not allocate any GST exemption because he expects C (a non-skip person) to live to age 35 and therefore receive everything in the trust. However, C dies unexpectedly at age 29 in 2014. By that time, the trust has quadrupled in value and is now worth $10 million. T can file a timely gift tax return in 2014 and retroactively allocate $2.5 million of GST exemption to the trust under IRC §2632(d). Even though the trust is now worth $10 million, the retroactive allocation of GST exemption in 2014 will nevertheless be treated as if it had been timely made in 2010 and it will therefore produce an inclusion ratio of zero.

Automatic Allocations.

Whether GST exemption will be automatically allocated to a particular transfer made during the transferor’s lifetime depends on the type of transfer and also on what type of elections (if any) are made with respect to the transfer (or to the trust to which the transfer is made).

Direct Skip Transfers.

• General Rule. The general rule is that a transferor’s GST exemption is automatically allocated to a lifetime direct skip transfer to the extent necessary to produce a zero inclusion ratio for the direct skip, or to make the inclusion ratio as close to zero as possible (if it is not possible to produce a zero inclusion ratio) (IRC §2632(b)(1) & (b)(2)).
• Exception. A transferor can, however, elect not to have the automatic allocation rule apply to a direct skip transfer (IRC §2632(b)(3)).
• How to make the election. An election not to have the automatic allocation rule apply to a direct skip transfer must be made on a timely filed gift tax return for the year the transfer is made. The election can be made in either of two ways:
• By describing the transfer and the extent to which the automatic allocation is not to apply; (26 CFR § 26.2632-1(b)(1)(i)) or
• By making a payment of the GST tax attributable to the direct skip transfer (26 CFR § 26.2632-1(b)(1)(ii)).

What happens if the election is made? If the transferor elects out of the automatic allocation of GST exemption to a direct skip transfer, then GST tax will be owed on the direct skip transfer.

Examples – Electing out of Automatic Allocation for a Direct Skip Transfer.

• Example #1. Transferor (“T”) gives $100,000 more than the annual gift tax exclusion amount to his grandson (“GS”) in year 1. T files a gift tax return for that year and reports the gift to GS on the return but T does not allocate GST exemption to the transfer. T does not expressly state in the return that the automatic allocation rules do not apply nor does T pay the GST tax attributable to the transfer. T’s unused GST exemption is automatically allocated to the direct skip transfer to the extent necessary to make the inclusion ratio for the transfer zero or as close to zero as possible (Harrington supra note 16 at 4-13).
• Example #2. Same fact as the last example, except that T does not file a timely gift tax return reporting the transfer to GS. The result is the same as in Example #1: T’s unused GST exemption is automatically allocated to the direct skip transfer to the extent necessary to make the inclusion ratio for the transfer zero or as close to zero as possible.
• Example #3. Transferor (“T”) makes a gift of $100,000 to a trust for the benefit of his two grandchildren, GC1 and GC2 in year 1. T files a gift tax return reporting the gift to the trust but does not allocate any GST exemption to the trust. T does not pay any GST tax on the direct skip transfer and does not state that the automatic allocation rule does not apply to the transfer. The trust is a skip person and T’s unused GST exemption will be automatically allocated to the direct skip transfer to the extent necessary to make the inclusion ratio zero or as close to zero as possible.

Indirect Skip Transfers. Indirect skip transfers are treated differently depending upon when the transfer occurred.

• Transfers prior to 2001. For transfers prior to 2001, GST exemption was automatically allocated only to direct skip transfers. So there would not be any automatic allocation of GST exemption to indirect skip transfers made prior to 2001.
• Transfers after 2000. For transfers made after December 31, 2000, a transferor’s unused GST exemption will be automatically allocated to lifetime transfers that are “indirect skips” (as well as to direct skip transfers). A transfer is an “indirect skip” if it is made to a “GST trust” after December 31, 2000. A transferor’s unused GST exemption will be allocated to the transfer to the extent necessary to make the inclusion ratio zero or as close as possible to zero. So the automatic allocation rules generally apply to transfers made after 2000 that are either a direct skip or are made to a “GST trust”.
• However, a transferor can elect to treat any trust as a “GST trust” with respect to any or all transfers made by the transferor to the trust (an “election in”).
• Alternatively, a transferor can also elect not to have the automatic allocation rules apply to a particular transfer or to any and all transfers made by the transferor to a particular trust (an “election out”).

Electing “IN” to Automatic Allocation. If a transferor elects “into” the automatic allocation rules for all transfers made to a trust, then the trust will be treated as a GST trust, whether or not it meets the statutory requirements for a GST trust. In such case, the transferor’s unused GST exemption will be automatically allocated to all transfers made to the trust (but not in an amount in excess of the value of the property transferred to the trust).

