GENERATION SKIPPING TRANSFER TAX (GSTT) PLANNING First … · The Generation Skipping Transfer (GST) tax has been reinstated for tax year 2012 and beyond, but with certain changes

GENERATION SKIPPING TRANSFER TAX (GSTT) PLANNING

First Run Broadcast: September 22, 2011

Live Replay: December 22, 2011

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)

The Generation Skipping Transfer (GST) tax has been reinstated for tax year 2012 and beyond,

but with certain changes that open new planning opportunities. This program will provide you

with an overview of the complex framework of the GST tax and an in-depth discussion of

advanced planning opportunities after the restoration of the tax and ahead of the forthcoming

sunset of certain safe harbors. Among other topics, this program will cover planning

opportunities for the larger GST exemption under the Tax Reform Act of 2010, advanced

planning techniques including the use of dynasty trusts and “HEET” Trusts, and avoiding pitfalls

on reporting on Form 709. The program will also discuss what practitioners can do in

anticipation of the sunset of certain safe harbors in 2013.

Quick overview of the GST tax generally

Planning to use the new larger GST exemption under TRA 2010

Advanced planning issues, including the use of dynasty trusts and the sophisticated

"HEET" Trusts

What to do about the sunset of GST tax safe harbor rules that will occur on January 1,

2013

Avoiding pitfalls in reporting on Form 709

Speakers:

Daniel L. Daniels is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP,

where his practice focuses on representing business owners, corporate executives and other

wealthy individuals and their families. A Fellow of the American College of Trust and Estate

Counsel, he is listed in “The Best Lawyers in America,” and has been named by “Worth”

magazine as one of the Top 100 Lawyers in the United States representing affluent individuals.

Mr. Daniels is co-author of a monthly column in “Trusts and Estates” magazine. Mr. Daniels

received his A.B., summa cum laude, from Dartmouth College and received his J.D., with

honors, from Harvard Law School.

PROFESSIONAL EDUCATION BROADCAST NETWORK

Speaker Contact Information

Generation Skipping Transfer Tax Planning

Daniel L. DanielsWiggin & Dana, LLP - Stamford(o) [email protected]

David T. LeibellWiggin & Dana, LLP - Stamford, Connecticutt(o) (203) [email protected]

Fundamental GST Planning, WithSpecial Attention to the Tax Relief

Act of 2010By

Dan Daniels and David Leibell

Wiggin and Dana LLP

© 2011 Wiggin and Dana

© 2011 Wiggin and Dana 2

Agenda

• Review of the GST Tax

• Overview of TRA 2010 and its GST Provisions

• Impact on 2010 GST Planning

• Impact on 2011 and 2012 GST Planning

• Impact on Post-2012 GST Planning


Introduction to the GST Tax

• Purpose of Tax

• Need to learn GST “vocabulary”– Skip person and non-skip person

– Taxable Termination

– Direct Skip

– Taxable Distribution

• Tax Rate– Inclusion ratio

– GST exemption


“Name That Transfer”

• T makes a gift of property to his grandchild, GC

• T transfers property to a trust to pay income hischild, C, for life, with the remainder to pass to C’schildren

• T makes a gift to a sprinkle trust for the benefit ofhis children and grandchildren

• Trustee of that trust makes distributions tograndchildren


“Name that Transfer”- Bonus Questions(Hint: Know the transferor “move down” rule)

• T makes a gift to a sprinkle trust for the benefit

of his grandchildren and great grandchildren

• Trustee later makes a distribution from the trustto a grandchild

• Trustee later makes a distribution from the trustto a great grandchild


Transferor

• In general– Transferor is decedent for property transferred at death

– Transferor is donor for property transferred by gift

• Why do we care who is the transferor?– Only the transferor can allocate GST exemption

– Identity of transferor provides starting point for determiningwhether a transferee is a skip person or not

• Identity of transferor can change over time– Transferor is person who transfers property and with respect to

whom the property was most recently subject to estate or gift tax


Interest

• Why do we care about the term “interest”?– Integral part of the definition of certain generation skipping

events

– A taxable termination occurs when there is

• A termination of an “interest” in property held in trust

• Unless immediately thereafter a non-skip person has an interest in

the property

– A transfer to a trust will be not be a direct skip as long as a non-skip person has an interest in the trust


Interest – Special Rule for Charities

• A charity may have an interest in a trust for GSTtax purposes in two situations:– Charity has a present non-discretionary right to receive income or

principal from the trust

– Charity is the remainderman of a CRAT, CRUT or pooled incomefund

• Example: T transfers property to a CRT to pay a unitrust percentageto GC for life, remainder to charity. T’s transfer is not a direct skip.Distributions to GC are taxable distributions.


Skip Person/Non-Skip Person

• A skip person may be a natural person or a trust

• A natural person is a skip person if she is assignedto the second or lower generation below thetransferor

• A trust is a skip person if either:– all interests in the trust are held by skip persons; or

– no person holds an interest in the trust and at no time after thetransfer may a distribution be made to a non-skip person

• A non-skip person is a natural person or trust that isnot a skip


Skip Person Quiz• T creates a trust naming his grandchild, GC, as the

only permissible income and principal beneficiary,remainder to great-grandchildren

• T creates a trust for GC. Trustee directed toaccumulate income until GC is 21 then pay incometo GC for life, remainder to GGC

• T creates a sprinkle trust for C and GC for the life ofC, remainder to GC

• T creates a trust to pay all income to GC, remainderto C


Skip Person Quiz – Advanced Questions

• T creates a CRT to pay an annuity interest to GC,remainder to charity

• T creates a sprinkle trust for C and his five GCs forthe life of C, remainder to GC; Crummey rights aregiven to all six beneficiaries


Inclusion Ratio

• What is it?

• Essentially, the proportion of the trust that issubject to GST tax

• More correctly, it’s a factor in determining theGST Tax Rate

• Tax rate = (Top Estate Tax Rate) X Inclusion Ratio


Determining Inclusion Ratio

• Inclusion ratio equals 1 - “applicable fraction”

• Applicable Fraction

– Amount of GST Exemption allocated/value ofproperty in the trust


Inclusion Ratio Example

• T transfers $100,000 to trust

• T allocates $40,000 of GST Exemption

• Applicable fraction equals $40,000/$100,000, or.40

• Inclusion ratio equals 1 - .40, or .60

• Tax rate equals .60 x 35% = 21%


GOAL IS AN INCLUSION RATIO OF EITHER ZEROOR ONE

• Mixed inclusion ratio wastes GST exemptionwhen distributions from a trust are made tochildren

• Mixed inclusion ratio causes unnecessary GST taxwhen distributions from a trust are made tograndchildren

• A trust with a zero inclusion ratio will be investeddifferently from a trust with a one inclusion ratio


Achieving a Zero Inclusion Ratio

• Allocate GST exemption to each transfer to the trust

• Timely allocation permits use of date-of-gift valuefor purposes of allocation

• Late allocation requires use of values as of datereturn is filed– Special first of the month rule

• Planning pointers:– Be sure trust agreement includes power for trustee to split into zero

and one inclusion ratio trusts

– Use intentional late allocation for life insurance in trust?


Automatic Allocation Rules

• Lifetime Direct Skips

• Automatic Allocation at Death

• Rules on Automatic Allocation to “IndirectSkips” (Repealed as of 1/1/2013)

• An Indirect Skip is a transfer that is not a directskip which is made to a “GST Trust”

• A “GST Trust” is any trust that could have ataxable termination or taxable distributionunless one of six exceptions applies


2010 Tax Relief Act, In General

• Increase in estate, gift and GST exemptions and decrease in tax ratesfor 2010, 2011 and 2012

– $5,000,000 exemptions

– 35% rate

– Exemption indexed for inflation from 2010, starting in 2012

• 2010 Tax Act sunsets in 2013

– $1,000,000 estate, gift and GST exemptions• Note that the GST exemption will be indexed for inflation

– 55% rate

• Estates of decedents who died in 2010 (even after enactment) had theoption to elect out of the estate tax and into carryover basis


Portability

• 2011 and 2012 estate and gift tax exemptions areportable between married couples

• The Executor of a deceased spouse may transferany unused estate tax exemption to the survivingspouse

• Portability of GST Exemptions is NOT available


Extended Deadlines for 2010 Estates

• Estate tax return and payment due nine monthsafter date of enactment (December 17, 2010)– Special due date applies for decedents dying from January 1 to

December 16, 2010– Note that nine months from December 17, 2010 is September 17,

2011, which is a Saturday, so that the actual due date wasSeptember 19, 2011.

