Advanced Generation-Skipping Transfer Tax Issues (With Forms) (Part 1) Julie K. Kwon Julie K. Kwon is a partner in the Chicago office of McDermott, Will & Emery. Ms. Kwon chairs the Estate and Gift Tax Committee of the ABA Real Property, Trust & Estate Section, and served as co-chair of that Section‘s Generation- Skipping Transfer Tax Committee. Ms. Kwon wishes to thank her partner, Carol A. Harrington, who generously contributed substantial portions of this outline. A. Introduction 1. From the first introduction of the federal generation-skipping transfer ( “ GST ” ) tax, the complexity of the rules governing GST taxation, alloca- tion of GST exemption, and drafting to make the most effective use of GST exemption has ensnared many an unwitting practitioner. The promulgation of assorted GST tax provisions in recent years, however, has vastly expanded the options of the taxpayer seeking to implement prudent GST planning now, remedy past errors, or accommodate changes in circumstances affecting the administration of trusts for the best interests of beneficiaries. Various GST tax relief provisions are found under the Economic Growth and Tax Re- lief Reconciliation Act of 2001, Pub. Law No. 107-16 (2001), ( “ E GTRRA ” ). Regulations dealing with modifications to grandfathered generation-skipping trusts were made final in 2000. Treas. Reg. §26.2601-1(b)(4). These regula- tions also address the effect of the exercise, release, and lapse of gen- eral powers of appointment over such trusts in response to cases on this issue. Regulations were issued in 2005 to amend Treas. Reg. §26.2632-1 re- garding the automatic allocation rules of section 2632(c), added to the Code by the 2001 Act. Regulations also were issued in 2005 addressing the generation assignment rules of section 2651(f)(1) for intra-family adop- tions and the predeceased ancestor exception, modified by the 1997 Act. Both final and proposed Regulations were issued in 2007 regarding qualified severances under section 2642(a)(3), also added to the Code by the 2001 Act, including regulations regarding the income tax effect of a qualified severance. Revenue Ruling 92–26, 1992-1 C.B. 314, addressed the effect of the reverse qualified terminable interest property (QTIP) election. Revenue Procedure 2004-46, 2004-2 C.B. 142, provides a simplified procedure to ob- tain an extension of time to allocate GST exemption for certain annual ex- clusion transfers. Revenue Procedure 2004-47, 2004-2 C.B. 169, provides a simplified procedure to obtain an extension of time to make a reverse QTIP election for certain QTIP trusts. The responsibility of practitioners to avail themselves of these options to implement effective GST planning for their clients has increased in equal measure. This outline discusses ad- vanced issues in GST tax planning and administration and assumes familiar- ity with the rules governing allocation of GST exemption and determination of the inclusion ratios of trusts. For comprehensive summaries of these rules, see Carol A. Harrington, Lloyd Leva Plaine, and Howard M. Zaritsky, Generation-Skipping Transfer Tax (Warren Gorham & Lamont RIA, 2d ed. 2001 & 2006 Supp.); Carol A. Harrington and Frederick G. Acker, Tax Management Portfolio No. 850, Generation-Skipping Tax (BNA, Inc. 2006). All references to the “ Code ” are to the Internal Revenue of Code of 1986, as amended. Unless otherwise specified, all references to “ s ections ” refer to sec- tions of the Code. All references to “ regulations ” refer to Treasury Regulations. B. Separate Shares And Trusts 1. To maximize the benefit of the allocation of GST exemption, trusts should have inclusion ratios of either zero or one. A trust with an inclu- sion ratio of between zero and one wastes GST exemption allocated to it whenever a distribution is made to a non-skip person because non-exempt as- sets could have been distributed to the non-skip person without any GST tax. Similarly, if a distribution is made to a skip person from the trust, some GST tax will be due. In contrast, the existence of two trusts with zero and one inclusion ratios respectively allows distributions to maximize the benefit of the GST exemption. The trust with an inclusion ratio of one should be used to provide for beneficiaries who are non-skip persons while the trust with an inclusion ratio of zero should be used to provide for skip persons. 