• A GST trust election is made by attaching a statement (GST trust election statement) to a timely filed gift tax return for the year of the first transfer covered by the election.
• Once a transferor makes an election to treat a trust as a “GST trust” with respect to future transfers, the transferor does not need to file a gift tax return in future years to allocate GST exemption to any transfers made to the trust.
• An “election in:” with respect to future transfers remains in effect unless and until it is terminated by the transferor (1) by filing a termination statement or (2) by electing out of the automatic allocation rules altogether.
• If the trust meets the statutory requirements for a GST trust, then the automatic allocation rules will still apply to it (even without an election “in”) unless the transferor affirmatively elects “out” of the automatic termination rules.
• Example – Electing “in” to Automatic Allocation. On December 1, 2021, Transferor (“T”) transfers $1 million to an irrevocable trust that benefits his only child (“C”) and his grandchildren (“GC1 & GC2”). On April 1, 2022, T files a gift tax return making the election to treat the trust as a GST trust with respect to the year 1 transfer and all future transfers. T’s GST exemption in the amount of $1 million will be automatically allocated to the trust effective December 1, 2021. In addition, any future transfers that T makes to the trust will also have GST exemption allocated to them, regardless of whether or not T files a gift tax return in those late years.

Electing “OUT” of Automatic Allocation. Under the regulations, a transferor can prevent automatic allocation of GST exemption to an indirect skip transfer (i.e., a transfer made to a “GST trust” after December 31, 2000) by affirmatively electing “out” of the automatic allocation rules.

How to make the election out. A transferor may elect out of automatic allocation rules in either of two ways.

• First, a transferor can elect out of automatic allocation of GST exemption by attaching a statement (an “election out” statement) to a timely filed gift tax return for the calendar year during which the transfer was made (26 CFR § 26.2632-1(b)(2)(ii) and (iii)).
• Second, a transferor can also elect not to use the automatic allocation rules by affirmatively allocating GST exemption to an indirect skip on a timely filed gift tax return in an amount that is less than the value of the property reported on the gift tax return (26 CFR § 26.2632-1(b)(2)(ii)).
• Example #1 – How to Elect Out. On December 1, 2021, Transferor (“T”) transfers $1 million to an irrevocable GST trust that benefits his children and grandchildren. On April 1, 2022, T files a gift tax return that states that T is electing out of the automatic allocation of GST exemption to the trust for the gift made to the trust in 2021 and for all subsequent gifts made in later years. F’s timely filing of a gift tax return electing out of the automatic allocation rules for the trust results in no allocation of T’s GST exemption for the gift made to the trust in 2021 or for any later gifts, even if T does not file any gift tax returns in later years (Harrington supra note 16 at 4-18).
• Example #2 – How to Elect Out. On December 1, 2021, Transferor (“T”) transfers $1 million to an irrevocable GST trust that benefits his children and grandchildren. On April 1, 2022, T files a gift tax return allocating only $500,000 of GST exemption to the transferor. By filing a timely gift tax return and allocating only part of T’s available GST exemption to the transfer, T has effectively elected out of the automatic allocation rules for the remaining part of the transfer made to the trust in 2021 for which T did not allocate GST exemption (26 CFR § 26.2632-1(b)(4)(iii), Ex. 6 (modified)).

Transfers covered by election out. An election out statement may be used to elect out of:

• One or more (or all) current year transfers made by the transferor to a specified trust or trusts;
• One or more (or all) future transfers made by the transferor to a specified trust or trusts;
• All future transfers made by the transferor to all trusts; or
• Any combination of the above (26 CFR § 26.2632-1(b)(2)(iii)(A)).

Limit of election out. An election out does not affect the automatic allocation of GST exemption to any transfer not covered by the election out statement (26 CFR § 26.2632-1(b)(2)(iii)(C)(1)).

Terminating an election out. An election out can ordinarily be terminated but generally only to the extent that the election out applies to future transfers. A transferor can terminate an election out by attaching a termination statement to a timely filed gift tax return for the calendar year for the first transfer to which the election out is not to apply (26 CFR § 26.2632-1(b)(2)(iii)(E)).

• Example #1 – Electing Out. On January 1, Year 1, Transferor (“T”) transfers $300,000 to a trust (Trust X) that is a GST trust. On July 1, Year 1, T transfers another $200,000 to the trust. On a timely filed gift tax return for year 1, T attaches an election out statement that reads as follows: “T hereby elects that the automatic allocation rules will not apply to the $300,000 transfer made to Trust X in Year 1.” The election out of the automatic allocation rules will only apply to the first transfer of $300,000 to the trust on January 1. Accordingly, GST exemption will be allocated to the $200,000 transfer to the trust but not to the $300,000 transfer to the trust (26 CFR §26.2632-1(b)(4)(iv), Ex. 1(i) (modified); See also Harrington supra note 16 at 4-23)