• Deadline for filing returns reporting generationskipping transfers similarly extended

• Deadline for disclaimers similarly extended


2010 Tax Relief GST Provisions

• 2010 Rules:– 0% GST tax rate– $5 million GST exemption– “Helpful” provisions of EGTRRA 2001 (automatic allocation rules,

qualified severance rules, 9100 relief) still available

• 2011 and 2012 Rules:– 35% GST tax rate– $5 million GST exemption– “Helpful” provisions of EGTRRA 2001 still available

• 2013 and Thereafter Rules:– 55% GST tax rate– $1 million GST exemption (indexed for inflation)– “Helpful” provisions of EGTRRA 2001 eliminated


GST Opportunities for 2011 and 2012• Unprecedented opportunity to use $5 million of

GST exemption– “Window” may close in 2013

– Consider funding new trusts

– Consider reciprocal trust issues

– Consider allocating exemption to old trusts that were too large tofully shelter from GST tax in prior years

• Take advantage of the “helpful” EGTRRA 2001provisions while they last– Qualified severance rules

– 9100 relief

– Warn clients of possible expiration of automatic allocation rulesfor indirect skip transfers

Copyright 2011 by Daniel L. Daniels. All rights reserved.

The Federal Generation Skipping Transfer Tax:

An Brief Overview, with Particular Attention to Issues Raised by the 2010 Tax ReliefAct

by

Daniel L. Daniels and David T. LeibellWiggin and Dana LLP

30 Milbank AvenueGreenwich, CT 06830

(203) [email protected]

www.wiggin.com

1\310\2568059.1


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FEDERAL GENERATION SKIPPING TRANSFER TAX

I. OVERVIEW

A. Purpose of the Tax

The purpose of the federal generation-skipping transfer tax (“GST Tax”) is toensure that property is subject to US transfer tax at each generational level.

B. Quick Review of GST Tax “Vocabulary”

The GST Tax employs a dizzying number of defined terms. For purposes of anintroduction to the tax, the most important of these terms are “taxable termination,”“taxable distribution,” “direct skip,” “skip person,” “non-skip person,” “transferor” and“inclusion ratio.”

1. Skip Person; Non-Skip Person. A skip person is a person assigned to thesecond generation or more below the transferor, e.g., a grandchild. A non-skip person isany person who is not a skip person.

2. Taxable Termination, Taxable Distribution and Direct Skip. These termsrefer to the three types of transfers to which the GST Tax applies. Although thedefinitions of these terms contained in the Code are predictably opaque, they are fairlyeasily understood by example.

(a) Taxable Termination. The Code defines a taxable termination asthe termination of an interest in property held in trust unless immediately thereafter anon-skip person has an interest in the property or unless thereafter no distributions maybe made to a skip person. IRC § 2612(a). Example: T creates a lifetime trust for C,remainder to GC. A taxable termination occurs on C’s death.

(b) Taxable Distribution. A taxable distribution is any distributionfrom a trust to a skip person other than a taxable termination or a direct skip. IRC §2612(b). Example: T creates a sprinkle trust for the benefit of C and GC for the life ofC, remainder to GC. Any distribution to GC during C’s life is a taxable distribution. AtC’s death, there is a taxable termination. If the trust continues for GC after C’s death,further distributions from the trust to GC are not taxable distributions.

(c) Direct Skip. A direct skip is a transfer subject to estate or gift taxof an interest in property to a skip person. IRC § 2612(c). Example: T transfers$100,000 outright to GC.

It is important to note that for taxable terminations and taxable distributions, theGST Tax is imposed on a “tax inclusive” basis, similar to the estate tax, in that thetaxable amount includes the GST Tax itself. For direct skips, on the other hand, the tax isimposed only on the amount actually received, similar to the gift tax. However, any GSTTax paid by the donor upon a direct skip is treated as an additional taxable gift.


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3. Inclusion Ratio. The GST Tax rate is the top estate and gift tax rate then ineffect multiplied by the “inclusion ratio,” if any. IRC § 2641. The inclusion ratio is afraction representing, in essence, the excess value of the property transferred over theamount of the transferor’s generation-skipping tax exemption (“GST Exemption”)applied to the transfer. Example: T transfers $1,000,000 to a trust for C, remainder toGC. At the time of the gift, T allocates $1,000,000 of his GST Exemption to the trust.Therefore, the trust has an inclusion ratio of zero. Although there will be a taxabletermination at C’s death, no GST Tax would be imposed because the trust has a zeroinclusion ratio.

If in the above example T had allocated only $600,000 of his GST Exemption tothe $1,000,000 transfer, the trust’s inclusion ratio would have been 0.4 (i.e., thedifference between the amount of the transfer [$1,000,000] and the amount of GSTExemption applied [$600,000], divided by the total value of the transfer [$1,000,000],equals $400,000/$1,000,000 equals 0.4). Accordingly, assuming a top rate of 35%, thetax rate applied at the time of the taxable termination would be 35% x 0.4).

II. BASIC DEFINED TERMS: “TRANSFEROR,” “INTEREST,” “SKIPPERSON,” “NON-SKIP PERSON,” AND “TRUST”

A. Transferor

1. In general. In general, the transferor of property for GST Tax purposes is(a) the decedent as to any property subject to the federal estate tax and (b) the donor as toany property subject to the federal gift tax. IRC § 2652(a)(1). However, if property isthe subject of a QTIP election under IRC § 2056 or § 2523, the transferor’s spouse isdeemed to be the transferor of the property for GST Tax purposes unless a special“reverse” QTIP election is made. The identity of the transferor is important indetermining (and planning for) whose GST Exemption is used and in determininggeneration assignments.

2. Change in Transferor Upon a Chapter 11 or 12 Event. The transferor is theperson who transfers property and with respect to whom the property was most recentlysubject to federal estate or gift tax. IRC § 2652(a)(1); Treas. Regs. § 26.2652-1(a)(1)1.Therefore, the identity of the transferor can change over time. Example: T transfersproperty to a trust for C in which C has an unlimited right of withdrawal after attainingage 30. If C dies prior to age 30, remainder to GC. At the date of the transfer, T is theGST transferor. If C dies prior to age 30, T remains the GST transferor. If C dies afterage 30, C becomes the transferor because the property is includible in C’s estate at thattime for federal estate tax purposes.

1 The inclusion of an insurance trust included in the transferor’s estate by reason of IRC § 2035 does notresult in a new transfer for GST purposes nor does it change the trust’s inclusion ratio. See Treas. Regs.§ 26.2652-4(a)(3).


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3. Transferor Move-Down Rule. Under IRC § 2653(a), if property continuesto be held in a trust after a generation skipping transfer, the transferor is treated as havingbeen moved down to the first generation above the highest generation of trustbeneficiaries. Example: T has used all of his GST exemption. She transfers $1,000,000to a trust for the benefit of her grandchildren and more remote descendants. T’s transferis a direct skip resulting in GST tax. Distributions to T’s grandchildren from the trustwill not be treated as taxable distributions because they are no longer skip persons withrespect to T. However, the a distribution to a great grandchild would be a taxabledistribution. Similarly, the death of all of T’s grandchildren, leaving only greatgrandchildren as trust beneficiaries, would be a taxable termination.

4. Gift Splitting. Gift splitting between husband and wife causes each to bethe GST transferor of one-half of the property. IRC §§ 2513, 2652(a)(2).

5. Reverse QTIP Election.

Recall that the GST transferor changes each time property is subject toestate or gift tax. Accordingly, if H leaves property in a QTIP trust for W, H is thetransferor of the property at his death, but W becomes the transferor at her death becausethe property is includible in her estate. With respect to QTIP property only, the creator ofthe QTIP trust may elect to treat the trust as if no QTIP election had been made forpurposes of determining the GST transferor. IRC § 2652(a)(3). In other words, in theexample above, H’s executor could elect to have H treated as the transferor of the QTIPtrust for GST purposes notwithstanding the fact that the QTIP property later will beincluded in W’s estate. This election is commonly referred to as the “reverse QTIP”election. The election must be made over the entire QTIP trust. Treas. Regs. § 26.2652-2(a). Planning pointer: Properly drafted QTIP trusts should always allow for a divisioninto QTIP and “reverse QTIP” shares to avoid creating a trust which is only partiallyGST-Exempt.2

B. Interest

1. In general. It is important to know who has an “interest” in a trust for GSTTax purposes because: (1) no taxable termination can occur as long as a non-skip personhas an “interest” in the trust; and (2) a trust will not be a “skip person” for purposes ofdetermining whether a direct skip has occurred as long as a non-skip person has an“interest” in the trust. In general, a person has an “interest” in trust property for GST Taxpurposes if the person has a present right to receive income or principal from the trust.

2 Under a transition rule, if a reverse QTIP election was made with respect to a trust prior to December27, 1995, the transferor (or his executor) may elect to treat the trust as two trusts, one with a zeroinclusion ratio and one with a one inclusion ratio. The reverse QTIP election is treated as applying onlyto the trust with the zero inclusion ratio. In order to be eligible for this transition rule, a statement mustbe attached to a copy of the return on which the reverse QTIP election was made (i) indicating that anelection is being made to treat the trust as two separate trusts and (ii) identifying the values of the twoseparate trusts. The statement must have been filed at the IRS office where the return was filed beforeJune 24, 1996.