2. Now that trusts can be divided in a qualified severance to achieve trusts with inclusion ratios of zero and one, the rules for separate trusts and shares are not as important as they were previously. Nonetheless, it is helpful to know when trusts are separate, so that a qualified severance can be used if necessary. a. Substantially Separate And Independent Shares. If a single trust con- sists solely of separate and independent shares for different beneficiar- ies, the share attributable to each beneficiary or group of beneficiaries is treated as a separate trust for purposes of the GST tax. The phrase “ s ubstantially separate and independent shares” generally has the same meaning as provided in Treas. Reg. §1.663(c)-3. Treatment of a single trust as separate trusts under this section does not permit separate trust treat- ment for income tax or any other purposes under the Internal Revenue Code. Additions and distributions from such trusts are allocated pro rata among the separate trusts unless otherwise expressly provided in the governing instrument. Treas. Reg. §26.2654-1(a)(1)(i). i. The regulations state that a portion of a trust is not a separate share unless that share exists from and at all times after the creation of the trust. Treas. Reg. §26.2654-1(a)(1)(i). For this purpose, a trust is treated as created at the date of death of the grantor if the trust is in- cludable in its entirety in the grantor’s gross estate. Trusts that would not be included in the grantor’s gross estate would apparently be consid- ered created when irrevocable. It is not clear whether a new trust is cre- ated to the extent property is added to the trust when the addition occurs. ii. The meaning of this rule is explained in an example. Assume T creates an irrevocable trust with the discretionary power in the trustee to dis- tribute income or principal among T’s children and grandchildren. The trust provides that when T’s youngest child reaches age 21, the trust will be di- vided into separate shares, one share for each child of T. Thereafter, the income from the child’s share will be paid to that child for life with the remainder to that child’s children at the child’s death. The example states that the separate shares that come into existence when the youngest child reaches age 21 will not be recognized as separate trusts “ for purposes of chapter 13 ” because the shares do not exist from and at all after the creation of the trust. Treas. Reg. §26.2654-1(a)(5), Ex. 8. The example further states that any allocation of GST exemption to the trust or shares either before or after T’s youngest child reaches age 21 will apply with respect to the entire trust, including all three shares after the child reaches age 21. The example finally states that the result will be the same if the trust instrument provided that the trust was to be divided into separate trusts rather than shares when T’s youngest child reached age 21. iii. This example is troubling. The example states that after the youngest child reaches age 21 separate shares or trusts will not be recognized as separate trusts for purposes of the GST tax. First, the validity of this statement is highly questionable in light of section 2654 and its legisla- tive history that the separate share rule in section 2654 does not affect the treatment of trusts that are separate under state law. H.R. Rep. No. 795, 100th Cong., 2d Sess., at 354 (1988). Second, the statement applies beyond the mere allocation of GST exemption. For example, assume that all three children are living when the trust is established but that one child dies leaving descendants before the youngest child reaches age 21. When the trust divides into separate trusts for each child, the trusts are not rec- ognized as separate for all purposes of the GST tax. Thus it appears that no taxable termination occurs on the division of the trust into separate trusts. In contrast, if the failure to recognize the trust as separate re- lated only to the allocation of GST exemption, the division of the trust would be a taxable termination as to the deceased child’s trust if he or she has descendants then living. iv. Because the 2001 Act provides that the taxpayer can do a qualified severance, the detriment to the taxpayer created by this example is largely eliminated, assuming the regulation was even valid in the first place. The example, however, allows the taxpayer to delay a taxable event by choosing not to have a division be a qualified severance even though the trusts are actually separate, if the trusts were not separate from inception because the government cannot take a position contrary to its own regulations. b. Pecuniary Payments. If a person holds the current right to receive a mandatory pecuniary payment at the death of the transferor from a trust the pecuniary amount is a separate and independent share if (i) the trustee is required to pay appropriate interest and (ii) the pecuniary amount is pay- able in kind on the basis of date of distribution values or the trustee is required to fund the pecuniary payment in a manner that fairly reflects net appreciation or depreciation