• Example #2 – Electing Out. Same facts as the last example (Example #1) except that T’s election out statement instead reads as follows: “T hereby elects that the automatic allocation rules shall not apply to any transfers made to Trust X during Year 1.” The election out of the automatic allocation rules will be effective for both transfers made to Trust X during Year 1. Accordingly, no GST exemption will be allocated to the trust for year 1 (26 CFR §26.2632-1(b)(4)(iv), Ex. 1(ii) (modified)).
• Example #3 – Electing Out. Same facts as Example #1, except that T’s election out statement instead reads as follows: “T hereby elects that the automatic allocation rules will not apply to any transfers made by T to Trust X in Year 1 or to any additional transfers T may make to Trust X in subsequent years.” The election out of the automatic allocation rules will be effective for T’s transfers to Trust X in Year 1 and for all future transfers that T makes to Trust X unless and until T terminates the election out of the automatic allocation rules (26 CFR §26.2632-1(b)(4)(iv), Ex. 1(iii) (modified).

Definition of GST Trust

Why it matters.

For transfers made after December 31, 2000, unless there has been election “in” to the automatic allocation rules, the automatic allocation rules for transfers that are not direct skips will apply only to those trusts that meet the definition of a “GST trust.” It therefore becomes critically important to know what trusts fall within that definition in order to understand when the default rules for automatic allocation of GST exemption apply, and when they do not. Otherwise, GST exemption may inadvertently be allocated (or not allocated) in circumstances where the allocation (or non-allocation) is not advantageous.

What IS a “GST Trust?”

A GST trust is defined as any trust that can have a generation skipping transfer with respect to the transferor unless one or more of six (6) statutory exceptions applies (IRC §2632(c)(3)(B)).

• Exception #1 – “25/46”exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons before that individual reaches age forty-six (46) (or by a date that will occur or under other circumstances that are likely to occur before that individual reaches age forty-six (46)) (IRC §2632(c)(3)(B)(i)).
• Exception #2 – “25/10” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons and who are living on the date of the death of another person identified in the instrument who is more than ten (10) years older than such individual (IRC §2632(c)(3)(B)(ii)).
• Exception #3 – “25% gross estate” exception.” The trust instrument provides that if one or more non-skip persons die on or before a date or event so described (in exceptions #1 or #2), more than twenty-five percent (25%) of the trust principal must be distributed to the estates of such non-skip persons OR is subject to a general power of appointment held by such non-skip persons (IRC §2632(c)(3)(B)(iii)).
• Exception #4 – “Non-skip person” exception. Any portion of the trust would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer (IRC §2632(c)(3)(B)(iv)).
• Exception #5 – Charitable trust exception #1. The trust is a charitable remainder annuity trust, charitable remainder unitrust or charitable lead annuity trust.
• Exception #6 – Charitable trust exception #2. The trust is a charitable lead unitrust in which the non-charitable remainder interest is held by a non-skip person.

Examples of Trust that do (and don’t) qualify as GST Trusts.

• Example #1 – Trust that is a GST Trust. Transferor (“T”) makes a gift to a trust in year 1 for his child (“C”). Under the terms of the trust agreement, the trustee has discretion to distribute trust income and/or principal to C during C’s lifetime. At C’s death, the trustee is directed to distribute the remaining trust principal to C’s surviving descendants, per stirpes, or if none, then to T’s surviving descendants, or if none, then to charity. Assume that C has descendants who are living at the time the trust is created. The trust is a GST trust because it could have a generation skipping transfer with respect to T (e.g., to C’s descendants) and the trust does not fall within any of the six exceptions to the definition of a GST trust (Harrington supra note 16 at 4-28).
• Example #2– Trust that is a GST Trust. Same facts as in Example #1 above, except that C has no descendants living when the trust is created, but C is only 25 years old at the time. The trust is a GST trust because it could still have a GST with respect to T (e.g., if C has children in the future) and it does not fall within any of the six exceptions to the definition of a GST trust.
• Example #3 – Trust that is NOT a GST Trust. Same facts as in Example #1, except that C has a general power of appointment over trust assets that is exercisable at C’s death. The trust is NOT a GST trust because of the general power of appointment that C holds over the trust property. At C’s death, C will become the new “transferor” and so there cannot be a GST with respect to T.
• Example #4 – Trust that is NOT a GST Trust. Transferor (T) makes a gift to a trust in year 1 for his child (“C”). Under the terms of the trust agreement, the trustee has discretion to distribute trust income and/or principal to C during C’s lifetime. However, C has a unilateral right to withdraw up to one-half (1/2) of the trust principal at age thirty (30) and the balance at age forty (40). The trust is NOT a GST trust because a non-skip person (C) has the right to withdraw more than twenty-five percent (25%) of the trust principal prior to attaining forty-five (45) years of age.

Allocation of GST Exemption After the Transferor's Death

Voluntary Allocations.