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IRC § 2652(c)(1)(A). In addition, a person has an interest in the trust if the person is nota charity and is a permissible current recipient of the trust income or principal. IRC §2652(c)(1)(B). Generally, a future interest is not an “interest” for GST Tax purposesexcept for certain future interests in charities, as discussed below.

2. Charities. Special rules apply to determine whether a charity has an interestin a trust for GST Tax purposes. A charity may have an interest in a trust for GST Taxpurposes in two situations:

(a) Charity has a present nondiscretionary right to receive income orprincipal from the trust. IRC § 2652(c)(1)(A). Example: Charitable lead trust or a“nonqualified” charitable income trust.

(b) Charity is the remainderman of a CRAT, CRUT or pooled incomefund. Example: T creates a CRUT to pay a unitrust amount of 8% per year to GC,remainder to charity. The initial transfer to the trust is not a direct skip because the trustis not a skip person. However, the annual unitrust payments to GC will be taxabledistributions.

3. Future interests are not “interests” for GST Tax purposes. IRC §2652(c)(1)(C). (Except the interest of a charity as remainderman of a CRAT, CRUT orpooled income fund.)

4. Interests inserted in the trust primarily to avoid tax will be disregarded.IRC § 2656(c)(2).

5. Support Obligations. Suppose T creates a trust for the benefit of GC, aminor. Trust principal can be used to discharge C’s support obligation to GC. Before thefinal regulations were issued, there was a concern that C has an “interest” in the trust forGST Tax purposes, with the result that T’s transfer to the trust is not a direct skip and notax will be assessed until C’s support obligation ceases. However, the final regulationsclarify that an individual does not have an "interest" in a trust for GST Tax purposesmerely because a support obligation of that individual may be satisfied by a distributionthat is either within the discretion of a fiduciary or pursuant to a Uniform Gifts to MinorsAct or equivalent statute. Treas. Regs. § 26.2612-1(e)(2)(i).

6. Interest under a power of appointment. Suppose T creates a trust of whichGC is the only permissible income and principal beneficiary but GC has a power toappoint the trust property among T’s other descendants. Do the possible takers under thepower of appointment have “interests” in the trust for GST Tax purposes? If the powerof appointment is exercisable inter vivos, the answer may be “yes.” Possible takers undera testamentary power of appointment would not have an interest until the power wasactually exercised. In Estate of Eleanor R. Gerson v. Comm., 507 F.3d 435 (November9, 2007), the Sixth Circuit affirmed a Tax Court decision upholding regulations that treatas a separate taxable generation-skipping transfer the post-September 25, 1985, exerciseof a general power of appointment created under a trust that was irrevocable onSeptember 25, 1985. This has created a 2-2 split among the circuits on the grandfathering


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issue as it applies to the exercise of general powers of appointment contained ingrandfathered trusts. The 8th and 9th Circuits hold that the grandfathering rule isunambiguous and protects the taxpayer; the 2nd and 6th Circuits side with thegovernment. On May 27, 2008, the U.S. Supreme Court declined to review the SixthCircuit decision, which is now identified as Kleinman v. Commissioner, U.S., No. 07-1064, cert. denied May 27, 2008.

C. Skip Person; Non-Skip Person.

1. Skip Person.

(a) In general. A skip person may be either a natural person or a trust.A natural person is a skip person if assigned to the second or more remote generationbelow the transferor. A trust is a skip person if either (a) all interests in the trust are heldby skip persons or (b) no person holds an “interest” (for GST Tax purposes) in the trustand at no time after the transfer may a distribution be made to a non-skip person.

(b) Examples.

1. T creates a trust of which his grandchild, GC, is the only permissible incomeand principal beneficiary, remainder to T’s great-grandchildren. The trust is a skipperson.

2. T creates a trust for GC in which the Trustee is directed to accumulate theincome until age 21 and, thereafter, to pay the income to GC, remainder to GGC. At thetime the trust is created, GC is age 20. The trust is a skip person because at the time ofthe transfer no person holds an “interest” in the trust for GST Tax purposes and at notime after the transfer may a distribution be made to a non-skip person.

3. Same as the trust in example (2), except that on GC’s death, the trust propertypasses to GC’s then living descendants or, if none, to T’s then living descendants. Thetrust will not be treated as a skip person if the probability that a distribution “may” bemade to a non-skip person (i.e., if GC dies without descendants) is 5% or more. SeeTreas. Regs. § 26.2612-1(d)(2)(ii).

2. Non-Skip Person.

(a) In general. A non-skip person is a person or trust which is not askip person, that is, either (1) a natural person who is not assigned to the second or moreremote generation below the transferor or (2) a trust in which either (A) not all of theinterests are held by skip persons or (B) no person holds an “interest” but in which adistribution may be made to a non-skip person.

(b) Examples.


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1. T creates a sprinkle accumulation trust for C and C’s descendants for the lifeof C, remainder to GC. The trust is not a skip person because not all interests in the trustare held by skip persons.

2. T creates a trust for C in which the Trustee is directed to accumulate theincome until C attains age 30. At age 30, the entire trust principal is to be distributed toC. If C dies before attaining age 30, remainder to GC. The trust is a non-skip personbecause no person hold an “interest” in the trust at the time of the transfer but adistribution may be made to a non-skip person, C, if C survives to age 30.

3. T creates a trust to pay all income to GC, remainder to C. The trust is a skipperson because C’s remainder is not an “interest” for GST Tax purposes.

4. Same as example (3), except the remainderman is X Charity. The trust is askip person because X Charity’s remainder interest is not an “interest” for GST Taxpurposes.

5. Same as example (4), except that GC’s interest is a qualified annuity orunitrust interest. Under a special rule applicable to CRATs, CRUTs and pooled incomefunds, X Charity’s remainder interest is a GST Tax “interest” and, therefore, the trust is anon-skip person. However, the annuity or unitrust distributions to GC will be treated astaxable distributions for GST Tax purposes.

3. Crummey Trusts. Suppose T establishes a trust for the benefit of hischildren and grandchildren in which he gives simple Crummey withdrawal rights to eachof five grandchildren. An early Technical Advice Memorandum held that T’s transfers tothe trust constituted direct skips to the grandchildren holding Crummey withdrawalpowers. TAM 8901004. However, the regulations clarify that (a) a transfer to a trustsubject to a right of withdrawal is treated as a transfer to the trust and not as a transfer tothe holders of the withdrawal rights and (b) a transfer to a trust is only a direct skip if allinterests in the trust are held by skip persons. Treas. Regs. § 26.2612-1(f), Example 3.

D. Trust

1. In general. The regulations provide that a trust includes any arrangement(other than an estate) that has substantially the same effect as a trust. Treas. Regs. §26.2652-1(b)(1). Therefore, a trust can include not only the traditional trust agreementbut also arrangements involving life estates and remainders, estates for years andinsurance and annuity contracts if the identity of the transferee is contingent upon theoccurrence of an event. Id.

2. Example. T transfers cash to an UGMA or UTMA account in the name ofT's child, C, as custodian for T's grandchild, GC, a minor. The transfer is treated as atransfer to a trust. Treas. Regs. § 26.2652-1(b)(2), Example 1. The transfer shouldconstitute a direct skip even if C may use the funds to defray a support obligation. SeeTreas. Regs. § 26.2612-1(e)(2)(i).

III. GENERATION ASSIGNMENT


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A. Purpose

Generation assignments determine whether an individual is a skip person or anon-skip person. In turn, the determination of whether an individual is a skip person or anon-skip person determines whether there is a generation-skipping taxable transfer.

B. Generation Assignment is based either on family relationship or age

1. Family Relationship.

(a) A descendant of a grandparent is assigned to a generation bycomparing the number of generations between the descendant and the grandparent andthe number of generations between the transferor and the grandparent. IRC § 2651(b)(1).

(b) A present or former spouse of the transferor is assigned to the samegeneration as the transferor, regardless of the disparity between their ages. IRC §2651(c)(1).

(c) A descendant of a grandparent of a spouse or a former spouse ofthe transferor is assigned to a generation by comparing the number of generationsbetween the spouse and the grandparent with the number of generations between thedescendant and the grandparent. IRC § 2651(b)(2).

(d) A present or former spouse of a descendant of a either agrandparent or a spouse of a grandparent is assigned to the same generation as the samegeneration as the descendant. IRC § 2651(c)(2).

(e) A legally adopted person is treated as a blood relative of theadopting parent. IRC § 2651(b)(3)(A).

(f) If an individual can be assigned to more than one generation underthe above rules, he will be assigned to the youngest generation. IRC § 2651(e)(1).