in value of the assets available to pay the pecuniary amount measured from the date of death to the date of payment. Treas. Reg. §26.2654-1(a)(1)(ii). i. This draconian provision is unnecessary in light of the valuation rules that specifically provide for a discount from the pecuniary amount and for allocation of GST exemption based on date of distribution values if similar requirements are not met. See Treas. Reg. §26.2642-2(b). The valuation rules solve the potential abuse problems with pecuniary payments, and a separate share rule for mandatory pecuniary payment is unnecessary. In ad- dition, the separate share rule is a much harsher penalty than the penalty under the valuation rules in that the pecuniary payment is not treated as separate from the trust from which it is paid while the valuation rules ei- ther discount the value or use distribution values to determine the inclu- sion ratio. This means that for purposes of GST exemption allocation, and apparently other GST tax purposes, the pecuniary payment is not separate from the trust from which it is made. ii. For example, assume that T’s revocable trust holds $7,500,000 after estate taxes are paid and the trust instrument provides for a $1,500,000 gift at T’s death to T’s grandchildren with the balance of $5,000,000 after taxes passing elsewhere. If the pecuniary payment for any reason does not meet the separate share rules, it will be impossible to allocate GST exemp- tion to result in a zero inclusion ratio for the gift to the grandchildren. This is because the allocation under this rule must apply to all of the as- sets, including the balance of the trust of $5,000,000. Thus an allocation of $1,500,000 can only be made to the entire trust, resulting in an inclu- sion ratio of .8 (1 - 1,500,000/7,500,000). iii. This problem exists only for pecuniary gifts made from a revocable trust at death where no election is made to treat the trust as a part of the estate under §645. This problem does not exist for pecuniary bequests made pursuant to a will or revocable trusts treated as an estate. This is due to the express provision in the statute that an estate or a revocable trust treated as an estate is not a trust arrangement. §2652(b)(1). Because an estate or revocable trust treated as an estate is not a trust, a pecuni- ary gift pursuant to a will or such a trust is not part of a trust to which the separate share rule can apply. c. Multiple Transferors To A Single Trust. Portions of a trust attribut- able to different transferors are treated as separate trusts for purposes of the GST tax. Additions to and distributions from such trusts are allo- cated pro rata among the separate trusts unless otherwise expressly pro- vided in the governing instrument. If the separate portions are actually severed into separate trusts pursuant to Treas. Reg. §26.2654-1(a)(3), pre- sumably the pro rata treatment would not apply, even if no express provi- sion exists in the governing instrument. Treas. Reg. §26.2654-1(a)(2)(i). The portion of a single trust attributable to one of several transferors is determined by multiplying the fair market value of the single trust immedi- ately after the contribution by a fraction. The numerator of the fraction is the value of the separate trust immediately after the contribution. The denominator of the fraction is the fair market value of the property in the trust immediately after the transfer. Treas. Reg. §26.2654-1(a)(2)(ii). d. Severance Of A Single Trust — Separate Shares Or Multiple Transferors. A trust with separate shares or multiple transferors may be divided to re- flect separate trusts for the separate portions at any time. The rules re- garding severance in funding of separate trusts in Treas. Reg. §26.2654- 1(b)(1)(ii)(C) apply to such a division. Treas. Reg. §26.2654-1(a)(3). e. Allocation Of GST Exemption To Separate Shares. When separate shares are treated as separate trusts, an individual’s GST exemption may be allo- cated to the separate trust. In addition, the regulations clarify that where the automatic allocation rules apply to trusts treated as separate under the regulations, the transferor’s GST exemption not previously allo- cated is automatically allocated on a pro rata basis among the separate trusts, except to the extent the transferor opts out of the automatic allo- cation rules. The transferor can elect out of the automatic allocation as to any share. Treas. Reg. §26.2654-1(a)(4). f. Divisions Of Trusts Included In The Gross Estate i. In General. These rules apply only to trusts included in the gross es- tate and not to irrevocable lifetime trusts not includable in the trans- feror’s gross estate at death. Treas. Reg. §26.2654-1(b)(1).
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