When a transferor dies, the executor of the transferor’s estate can allocate the transferor’s unused GST exemption to property that was included in the gross estate of the decedent (or that was transferred during the decedent’s lifetime) by making a voluntary allocation on a timely filed federal estate tax return (26 CFR §26.2632-1(d)(1)).

Voluntary allocations of GST exemption after death are made on Schedule R of the federal estate tax return (IRS Form 706) (Harrington supra note 16 at 4-41).

If allocation of GST exemption is made with respect to property included in a decedent’s gross estate on a timely filed federal estate tax return, then the allocation is effective as of the decedent’s date of death (26 CFR §26.2632-1(d)(1)).

A late allocation of GST exemption by an executor with respect to a lifetime transfer is generally effective as of the date on which the allocation is made.

GST exemption can be allocated after death by use of a formula (just as it can during lifetime).

Allocations of GST exemption to a trust following a transferor’s death must clearly identify the trust and the amount of the decedent’s GST exemption allocated to the trust (Harrington supra note 16 at 4-41).

If GST exemption is voluntarily allocated to a trust and the trust has no potential for GST tax, then the allocation will be invalid (26 CFR §26.2632-1(d)(1)).

• Example #1 – Invalid Allocation of GST Exemption. Transferor (“T”) creates a trust at death for the benefit of his child (“C”). The trust provisions state that the trust principal will be distributed to C in stages at ages 25, 30 and 35. C also has a testamentary general power of appointment over the trust assets. Any un-appointed assets will pass to C’s surviving descendants, per stirpes. (Assume that T is 21 years of age at the time of T’s death.) On Schedule R of the federal estate tax return, T’s executor allocates the entire remaining GST exemption to the trust. The attempted allocation is invalid because no GST tax could be imposed on the trust with respect to T. The general power of appointment that C holds over the trust assets will cause him to be viewed as the new “transferor” of the assets at his (C’s) death. Because T will no longer be the transferor when the assets pass to C’s descendants, there is no potential for imposition of GST tax with respect to him (T) at that time (Ltr. Rul. 200838022, April 28, 2008).
• Example #2 – Valid Allocation of GST Exemption. Same facts as Example #1 (above), except now assume that C does not hold a testamentary general power of appointment over the trust assets. The voluntary allocation of GST exemption to the trust would be valid, because T remains the “transferor” with respect to the trust assets when C dies. Since the trust assets will at that time pass to remaindermen (C’s descendants) who are “skip persons” in relation to T, it is possible at the time the allocation is made to the trust that there will be a future generation skipping transfer (i.e., a taxable distribution or termination) when C dies

Automatic Allocations.

When it happens. A decedent’s unused GST exemption is automatically allocated on the due date for filing the federal estate tax return to the extent that it has not already been allocated on or before that date (IRC. §2632(e); 26 CFR §26.2632-1(d)(2)).

Priority for Automatic Allocations. Unused GST exemption is allocated according to the following priorities:

Unused GST exemption is first allocated on a pro rata basis to direct skip transfers occurring at the transferor’s death.

Any remaining GST exemption is allocated on a pro rata basis to trusts from which a taxable termination or taxable distribution may occur.

Irrevocability of Automatic Allocations. The automatic allocation of GST exemption is irrevocable, and an allocation made by an executor after the automatic allocation is made is ineffective.

• Example – Automatic Allocation Priorities:

• Facts. Transferor (“T”) dies in year 1. At the time of his death, T has $5.5 million of unused GST exemption. Prior to the time of his death, T contributed $5,000,000 to Trust 1 and another $5,000,000 to Trust 2. Both trusts benefit T’s child (“C”) and C’s descendants. Trust 1 provides that during C’s lifetime, the trustee may distribute income and principal among C or C’s descendants, and at C’s death, any remaining principal is distributed to C’s descendants. Trust 2 provides for outright distribution of principal to C in stages at ages 30, 35 and 40. Assume C is already 38 years of age. Also assume that the T made direct skip transfers of $500,000 at death, and that GST exemption was not voluntarily allocated to any of the transfers.
• Under the automatic allocation rules, $500,000 of GST exemption will first be allocated to the direct skip transfers made at T’s death.
• The remaining $5,000,000 of GST exemption must be allocated pro rata between Trust 1 and Trust 2. So each of those trusts will have an inclusion ratio of .50 [1 minus ($2.5 million divided by $5 million)], even though Trust 1 is far more likely to actually incur GST tax than Trust 2.
• Instead of relying on the automatic allocation rules, T’s executor should voluntarily allocate the entire remaining GST exemption ($5,000,000) to Trust 1 (Harrington supra note 16 at 4-43).

Exceptions to Automatic Allocation. The regulations provide a couple of exceptions to the automatic allocation rules that prevent GST exemption from being wasted unnecessarily.