2. Age. Persons not assigned to a generation by family relationship areassigned based on age relative to the transferor. IRC § 2651(d).

(a) Any person not more than 12-1/2 years younger than the transferoris assigned to the transferor’s generation. IRC § 2651(d)(1).

(b) Any person more than 12-1/2 years younger but not more than 37-1/2 years younger is assigned to the first generation below the transferor. IRC §2651(d)(2).

(c) Any person more than 37-1/2 years younger than the transferor isassigned to a second or succeeding generation below the transferor and, therefore, will bea skip person relative to the transferor. IRC §2651(d)(3).

3. Charities. Charities and governmental entities are assigned to thetransferor’s generation. IRC § 2651(e)(3).

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4. Chart Summarizing Generational Assignments.

Generation Assignment Family Relationship AgeTransferor's Generation Transferor; his Spouse; his

Siblings and TheirSpouses; and his Spouse'sSiblings and TheirSpouses; Charities andGovernmental Entities

Unrelated person who isnot more than 12-1/2 yearsyounger than the transferor

One Generation Below theTransferor

Transferor's and spouse'schildren, nephews, niecesand their spouses

Unrelated person who ismore than 12-1/2 yearsyounger but not more than37-1/2 years younger thanthe transferor

Two or More GenerationsBelow the Transferor

Transferor's and spouse'sgrandchildren,grandnephews, grandniecesand their spouses and moreremote descendants andcollaterals and theirspouses

Unrelated person who ismore than 37-1/2 yearsyounger than thetransferor.

IV. TAXABLE TRANSFERS

A. Taxable Terminations

1. In general. A taxable termination occurs when there is a termination of aninterest in property held in trust unless:

1. immediately thereafter a non-skip person has an interest in the trust; or

2. no distribution3 may thereafter be made to a skip person; or

3. a transfer subject to the federal estate or gift tax occurs at the time of thetermination, with the result that there is a new transferor for the trust. IRC § 2612(a)(1);Treas. Regs. § 26.2612-1(b)(1).

2. Examples.

3 Other than a distribution the probability of which occurring is so remote as to be negligible, i.e., if thereis less than a 5% probability that the distribution will occur.

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(a) T creates a trust to pay the income to C for life, remainder to GC.C’s death is a taxable termination. See Treas. Regs. § 26.2612-1(f), Examples 4, 8 and11.

(b) T creates a trust to sprinkle income and principal among C, GCand GGC. Upon the death of C, the remaining trust property is to be distributed to GGC.Therefore, at C's death, both C's interest and GC's interest terminate. Before the finalregulations were issued, it was unclear whether one or two taxable terminations occurredin this scenario. The final regulations clarify that only one taxable termination occurs.Treas. Regs. § 26.2612-1(f), Example 10.

B. Taxable Distributions

A taxable distribution is any distribution from a trust to a skip person otherthan a taxable termination or a direct skip. IRC § 2612(b). Example: T creates a trust inwhich the trustee is authorized to sprinkle the income and principal among C and GC.Any distribution of income or principal to GC during C's lifetime is a taxabledistribution.4 Treas. Regs. § 26.2612-1(f), Example 12. (The distribution to GC at C'sdeath would be a taxable termination.)

C. Direct Skips

A direct skip is a transfer to a skip person of property subject to the estate orgift tax. IRC § 2612(c).

Example 1: T gifts $1,000,000 to GC. The transfer is a direct skip subject toboth gift and GST Tax.

Example 2: T gifts $1,000,000 to a trust in which GC holds the only presentinterest. The transfer is a direct skip subject to both gift and GST Tax.

D. Predeceased Ancestor Exception

1. Pre-1998 Law

Prior to the Taxpayer Relief Act of 1997, under IRC § 2612(c)(2), if a child ofthe transferor or of the transferor's spouse predeceases the transferor, that child’sdescendants are “moved up” one generation for purposes of determining whether a directskip has occurred. In addition, under the final regulations, a parent will be deemed tohave predeceased the transfer in question if the parent does not survive the transfer bymore than 90 days and either local law or the governing instrument provides that theparent shall be deemed to have predeceased. Treas. Regs. § 26.2612-1(a)(2).

4 If the distribution is from income, an income tax deduction is available for the GST Tax paid. IRC§164(a)(4); 164(b)(4).

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2. Post December 31, 1997 Law

Under § 511 of the Taxpayer Relief Act of 1997, old section 2612(c) wasrepealed. In its place was enacted § 2651(e), which creates an expanded predeceasedancestor exception. Under the new law, effective for generation-skipping transfers madeafter December 31, 1997, the exception is available in the case of direct skips, taxabledistributions and taxable terminations as long as the predeceased ancestor was dead at thetime the transfer was first subject to estate or gift tax. In addition, the new law extendsthe benefits of the predeceased ancestor exception to grandnieces and grandnephews;provided, however, that this additional benefit is only available if the transferor had noliving descendants at the time of the transfer.

Example 1: T’s daughter, C, predeceases T, leaving GC surviving. Underboth the old and the new law, T’s gift of $1,000,000 to GC will be treated as a taxablegift for gift tax purposes but will not be treated as a direct skip for GST Tax purposes.

Example 2: T establishes an irrevocable trust providing for income to be paidto GC for 5 years. At the end of the 5 year period, the trust terminates and the trust isdistributed to GC. T's child, C, who is GC's parent, was deceased at the time of thetransfer to the trust. Therefore, under both the old and the new law, GC is treated as achild of T rather than a grandchild and the initial transfer to the trust is not a direct skip.In addition, under both the old and the new law, any distributions from the trust to GCwill not be taxable distributions. Treas. Regs. § 26.2612-1(f), Example 6.

Example 3: Same facts as Example 2 above, except that T's spouse, S, is alsoan income beneficiary of the trust. Since S has an interest in the trust, the trust is not askip person and the transfer is not a direct skip. Therefore, under old law, thepredeceased parent exception does not apply. Upon the expiration of the 5 year term ofthe trust, a taxable termination occurs. Treas. Regs. § 26.2612-1(f), Example 7. Underthe new law, the distribution to GC at the end of the trust term will not be a taxabletermination.

Example 4: Reverse QTIP Problem: T's Will establishes a reverse QTIPTrust for the benefit of S, remainder to T's child, C, if C is then living, otherwise to T'sgrandchild, GC. T dies survived by S, C and GC. C later dies and then S dies, with theresult that the remainder passes to GC. Even under the new law, the exception probablydoes not apply because C was not deceased at the time the trust was first subject to estatetax, i.e., T's death.

Example 5: Collateral Heirs: T transfers $1,000,000 to his brother'sgrandchild, GN on January 1, 1998. T's brother is deceased. If T has no livingdescendants on January 1, 1998, the transfer is not a direct skip. If T does have livingdescendants on January 1, 1998, the transfer is a direct skip.

E. GST Annual Exclusion/ GST Med-Ed Exclusion

1. GST “Annual Exclusion.”

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(a) A direct skip to an individual that qualifies for the gift tax annualexclusion, while not technically exempt from the GST Tax, will have an inclusion ratio ofzero, with the result that no GST Tax is imposed. IRC § 2642(c).

(b) A direct skip to a trust which qualifies for the gift tax annualexclusion will not have a zero inclusion ratio unless (i) the trust is exclusively for onebeneficiary during that beneficiary’s lifetime and (ii) the trust will be includible in thebeneficiary’s gross estate if he dies before termination of the trust. IRC § 2642(c)(2).

2. GST Med-Ed Exclusion.

(a) A direct skip transfer which qualifies for the gift tax exclusion fordirect payments of certain medical or education expenses, while not technically exemptfrom the GST Tax, will have an inclusion ratio of zero, with the result that no GST Tax isimposed. IRC § 2642(c)(3).

(b) Likewise, a transfer from a trust is not a taxable distribution if itwould qualify for the gift tax medical/education expense exclusion if made by anindividual. IRC § 2611(b)(1).

i. Example 1: T creates a trust for the benefit of C and GC,remainder to GC. Direct payment to the provider by the Trustee for GC’s medical oreducational expenses would not be a taxable distribution from the trust. If the Trusteemakes the payments to GC to be used for educational or medical expenses, thedistributions would be taxable distributions.

ii. Example 2: T creates a trust for the sole benefit of his fivegrandchildren, remainder to great-grandchildren. Although the Trustee’s direct paymentof educational or medical expenses would qualify for the GST med/ed exclusion, therewould be no need to use the exclusion: Because the initial transfer to the trust would be adirect skip, subsequent distributions from the trust to grandchildren would not be taxabledistributions. (Under the same principle, however, if distributions to great-grandchildrenwere permitted, these would be treated as taxable distributions.)

F. Gallo Exclusion- Expired

The Gallo exclusion provided that the GST Tax would not apply to directskips prior to January 1, 1990, to a grandchild to the extent the aggregate transfers to thatgrandchild by the transferor did not exceed $2,000,000.