• Exception #1 – “new transferor” exception. GST exemption will not be automatically allocated to a trust that will have a new “transferor” with respect to the entire trust before any GST is made from the trust (26 CFR §26.2632-1(d)(2)).
• Example – New Transferor Exception. Transferor (“T”) is survived by his spouse (“S”) and several children. T’s will creates a QTIP marital trust for the benefit of S and T’s children. Under the terms of the trust provisions in T’s Will, the trust will pay all of the trust income to S during her lifetime and will terminate at S’s death and distribute the remaining balance to T’s surviving descendants, per stirpes. Assume that T’s executor makes a timely QTIP election for the marital trust. No GST exemption will automatically be allocated to the QTIP marital trust because without a reverse QTIP election, S will become the new transferor with respect to the trust at her death and prior to that time, there cannot be any GSTs made from the trust (Harrington supra note 16 at 4-45).
• Exception #2 – “9 month rule.” No automatic allocation of GST exemption is made to a trust if, during the nine (9) month period ending immediately after the death of the transferor, no GST has occurred with respect to the trust, and at the end of such period, no future GST can occur with respect to the trust (26 CFR §26.2632-1(d)(2)).

Estate Tax Inclusion Period (ETIP)

What is an “Estate Tax Inclusion Period”? An “estate tax inclusion period” is the period during which the value of transferred property would be includable (other than by reason of IRC §2035) in the gross estate of the transferor (or the transferor’s spouse) if the transferor (or the transferor’s spouse) were to die immediately after the transfer (IRC §2642(f)(3)).

The “ETIP” Rule. Under the ETIP rule, if GST exemption is allocated to transferred property that would be includable (other than by reason of IRC §2035) in the gross estate of the transferor if the transferor were to die immediately after the transfer, then the allocation of GST exemption will not be effective until the end of that period known as the ETIP (IRC §2642(f)(1)).

Reason for the ETIP Rule. If a transfer is includable in the transferor’s gross estate for federal estate tax, then it is, by definition, not a generation skipping transfer and thus not subject to GST tax. Therefore any GST exemption allocated to the transfer would be wasted. So the ETIP rule provides that GST exemption cannot be allocated to the transfer until after the period during which the transfer could be brought back into the transferor’s gross estate for federal estate tax purposes. It is basically a rule intended to protect against unnecessary dissipation of GST exemption.

Situations Where the ETIP Rule Commonly Comes into Play

Grantor Retained Annuity Trusts (“GRATs”). A GRAT is a trust that pays out an annuity to the transferor of entrusted property for a term of years and then at the end of the stated term, the balance remaining in the trust is distributed to the designated remainder beneficiaries (e.g., grantor’s descendants). If the grantor dies during the trust term, then the value of the trust assets will be brought back into the transferor’s estate pursuant to IRC §2036. Accordingly, if GST exemption is allocated to a GRAT, then the allocation of GST exemption will not be effective until after the term of the GRAT (or the grantor’s death, if that occurs sooner), because it is at that time when it is known whether the transferred property will be brought back into the transferor’s gross estate for federal estate tax purposes.

Qualified Personal Residence Trusts (“QPRSTs”). A QPRT is a trust involves the transfer of a personal residence to a trust. The trust agreement for the QPRT allows the transferor of the personal residence to continue living in the residence for a stated number of years and at the end of the stated trust term, the residence is distributed out of the trust to designated remainder beneficiaries. As with a GRAT, if the grantor dies during the trust term, the value of the trust assets will be includable in the transferor’s gross estate for estate tax purposes pursuant to IRC §2036. Accordingly, if GST exemption is allocated to a QPRT, then the allocation will not be effective until after the stated term, (or the grantor’s death, if that occurs sooner), because it is at that time when it is known whether the transferred property will be brought back into the transferor’s gross estate for federal estate tax purposes.

Examples of the ETIP Rule

• Example #1 – QPRT. Transferor (T) creates a qualified personal residence trust and transfers his residence to the QPRT. Under the terms of the trust agreement, T is entitled to exclusive occupancy during the trust term of 9 years. At the end of the 9 year term, the trust distributes to T’s grandchild (GC). If T dies within the 9 year term, the value of the trust will be includable in T’s gross estate under IRC §2036(a). The trust is therefore subject to an ETIP. The ETIP ends at the end of the 9 year term if T survives until that time. The allocation of GST exemption to the trust is therefore not effective until the end of the ETIP and the exemption will be applied against the value of the trust at that time.
• Example #2 – GRAT. Transferor (“T”) creates a grantor retained income trust (GRAT) and transfers investment securities to the GRAT. Under the terms of the trust agreement, T reserves a 10 percent annuity interest for nine (9) years. At the end of 9 years (or T’s earlier death), the trust will be maintained for the benefit of T’s grandchildren (GC1, GC2 & GC3). The reserved annuity interest will result in an inclusion in T’s gross estate for federal estate tax purposes if T dies within the 9year GRAT term. So during the period of the annuity interest, an ETIP exists. T therefore cannot effectively allocate GST exemption to the trust until the end of the 9 year term.

Valuing ETIP Property.

In General. The time for valuing ETIP property for the purpose of allocating GST Exemption to the property depends on whether or not the transferor lives through the estate tax inclusion period.

Transferor’s death before ETIP ends. If the transferor dies before the expiration of the ETIP, then the transferred property will be includable in the transferor’s gross estate for estate tax purposes and therefore the property will be valued at that time (i.e., at the time of the transferor’s death).

• Example: Transferor (“T”) creates a qualified personal residence trust with a 5 year term and transfers his residence to the QPRT. At that time, the residence is worth $200,000. Under the terms of the trust agreement, T is entitled to exclusive occupancy during the trust term of 5 years. At the end of the 5 year term, the trust will distribute the trust asset (the residence) to T’s grandchild (“GC”). T dies in year 3 when the residence is worth $300,000. The value of the residence ($300,000) will be includable in T’s gross estate under IRC §2036(a), and therefore the trust will be valued for GST allocation purposes at that value. So in order to obtain a zero inclusion ratio, T will need to allocate $300,000 of GST exemption to the trust.

Transferor outlives ETIP. If the transferor is still living at the end of the ETIP, then the transferred property will be valued for GST allocation purposes at that time (i.e., the end of the ETIP), provided that GST exemption is allocated by the due date for filing a gift tax return to report the value of the gifted property at the end of the ETIP.

• Example #1 – Timely Allocation: Transferor (“T”) transfers stock to a GRAT with a 5 year stated term on January 1, 2020. At the time of the transfer, the transferred stock is worth $400,000. T is still living at the end of the 5 year term (January 1, 2025), and the stock is worth $1,000,000 at that time. For GST allocation purposes, the stock will be valued at that time, provided that GST exemption is allocated to the trust either automatically or on a timely gift tax return filed for 2025. So in order to obtain a zero inclusion ratio, T will need to allocate $1,000,000 of GST exemption to the trust.
• Example #2 – Late Allocation. Same facts as the preceding example, except that GST exemption is not allocated to the trust until the year 2028 and that by that time, the stock is now worth $1,500,000. Because the allocation was not timely made, the stock must be valued at the later date (i.e., in 2028 – 3 years after the end of the ETIP). So in order to obtain a zero inclusion ratio, T will need to allocate $1,500,000 of GST exemption to the trust.

Allocation of GST exemption during the ETIP. If an allocation of GST exemption is made prior to the end of the ETIP, the allocation will not become effective until the termination of the ETIP.

• Example – Allocation during ETIP: Same facts as Example #1, except that T allocates GST exemption to the trust in 2022 (i.e., before the end of the trust term). The allocation is not effective until 2025 (i.e., the end of the GRAT term) when the ETIP ends.

Who is the "Transferor"?

General Rule. The “transferor” is generally the individual to/for whom the transferred property was most recently subject to federal estate or gift tax.

• Example #1 –Gift of Property – In the case of a gift, the transferor is normally the donor.
• Example #2 – Testamentary Transfer – In the case of a testamentary transfer, the transferor is usually the decedent.

Changed Transferor.

However, one of the confusing things about GST tax (and estate and gift tax more generally) is that who the “transferor” is with respect to a particular transfer can change. For example, all transfers between spouses that qualify for the estate or gift tax marital deduction will result in the property being subject to estate or gift tax for subsequent transfers by the donee spouse. Thus, under the general rule for determining the transferor for GST tax purposes, if the property is subsequently transferred to another person in a transfer subject to estate or gift tax, the donee spouse will be viewed as the “transferor” of the property.

Common Situations involving a “Changed Transferor.”

A new “transferor” for GST tax purposes can arise in two fairly common situations. One such situation is when a spouse is given a general power of appointment over trust property, and another is when a spouse makes a so-called “QTIP” election with respect to trust property.

Holder of a (General) Power of Appointment. If a married individual transfers property at death or during lifetime to a trust for his or her spouse and if the spouse is given a general power of appointment over the trust property, then the spouse will thereafter be considered the “transferor” of the trust property for GST tax purposes when the property is later transferred to other persons such as “skip persons”.

• Example – General Power of Appointment. Transferor (“T”) creates a trust for the benefit of his spouse (“S”) that qualifies for the marital deduction under IRC §2056(b)(5) because S is given both a life estate interest in the property and a general power of appointment over the trust funds. On S’s subsequent death, S becomes the “transferor” of the property because the trust is subject to estate tax (under IRC §2041) in S’s estate on account of the general power of appointment held by the spouse. If the remainder beneficiaries of the trust at S’s death include “skip persons” (such as grandchildren), then only S (or her executor) can allocate GST exemption to the trust. If T had previously allocated GST exemption to the trust, the exemption from T would be “wasted”.