V. GST EXEMPTION; INCLUSION RATIO

A. In General

1. Each individual has an exemption from the GST Tax (the “GSTExemption”). IRC § 2631(a). Under EGTRRA 2001, as modified by the 2010 TRA, theGST Exemption is as shown in the following chart:

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Year GST Rate GST Exemptionat Death

2001 55% $675,000/$1,060,000

2002 50% (and 5%surtax repealed)

$1,000,000/$1,060,000

2003 49% $1,120,000/$1,060,000

2004 48% $1,500,000/$1,500,000QFOBDrepealed

2005 47% $1,500,000/$1,500,000

2006 46% $2,000,000/$2,000,000

2007 45% $2,000,000/$2,000,000

2008 45% $2,000,000/$2,000,000

2009 45% $3,500,000/$3,500,000

2010 0% $5,000,0002011 35% $5,000,0002012 35% $5,000,0002013 55% $1,000,000/5

2. The exemption may be used for transfers during lifetime or at death. IRC§ 2632(a)(1).

3. Since only the transferor (or the transferor’s Executor) can allocate the GSTExemption, once a new transferor is determined with respect to any property, anyprevious allocation of GST Exemption is lost. See IRC § 2631(a).

Example: T leaves $1,000,000 to a QTIP trust for S. At S’s death, theproperty passes to a lifetime trust for T’s child, C, remainder to GC. At S’s death, theproperty is included in S’s estate under IRC § 2044 and S becomes the GST transferor ofthe property. IRC § 2652(a)(1). Therefore, T’s earlier allocation of GST Exemption to

5 Indexed for inflation. Estimated to be in excess of $1,340,000.

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the trust is wasted. If S does not allocate her own GST Exemption to the trust, a GSTTax will be due at C’s death.6

4. In general, an allocation of GST Exemption may be made at any timebefore the due date (including extensions) of the transferor’s estate tax return. IRC §2632(a)(1).

5. Valuation Rules.

(a) For lifetime transfers subject to the gift tax, if an allocation of GSTExemption is made on a timely-file gift tax return, the value of the property for purposesof allocating the GST Exemption will relate back to its value at the time of the transfer.IRC § 2642(b)(1); Treas. Regs. § 26.2642-2(a)(1).

(b) On the other hand, if the allocation is made on a late-filed gift taxreturn, the value of the property for purposes of allocating the GST Exemption will be itsvalue on the date the return is filed. IRC § 2642(b)(3); Treas. Regs. § 26.2642-2(a)(2).Given that it is often impossible to know the value of the property at the precise time thatthe return is filed, the regulations provide some relief for late allocations to transfers intrust. Under this rule, the transferor may elect to value property in trust as of the first dayof the month in which the gift tax return is filed. Treas. Regs. § 26.2642-2(a)(2). Theelection is made by stating the following on the gift tax return on which the allocation ofGST Exemption is made: (i) that the election is being made; (ii) the date on which theproperty was valued; and (iii) the fair market value of the trust assets on that valuationdate. Id. This special rule for late allocations does not apply to life insurance held in alife insurance trust if the insured individual has died. Id.

(c) In general, if GST Exemption is allocated to property included inthe transferor's gross estate, the value of property is its value as finally determined forfederal estate tax purposes. Treas. Regs. § 26.2642-2(b). Special rules are provided forvaluation of section 2032A special use valuation property, Treas. Regs. § 26.2642-2(b)(1), and for pecuniary payments, Treas. Regs. § 26.2642-2(b)(2) and (3).

(d) An "intentional" late allocation of GST Exemption can be a useful,albeit risky, technique in the case of a GST-Exempt Trust holding relatively new lifeinsurance.

Example: T creates a second-to-die life insurance trust designed to last inperpetuity. Annual premiums on the $2 million policy in the trust are $40,000. If Tmakes timely allocations of GST Exemption to the trust for, say, 3 years, he will haveallocated $120,000 of exemption. On the other hand, the value of the insurance policy at

6 Under the current version of Schedule R, it should no longer be possible to make this mistake.Schedule R provides that if GST Exemption is allocated to a QTIP trust, the reverse QTIP election isdeemed to have been made, with the result that the surviving spouse cannot become the transferor of thetrust and exemption is not wasted.

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the end of 3 years is likely to be far less than $120,000, e.g., $100,000. T could "gamble"and wait to make a late allocation of GST Exemption to the trust at the end of the threeyear period, thereby using only $100,000 of exemption to cover the full value of thepolicy.

Caveat: Beyond ensuring that T understands that this technique involvesgambling on his life expectancy, T's lawyer should be careful to ensure that the entireallocation of GST Exemption is a late allocation. For example, suppose that T paidpremiums as follows:

1/1/2005 $40,0001/1/2006 $40,0001/1/2007 $40,000

Assume that the value of the trust on 1/1/07 is $120,000 but that T makes anallocation of GST Exemption of $100,000 on April 1, 2007, intending it to be a lateallocation and that the value of the trust at that time is $100,000. However, thatallocation will be insufficient because it will be treated first as a timely allocation to thepremium payment made on 1/1/07 and as a late allocation to the balance. This results inan inclusion ratio for the trust of 6.67%. The calculation of this inclusion ratio is set forthin the footnote below.7

B. Automatic Allocation Rules

In some cases, the transferor’s GST Exemption will be allocated automaticallyto a transfer unless the transferor elects not to have the exemption allocated, as discussedbelow.

1. Lifetime Direct Skips. The transferor’s GST Exemption is automaticallyallocated to any lifetime direct skip in an amount sufficient to exempt the transfer fromthe GST Tax (or, in the amount of the transferor’s remaining GST Exemption if there isnot enough exemption left to exempt the entire transfer from the GST Tax). IRC §

7 Assume that the allocation of GST Exemption is made on April 1, 2007, and that the value of the trustat that time is $100,000. Assume, however, that the value of the trust at the time of the January 1, 2007,premium payment was $120,000. The first $40,000 of the allocation will be treated as timely.Therefore, immediately after that allocation, the trust has an applicable fraction of .333($40,000/$120,000) and an inclusion ratio of .667 (1- .333). The inclusion ratio for the trust as to thelate allocation is determined in accordance with Treas. Regs. § 26.2642-4(b), Example 2, as follows:The "non-tax" portion of the trust as of the late allocation date is the applicable fraction (.333) at thattime multiplied by the value of the trust at that time ($100,000), or $33,300. The numerator of the newapplicable fraction is the sum of the nontax portion ($33,300) plus the GST Exemption allocated late($60,000) or $96,000. The denominator of the new applicable fraction is the value of the trust at thetime of the late allocation ($100,000), resulting in an applicable fraction of .933 and an inclusion ratioof .067. Thus, 6.7% of the trust is still generation-skipping taxable.

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2632(b)(1). The transferor may elect out of this automatic allocation on a timely file gifttax return. IRC § 2632(b)(3); Treas. Regs. § 26.2632-1(b)(1)(i).

2. Order of Automatic Allocation at Death. To the extent that the transferor’sGST Exemption is not fully allocated by his Executor on a timely filed federal estate taxreturn (including extensions), the statute automatically and irrevocably allocatesexemption in the following order of priority:

First, to direct skips occurring at the transferor’s death. IRC § 2632(c)(1)(A).

Second, pro rata to any trusts from which a taxable termination or taxabledistribution may occur at or after the transferor’s death. IRC § 2632(c)(1)(B); Treas.Regs. § 26.2632-1(d)(2).

3. Automatic Allocation to “Indirect Skips.”

Effective for transfers after December 31, 2000, the law provides forautomatic allocation of generation-skipping transfer tax exemption (GST exemption) to anew class of transfers labeled “indirect skips.”8 An indirect skip is a transfer of propertythat is not a direct skip and which is made to a “generation skipping transfer trust” or“GST trust.” A GST Trust is a trust that could have a taxable termination or a taxabledistribution, unless one of the following exceptions applies:

(a) Exception 1: The trust instrument provides that more than 25% ofthe trust corpus must be distributed or may be withdrawn by one or more individuals whoare non-skip persons (a) before the date that the individual attains age 46, (b) on or beforeone or more dates specified in the trust instrument that will occur before the date thatsuch individual attains age 46, or (c) upon the occurrence of an event that, in accordancewith regulations prescribed by the Treasury, may reasonably be expected to occur beforethe individual attains age 46.

Master Example: T creates an irrevocable sprinkle trust for the benefit of hisspouse, S, and children. The trust instrument provides that the trust shallterminate upon the death of the survivor of T and S, at which time any remainingtrust principal will be distributed to separate, continuing trusts for each of T’sdescendants, per stirpes. The trust instrument provides that each descendant isentitled to withdraw 1/3 of his trust at age 30, an additional 1/3 at age 35 and thebalance at 40. (Under normal circumstances, this trust will be distributed outrightto children during their lifetimes and would not be intended as a GST vehicle).

Analysis: The children’s withdrawal rights do not come into being until the latterof (1) the death of the survivor of T and S and (2) the children’s attaining age 40.The death of the survivor of T and S is an event which may occur after the

8 These automatic allocation rules are contained in EGTRRA 2001 and, pursuant to TRA 2010, will berepealed as of January 1, 2013 unless Congress changes the law.

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children attain age 46; therefore, the trust instrument cannot be said to providethat more than 25% of the trust corpus “shall” be distributed to non-skip personsbefore they attain age 46. On the other hand, Exception 1 could shield the trustfrom deemed allocation if, under Treasury Regulations, the withdrawal ages setforth in the trust instrument are events that “may reasonably be expected to occur”before the individual attains age 46.

Example A: T creates an irrevocable trust for his child, C, funded with annualexclusion gifts. The trust instrument provides that C has the right to withdraw 1/3of the principal at age 35, an additional 1/3 at age 40 and the balance at age 45.The trust is not a GST trust and will not be subject to deemed allocation of T’sGST exemption.

Example B: T creates an irrevocable trust for his child, C, funded with annualexclusion gifts. The trust instrument provides that C has the right to withdraw25% of the trust principal at age 45. The trust is a GST trust because C does nothave the right to withdraw more than 25% of the trust before age 46. The trustwill be subject to deemed allocation of T’s GST exemption.

(b) Exception 2: The trust instrument provides that more than 25% ofthe trust corpus must be distributed to or may be withdrawn by one or more individualswho are non-skip persons and who are living on the date of death of another personidentified in the trust instrument who is more than 10 years older than such individuals.

Master Example Analysis: The trust does not fall within the literal terms ofException 2 because the trust property is not distributable to (or subject towithdrawal by) non-skip persons upon the death of the survivor of T and S.Rather, the trust property continues on in separate trusts.

Example C: T creates an irrevocable sprinkle trust for the benefit of his spouse,S, and T’s children. The trust instrument provides that the trust shall terminateupon the death of the survivor of T and S, at which time any remaining trustprincipal is to be distributed to T’s children. T and S are both more than 10 yearsolder than T’s oldest child. The trust is not a GST trust and no automaticallocation of T’s GST exemption will be made.

Query whether the result would be the same if the trust provided for a distributionto T’s “then living descendants, per stirpes” upon the death of the survivor of Tand S rather than a distribution to T’s children. In that event, because adistribution could be made to a grandchild if a child predeceased T and S, the trustmight not comply with the statute’s literal requirement that the trust instrumentprovide that more than 25% of the trust corpus “must be distributed” to non-skippersons upon the death of an individual more than 10 years older

(c) Exception 3: The trust instrument provides that if one or moreindividuals who are non-skip persons die on or before a date or event described inException 1 or 2 above, more than 25% of the trust corpus either must be distributed to

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the estate or estates of one or more of such individuals or is subject to a general power ofappointment exercisable by one or more of such individuals.

Master Example Analysis: Same issues as above.

Example D: T creates an irrevocable trust for his child, C, funded with annualexclusion gifts. The trust instrument provides that C has the right to withdraw 1/3of the principal at age 35, an additional 1/3 at age 40 and the balance at age 45.The trust instrument further provides that if C dies prior to withdrawing the entireprincipal of the trust, then the property subject to C’s withdrawal rights isdistributed as C shall appoint (including C’s estate) or in default of appointment,to C’s estate. The trust is not a GST trust and will not be subject to deemedallocation of T’s GST exemption.

(d) Exception 4: The trust is a trust any portion of which would beincluded in the estate of a non-skip person (other than the transferor) if such person diedimmediately after the transfer. “Flush language” indicates that withdrawal powers (e.g.,Crummey powers?) will be ignored if limited to annual exclusion amount.

Master Example Analysis: Depending on what is made of the “flush language,”this exception is likely inapplicable to the trust in the master example. Somecommentators suggest that a hanging Crummey amount may inadvertently triggerthis exception and avoid automatic allocation.

Example E: T creates an irrevocable trust for the benefit of his child, C, to last forC’s lifetime. Any trust principal remaining at C’s death is subject to C’s generalpower of appointment. The trust is not a GST trust. The result presumably wouldbe the same if C possessed a general power of appointment over only a portion ofthe trust.

(e) Exception 5: The trust is a charitable lead annuity trust, acharitable remainder annuity trust or a charitable remainder unitrust.

(f) Exception 6: The trust is a charitable lead unitrust and is requiredto pay the remainder to a non-skip person if such person is alive at the termination of thelead interest.

4. An individual can elect out of the automatic allocation rules on a timelyfiled gift tax return for the year in which the election is to become effective. The “opt-out” can be with respect to any or all transfers made to a particular trust. FinalRegulations on Election Out of GST Deemed Allocations, T.D. 9208, 70 Fed. Reg.37258-02 (6/29/2005).

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C. Retroactive Allocation of GST Exemption.

IRC § 2632(d), added by EGTRRA 20019, provides that generation-skippingtransfer tax exemption can be allocated retroactively where there is an unnatural order ofdeath. If a lineal descendant of the transferor predeceases the transferor, then thetransferor can allocate unused GST exemption to any previous transfer on a chronologicalbasis. For example, suppose a transferor creates a trust for the benefit of child until age35 providing that if the child dies prior to age 35, any remaining trust property will bedistributed to the child’s children (the grandchildren of the transferor). If the child diesprior to age 35 and the transferor is still living, the transferor can allocate exemption tothe trust to avoid a GST tax on the taxable termination that occurs at that time. Thetransferor is permitted to allocate based on the value of gifts made to the trust at the timethe gifts were made. The retroactive allocation rule is applicable only if the beneficiary:

i. Is a non-skip person;

ii. Is a lineal descendant of the transferor’s grandparent or agrandparent of the transferor’s spouse;

iii. Is a generation younger than the generation of thetransferor; and

iv. Dies before the transferor.

D. Relief for Late Elections.

1. In general. Under prior law, the allocation of generation-skippingexemption must have been made on a timely filed gift tax return in order for the donor tobe able to use the date-of-gift value for purposes of the allocation. If the allocation wasmade on a late-filed return, the donor generally was required to use the value as of thedate of the allocation. There was no statutory relief for an inadvertent failure to allocateexemption on a timely filed return. Effective for requests for relief pending on or filedafter December 31, 2000 EGTRRA 2001 authorizes the IRS to grant extensions of timeto allocate generation-skipping exemption. If such an extension is granted, the donor ispermitted to use the date-of-gift value rather than the value as of the date of theallocation.10

2. Notice 2001-50. Notice 2001-50, 2001-34 IRB 189 (8/20/2001), confirmsthat the procedure for obtaining relief for a late GST allocation election will be similar tothose used for “9100 relief” under Reg. § 301.9100-3. In general, the transferor must

9 Along with the rest of the GST changes made by EGTRRA 2001, pursuant to TRA 2010, this provisionsunsets after December 31, 2012.

10 This provision is contained in EGTRRA 2001 which, as modified by TRA 2010, will not apply after2012.

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show that he acted “reasonably and in good faith” under the circumstances. Reliance onadvice of counsel generally counts as acting reasonably and in good faith.

3. REG-147775-06 (4/26/2008). Proposed regulations were issued under Reg.§ 2642(g) to further describe the circumstances and procedures under which an extensionof time will be granted to individuals or estates who fail to make a timely allocation oftheir GST exemption. Notice 2001-50 will be made obsolete upon the adoption of thefinal regulations and relief will then only be available under the final regulations.

E. Substantial Compliance Rule Extended to GST Exemption Allocations.

Under pre-EGTRRA 2001 law, the substantial compliance rule did not applyto the allocation of GST exemption, meaning that, notwithstanding the donor’s intent thatexemption be allocated, a technical misstep in the mechanics of making the allocationcould frustrate that intent. Effective for transfers after December 31, 2000, the new lawprovides that the substantial compliance doctrine will apply to allocations of generation-skipping exemption. When requesting relief, the taxpayer must follow the procedures forrequesting a private letter ruling. In determining whether there has been substantialcompliance, all relevant circumstances will be considered, including evidence of intentcontained in the trust instrument and such other factors as the Secretary of the Treasurydeems appropriate.11

F. Inclusion Ratio

All generation-skipping transfers are taxed at a flat rate equal to the maximumestate and gift tax rate multiplied by the “inclusion ratio.” IRC §§ 2602, 2641. When atransferor allocates GST Exemption to a transfer, he reduces the inclusion ratio of theproperty or trust involved in the transfer and, therefore, reduces the tax rate. Therefore, itis not technically correct to state that an allocation of GST Exemption “exempts”particular property or a particular trust from the GST Tax. Rather, the allocation of GSTExemption reduces the tax rate (potentially to zero) that continues to apply to theproperty or trust as a whole.