“QTIP” (Qualified Terminable Interest Property) Trust. If a married individual transfers property at death or during lifetime to a trust for the benefit of his or her spouse which qualifies as a “QTIP” (“qualified terminable interest property”) trust and if the spouse makes a QTIP election with respect to that trust, then the transfer to the QTIP trust will qualify for the estate or gift tax marital deduction (IRC §2056(b)(7); IRC §2523). However, the corollary to the QTIP marital deduction is that the property for which the QTIP election was made will thereafter be taxable to the surviving spouse or the spouse’s estate for estate and gift tax purposes when it is passed on to the remainder beneficiaries (IRC §2044; IRC §2519). Consequently, the surviving spouse is thereafter treated as the “transferor” for GST tax purposes if those remainder beneficiaries are “skip persons”.

Requirements for a QTIP Trust. A QTIP trust is one that meets the following requirements:

• Property passing during life or at death to a spouse;
• The spouse is a U.S. citizen;
• The spouse is entitled to all of the trust income during lifetime, payable annually or in more frequent intervals;
• No person has a power to appoint any part of the trust property to any persons other than the spouse during the spouse’s lifetime; and
• The donor-spouse (or the executor of the donor spouse’s estate) make a “QTIP” election on the applicable gift or estate tax return.

Effect of QTIP Election. The QTIP election will allow the transfer to the QTIP trust to qualify for the estate or gift tax marital deduction. However, as a consequence of the election, the property in the QTIP trust will be taxable to the spouse’s estate for estate tax purposes when the spouse dies. The spouse therefore becomes the “transferor” for federal estate and gift tax purposes and for GST tax purposes as well.

• Example – QTIP Trust. Husband (H) in his Will creates a testamentary QTIP trust to benefit his wife (W), who is his second wife and the children (C1 & C2) from his previous marriage. Under the terms of the QTIP, W is entitled to all of the trust income during her lifetime and at her death the remaining trust balance will be distributed to the children. If either C1 or C2 are not living when W dies, then their respective share of the trust balance will be administered in trust for their descendants. At H’s death, H is the “transferor” of the property passing into the trust. However, following H’s death, the executor of H’s estate makes a QTIP election. Consequently, the trust property will be includable in W’s estate, pursuant to IRC §2044. Therefore, at W’s death, W becomes the new “transferor” with respect to the trust property. Accordingly, any GST exemption must be allocated to the trust by W’s executor.

Reverse QTIP Election

What is the “Reverse QTIP” election? There is a special election (often called a “reverse QTIP election”) that can be made by a donor spouse (in the case of a QTIP trust created by lifetime gift) or by a deceased donor spouse’s executor (in the case of a QTIP trust created at death) to treat the QTIP property as if no QTIP election has been made for GST tax purposes only. If the election is made, then the donor spouse will continue to be treated as the “transferor” of the QTIP property for purposes of GST tax (IRC §2652(a)(3)).

• Example – Reverse QTIP election. Transferor (“T”) creates a trust for T’s spouse (“S”), and makes a QTIP election for gift tax purposes. T is the “transferor” with respect to the trust. Following S’s death, the QTIP trust is included in S’s gross estate under IRC §2044. S therefore becomes the new “transferor” both for estate tax and also for GST tax purposes unless a reverse QTIP election is made. If T makes a timely reverse QTIP election, then S does not become the new “transferor” on S’s death despite the trust’s inclusion in S’s gross estate.

Why the election Reverse QTIP election can be important. A reverse QTIP election can be important because it enables the original transferor (donor spouse) to allocate his or her GST exemption to the QTIP trust. If the election is not made with respect to a QTIP trust, then the status of the “transferor” will change when the QTIP income beneficiary (the surviving spouse) dies. That makes it impossible for the previous transferor (donor spouse) to allocate GST exemption to the trust. Furthermore, if the donor spouse had previously allocated GST exemption to the trust, that GST exemption would be “lost” when the new person (the surviving spouse) becomes the new “transferor”.

When to make the Reverse QTIP Election. The reverse QTIP election will often be advisable whenever the donor spouse has sufficient GST exemption to allocate to the trust to make the inclusion ratio zero.

• Example – When to make the Reverse QTIP Election. Transferor (“T”) has $5 Million of unused GST exemption. T creates a lifetime QTIP trust for his spouse (“S”) and contributes $1 Million to the trust. T therefore makes a reverse QTIP election and allocates $1 Million of GST exemption to the trust. The allocation of GST exemption should produce an inclusion ratio of zero for the trust. By making the reverse QTIP election, T is able to guarantee that there will not be any GST tax with respect to the trust. In addition, because S does not have to allocate any of her GST exemption to the trust, the election effectively “saves” GST exemption for future allocation to other transfers.

Irrevocability of Election. The regulations provides that, once made, the reverse QTIP election is irrevocable (26 CFR §26.2652-2(a)).

Time for Making Election. The reverse QTIP election must be made on the tax return on which the QTIP election is made.

The reverse QTIP election can therefore be made on a late filed tax return provided that it is made on the same return on which the effective QTIP election is made.

However, from a practical standpoint, if the tax return is filed late, it may not be possible to allocate GST exemption to the transfer, which may affect the advisability of making the election.

“All or Nothing” Election. Unlike a QTIP election which can be made in whole or in part with respect to a trust, the reverse QTIP election can be made only as to “all or none” of the QTIP property. In other words, if a QTIP election is made with respect to the entire trust, then the reverse QTIP election must be made as to all of the trust or none of it. Similarly, if a QTIP election is made as to only part of the trust (“Partial QTIP Election”), then the reverse QTIP election must be made as to the entire portion of the trust for which the QTIP election was made or to none of the trust.

• Example – Total QTIP Election. Transferor (“T”) creates a QTIP trust in his Will for his spouse (“S”). T dies and the trust is funded. T’s executor makes the QTIP election with respect to the entire trust balance. T’s executor can make a reverse QTIP election with respect to the entire trust or he can decide not to make the election at all. But he cannot make the reverse QTIP election as to only a part of the trust.
• Example – Partial QTIP Election. Transferor (“T”) creates a QTIP trust in his Will for his spouse (“S”), which qualifies or the QTIP election. T’s executor makes the QTIP election with respect to one-half (1/2) of the trust. T’s executor can make a reverse QTIP election with respect to the entire one-half (1/2) portion for which the QTIP election was made or he can decide not to make the reverse QTIP election at all.

Adverse Effects of Reverse QTIP Election. A reverse QTIP election can have adverse tax consequences if there is only one QTIP trust and if the value of the trust exceeds GST exemption allocated to it.

• Adverse Effect #1 – Lesser GST Exemption. One potential adverse effect would arise if the donor spouse has less GST exemption to allocate to the trust than the beneficiary-spouse. If that is the case, then the reverse QTIP election will result in greater GST tax than if the election were not made.
• Adverse Effect #2 – Taxable Termination (versus Direct Skip). In addition, the IRS currently takes the position that, if a reverse QTIP election is made, the distribution of funds to skip persons at the death of the beneficiary-spouse is a taxable termination, rather than a direct skip (Rev. Rul. 92-26, 1992-1 CB 314; 26 CFR §26.2652-2(c), Example #1). That can be disadvantageous because a taxable termination results in higher GST tax than a direct skip because the tax base for a taxable termination includes the GST tax paid.
• Adverse Effect #3 – Loss of Predeceased Ancestor Exception. Another potential disadvantage of making the reverse QTIP election is that it can in certain circumstances prevent application of the Predeceased Ancestor Exception when it would otherwise apply.

Example – Adverse Effects of Reverse QTIP. T’s will creates a $5 Million testamentary QTIP Trust for the benefit of his spouse (“S”). T then dies. Assume that the QTIP election is made by T’s executor. T has only $1 Million of GST exemption remaining at the time of his death and so T’s executor allocates all $1 Million of T’s GST exemption to the trust. T has only one child (“C”) living at the time of his death, and C has children of his own (T’s grandchildren). The terms of the QTIP trust provide that if C is not living when S dies, then the trust balance is distributed to C’s children (T’s grandchildren). C dies after T dies but before S dies. S’s executor wants to know whether or not to make the reverse QTIP election.

If no reverse QTIP election is made, then T’s GST exemption is wasted, but no GST tax is imposed on the distribution to T’s grandchildren because the distribution to the grandchildren qualifies for the predeceased ancestor exception. (S is the new transferor and C died before S.)

If a reverse QTIP election is made, then the inclusion ratio for the trust would be 0.80 (1 – $1 Million / $5 Million = 0.80). At S’s death, the distribution to the grandchildren would be a taxable termination instead of a direct skip. (The predeceased ancestor rule would not apply because at the time of the transfer to the trust, C was still living.) If there is $5 Million remaining in the trust (net of estate tax) at S’s death, the GST tax would be $1,600,000 ($5 Million x 40% x 0.80).

In this particular case, making the reverse QTIP election produced a worse result because the trust must pay $1,600,000 more than it would have if no reverse QTIP election were made.

Suggested Solution. The solution to this problem illustrated in the preceding example is that whenever a QTIP trust is larger than the available GST exemption, the following should be done:

The QTIP trust should be divided into two (2) identical trusts, one that is equal to the amount of GST exemption and a second trust that is equal to the remaining QTIP balance.

The full amount of the transferor’s GST exemption should be allocated to the first trust which is equal to the GST exemption, so that that trust will have a zero inclusion ratio.

The reverse QTIP election should then be made for the trust with the zero inclusion ratio but not for the other trust.

Author: Jeffrey D. Scibetta

Originally published in October 2021

Copyright © 2021 Knox McLaughlin Gornall & Sennett, P.C.