1. Computation of the Inclusion Ratio--the “Applicable Fraction.” Theinclusion ratio is defined as 1 minus the “applicable fraction.” IRC § 2642(a)(1); Treas.Regs. § 26.2642-1(a). In general, the applicable fraction is a fraction, the numerator ofwhich is equal to the GST Exemption allocated to the trust or direct skip involved and thedenominator of which is the value of the property in the trust (or which is the subject ofthe direct skip), less any federal estate tax and state death taxes actually recovered fromthe trust and minus any charitable deduction property. IRC § 2642(a)(2).

11 This provision is contained in EGTRRA 2001 which, as modified by TRA 2010, will not apply after2012.

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(a) Example. T transfers $100,000 to a newly created irrevocable trustproviding that the trust income is to be paid to T’s child, C, for life, remainder to GC. Ona timely filed gift tax return, T allocates $40,000 of his GST Exemption to the transfer.

The applicable fraction with respect to the trust is .40, computed as follows:

GST ExemptionAllocated = $40,000 = .40Value of Trust $100,000

The inclusion ratio for the trust is .60, computed as follows:

Inclusion = 1 – Applicable = 1 - .40 = .60Ratio Fraction

Assuming a top estate tax rate of 35 percent, the tax rate applied to the taxabletermination occurring at C’s death is 21%, computed as follows:

GST Tax = Maximum Estate and = 35% x .60 = 21%Rate Gift Tax Rate x

Inclusion Ratio

Accordingly, if the value of the trust at C’s death is $600,000, a GST Tax inthe amount of $126,000 will be due ($600,000 x 21%). See Treas. Regs. § 26.2642-1(d),Example 1.

2. Recomputation of the Applicable Fraction Upon Addition To Trust.

(a) In general. Section 2642(d)(1) provides that the applicablefraction must be recomputed upon a transfer of property to an existing trust. In general,the numerator of the new applicable fraction is the sum of the amount of GST Exemptioncurrently being allocated to the trust, plus the "nontax portion" of the trust and thedenominator of the new applicable fraction is the value of the trust principal after the newtransfer to the trust. The recomputation is expressed by the following formula:

New Applicable Fraction =

(GST Exemption Allocated + "Nontax Portion")÷

([Value of property transferred less charitable ded. property] + value of all property in thetrust immediately after the new transfer).

For purposes of the above formula, the "nontax portion" of the trust is theproduct of the value of all property in the trust immediately before the new transfer andthe applicable fraction for the trust.

(b) Example. In 1995, T created a trust for the life of C, remainder toGC which he funded initially with $100,000 and allocated GST Exemption of $40,000 on

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a timely filed gift tax return. Therefore, at inception, the trust has an applicable fractionof .40 and an inclusion ratio of .60. In 1996, T adds another $50,000 to the trust when thetrust had a value of $110,000 before the addition. Therefore, the "nontax portion" of thetrust is $44,000 (i.e., $110,000 x applicable fraction of .40). If T allocates no GSTExemption to the trust, the new applicable fraction will be($44,000)/[$110,000+$50,000]) = $44,000/160,000 = .275 and the inclusion ratio will be.725. Thus, in order to cause an inclusion ratio of zero for the trust, T would be requiredto allocate $116,000 of GST Exemption at the time of the new transfer, as shown in thecomputation below.

Nontax portion of trust = $44,000

New Applicable Fraction = ($44,000+$116,000)/$160,000= ($160,000/$160,000) = 1

Inclusion Ratio = 1 - 1 = 0.

(c) Similar recomputation rules apply if additional exemption isallocated to the trust which does not effectively revoke a prior allocation of exemption.See Treas. Regs. § 26.2642-4(a), (b), Examples 1, 2 and 3.

(d) NB: The recomputation rules become significantly morecomplicated if GST Exemption is allocated at a time when it could apply as both a timelyallocation and a late allocation. See generally the examples contained in Treas. Regs. §26.2642-4(b), Examples 3 and 4 and footnote 4 of this outline.

G. Splitting Trusts to Cause a Zero or One Inclusion Ratio

1. The Case for "Pure" Inclusion Ratios. Ideally, a trust should have aninclusion ratio of either zero or one and not any number between zero and one. Forexample, suppose T leaves $2,000,000 at death to a trust permitting distributions to C andGC for the life of C, remainder to GC. Suppose T has only $1,500,000 of GSTExemption remaining. If the choice is available, T's Executor should divide the trust forC and GC into two trusts, one funded with $1,500,000 and one funded $500,000. T'sExecutor would allocate T's $1,500,000 GST Exemption to the first trust, causing aninclusion ratio of zero and would allocate no GST Exemption to the second trust, causingan inclusion ratio of one. This kind of planning would present the following advantages.

(a) Without the division of trusts, the single trust would have aninclusion ratio of .25, meaning that, assuming a top rate of 45%, an 11.25% GST Taxwould be imposed each time a distribution from the trust was made to GC and upon thetermination of the trust at C's death. By the same token, each time a distribution is madeto C from the trust, a portion of T's GST Exemption is wasted.

(b) With a division of trusts, all distributions to GC can be made fromthe zero inclusion ratio trust and all distributions to C can be made from the one inclusionratio trust.

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(c) With a division of trusts, the two trusts can be invested differently.Presumably, the zero inclusion ratio trust would be invested for growth, since allappreciation on that trust escapes estate and GST Tax at C's death. On the other hand, theone inclusion ratio trust might be invested for income to provide for distributions to Cduring C's lifetime. (Note that distributions directly to the service providers for GC'shealth and education could also be made from the one inclusion ratio trust without a GSTTax being imposed.)

(d) A "mixed" inclusion ratio trust requires the filing of a GST TaxReturn (gift tax return) each time a taxable distribution is made. This can addunnecessary delay and expense to the administration of the trust.

2. When Will Trusts Be Treated as Separate for GST Tax Purposes? It is notpossible to make an allocation of GST Exemption over only a portion of a trust.Therefore, in order to create “pure” inclusion ratios of either zero or one, it is oftennecessary to sever a trust into two trusts (or to treat a trust as two trusts), one with aninclusion ratio of zero and the other with an inclusion ratio of one. However, a singletrust will only be recognized as multiple trusts for GST Tax purposes under the followingrules.

(a) GST Exemption must be allocated to entire trust. If property isheld in trust, the allocation of GST Exemption must be made over the entire trust. Treas.Regs. § 26.2632-1(a).

(b) Separate Share Rule. A single trust will be treated as separatetrusts if it consists solely of separate and independent shares for different beneficiaries.Treas. Regs. § 26.2654-1(a)(1). Example: T creates an irrevocable trust providing thatone-half of the income is to be paid to T’s son, C, and one-half of the income is to be paidto T’s grandson, GC for 10 years. At the end of the 10 year period, the trust principal isto be distributed equally between C and GC. The trust will be treated as separate trustsfor GST Tax purposes, and T may allocate his GST Exemption differently as between thetwo trusts.

(c) Separate Share Must Exist From Inception of Trust. However, aportion of a trust is not a separate share unless that separate share exists at all times afterthe creation of the trust. Id. Example: T creates an irrevocable trust providing theTrustee with the discretionary power to distribute income and principal among T’schildren and grandchildren. The trust provides that when T’s youngest child attains age21, the trust will be divided into separate shares for each of T’s children, with each suchshare held in further trust for such child for life, remainder to such child’s children. Theseparate shares which come into existence when T’s youngest child attains age 21 are notrecognized as separate trusts for GST Tax purposes because the shares did not exist at theinception of the trust. Therefore, any allocation of T’s GST Exemption to the trust, eitherbefore or after T’s youngest child attains age 21, will apply to the whole trust. Treas.Regs. § 26.2654-1(a)(5), Example 8.

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(d) Pecuniary Payment from a Trust Can Be Treated as a SeparateShare. A right to receive a mandatory payment of a pecuniary amount at the death of atransferor from a trust that is included in the transferor’s gross estate or from atestamentary trust will be treated as a separate share if either (x) the Trustee is required topay “appropriate interest” to the person under Regs. § 26.2642-2(b)(4)(i); or (y) if thepecuniary amount is payable in kind on the basis of value other than the date ofdistribution value of assets, the Trustee is required to allocate assets to the pecuniarypayment in a way that fairly reflects net appreciation and depreciation in the value of thefund available to pay the pecuniary amount. Example: T creates a revocable trustproviding that, at T’s death, $500,000 is payable to T’s spouse, with the balance payableto T’s grandchildren. The trust instrument provides that the bequest to T’s spouse may besatisfied in non-cash assets at their values for federal estate tax purposes and does notrequire the Trustee to allocate assets to the bequest which fairly reflect net appreciationand depreciation in the entire revocable trust. The $500,000 bequest to T’s spouse willnot be treated as a separate share for GST Tax purposes and, therefore, any allocation ofT’s GST Exemption must be made over the entire revocable trust rather than only overthe property passing to the grandchildren. Treas. Regs. § 26.2654-1(a)(5), Example 4.

(e) Multiple Transferors to a Single Trust. If there are multipletransferors to a single trust, the portions of the trust attributable to different transferorsare treated as separate trusts for purposes of the GST Tax. Treas. Regs. § 26.2654-1(a)(2). Spouses using gift splitting are treated as separate transferors regardless of fromwhom the property was actually contributed. Treas. Regs. § 26.2652-1(a)(5).

3. When can a trust be severed to create separate trusts for GST Tax purposes.

(a) If the separate share rule applies under “b” through “e” above totreat a separate share as separate trusts for GST Tax purposes, any such separate sharemay be divided at any time into separate trusts to reflect that treatment. Treas. Regs. §26.2654-1(a)(3).

(b) If a trust is included in the transferor's gross estate or createdunder the transferor's will, a severance of the trust into two trusts will be recognized forGST Tax purposes if:

i. The trust is severed pursuant to a direction contained in thegoverning instrument; or

ii. The trust is severed pursuant to an authorization containedin the governing instrument or pursuant to local law, and

the terms of the each of the new trusts provide in the aggregate for the samesuccession of interests and beneficiaries as provided in the original trust;

the severance occurs (or the local law reformation proceeding is commenced)prior to the date prescribed for filing the federal estate tax return (including extensions)for the transferor's estate; and

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the new trusts are funded on a fractional basis or on a non-pro rata basis iffunding is based on either the fair market value of the assets on the date of funding or in amanner that fairly reflects net appreciation and depreciation in the assets from the date ofdeath until the date of funding.

(c) EGTRRA 2001 “Qualified Severance” Rules. Prior to EGTRRA2001, if an irrevocable trust had a fractional inclusion ratio, a division of the trust intotwo trusts, one with a zero inclusion ratio and one with a one-inclusion ratio, wasgenerally not permitted except for trusts funded at the transferor’s death. Effective forseverances occurring after December 31, 2000, IRC § 2642(a)(3) permitted a “qualifiedseverance” of a single trust into two or more trusts if (1) the single trust was divided on afractional basis and (2) the terms of the new trusts, in the aggregate, provided for thesame succession of interests of beneficiaries as was provided in the original trust. If thetrust had a fractional inclusion ratio, the severance would be respected for generation-skipping transfer tax purposes only if the single trust were divided into two trusts, one ofwhich received a fraction of the total assets equal to the applicable fraction of the singletrust immediately prior to the severance. In such a case, the trust receiving suchfractional share shall have an inclusion ratio of zero and the other trust shall have aninclusion ratio of one. The qualified severance rule is contained in EGTRRA 2001;pursuant to TRA 2010, this rule will no longer be available after December 31, 2012.

The severance must be reported on Form 706GS(T) “Generation SkippingTransfer Tax Return for Termination,” with “Qualified Severance” written on the top ofthe form and a Notice of Qualified Severance attached. The return and attached notice isdue on April 15 of the year following the year during which the severance occurred or bythe last day of the period covered by an extension of time, if an extenson of time isgranted, to file such form. Treas. Regs. § 26.2642-6(e)(1) (8/1/2007).12

H. The ETIP Rule

1. In general. Any allocation of GST Exemption to property subject to an"estate tax inclusion period" or "ETIP" is not effective until the termination of the ETIP.Treas. Regs. § 26.2632-1(c)(1). An ETIP is defined as the period during which, shoulddeath occur, the value of transferred property would be includible (other than by reasonof section 2035) in the gross estate of the transferor or the transferor's spouse. Treas.Regs. § 26.2632-1(c)(2).

(a) The ETIP rule does not apply to reverse QTIP trusts. Treas. Regs.§ 26.2632-1(c)(2)(C).

(b) A Crummey withdrawal power held by a spouse will not cause anETIP to arise if the withdrawal power is limited to the greater of $5,000 or 5% of the trustcorpus and if the power terminates no later than 60 days after the transfer to the trust.

12 The rules described above are repealed effective January 1, 2013 as a result of EGTRRA 2001’s sunsetprovision (as modified by TRA 2010).

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Treas. Regs. § 26.2632-1(c)(2)(B). This is a change from the Proposed Regulationswhich may allow greater use of traditional, single-life insurance trusts as generation-skipping vehicles.

(c) Property is not deemed to be includible in the gross estate of thetransferor or his spouse if the possibility that it will be included is so remote as to benegligible, i.e., if there is less than a 5 percent probability that the property would be soincluded. Treas. Regs. § 26.2632-1(c)(2)(A).

2. Purpose and Example. The purpose of the ETIP rule was to preventleveraging of GST Exemption through retained interest transfers, such as a QPRT. Forexample, in the absence of the ETIP rule, T could transfer his $500,000 residence into aQPRT, retaining the right to live in the residence for, say, 10 years, remainder to ageneration skipping trust for T's children and grandchildren. Due to T's retained interestthe value of the taxable gift might be only $250,000, thereby allowing T to remove a$500,000 asset from the GST Tax system at an "exemption cost" of only $250,000. TheETIP rule prevents this kind of planning by suspending the effectiveness of T's allocationof GST Exemption until the termination of the ETIP which, as discussed below, would bethe expiration of the 10 year term of the trust.

3. Termination of the ETIP. The ETIP terminates on the first to occur of thefollowing four events:

(a) The death of the transferor;

(b) The time at which no portion of the property would be includiblein the transferor's gross estate (without regard to IRC § 2035);

(c) The time of a generation-skipping taxable transfer, but only withrespect to the property involved in the generation-skipping transfer; and

(d) In the case of an ETIP arising by reason of an interest held by thetransferor's spouse, the first to occur of (i) the death of the spouse and (ii) the time atwhich no portion of the property would be includible in the spouse's estate (withoutregard to IRC § 2035).

Note: Under the Final Regulations for IRC § 2632(c), a transferor may electout of the automatic allocation rules for transfers subject to an ETIP at any time prior tothe due date of a federal gift tax return for the calendar year during which the ETIP closesregardless of whether any transfer was made in the calendar year in which the ETIPcloses.

VI. INCLUSION RATIO FOR CHARITABLE LEAD ANNUITY TRUSTS

A special rule applies to determine the applicable fraction (and, therefore, theinclusion ratio) for a charitable lead annuity trust (CLAT). Under Treas. Regs. §26.2642-3, in determining the applicable fraction for a CLAT, the numerator is the"adjusted GST Exemption" and the denominator is the value of all property in the trust

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immediately after the termination of the charitable lead annuity. The "adjusted GSTExemption" is defined as the amount of GST Exemption allocated to the trust increasedby an amount of interest equal to the interest that would accrue if the GST Exemptionwere invested at the interest rate assumed by the IRS in computing the value of thecharitable lead annuity, compounded annually, for the actual period of the charitable leadannuity. The amount of GST Exemption allocated is not reduced even if it is ultimatelydetermined that a lesser amount of GST Exemption would have produced a zeroinclusion ratio.

In Rev. Procs. 2007-45 and 2007-46, issued July 16, 2007, the IRS issuedsample trust provisions for inter vivos and testamentary CLATs, including sampleprovisions with suggested language to utilize when a skip person is a remainderbeneficiary.

VII. TAX BASE, COMPUTATION AND REPORTING

A. Taxable Terminations

The GST Tax on taxable terminations is imposed on a "tax-inclusive" basis,that is, the taxable amount includes the GST Tax itself. IRC § 2622. In this respect, theGST Tax on taxable terminations is similar to the estate tax. For example, suppose bothT and his son, C are in the top estate tax bracket, assumed to be 55% for this example. Ttransfers $1,000,000 to a generation-skipping trust for C, remainder to GC, but allocatesno exemption to the transfer. At C's death, a GST Tax of $550,0000 would be imposed.Similarly, if T had bequeathed the $1,000,000 outright to C, at C's death an estate tax of$550,000 would be due. Liability for the GST Tax on a taxable termination falls uponthe Trustee. IRC § 2603(a)(2).

B. Taxable Distributions

Although the statute states that the GST Tax on a taxable distribution isimposed upon the "amount received" by the transferee, the tax is effectively imposed on atax-inclusive basis because the transferee is liable for the tax. IRC §§ 2621, 2603(a).Thus, like the GST Tax on taxable terminations, the tax base for taxable distributions istax-inclusive.

C. Direct Skips

The GST Tax on direct skips is imposed only on the amount received and thetransferor is liable for the tax. IRC §§ 2623, 2603(a)(3). Therefore, the GST Tax ondirect skips is imposed on a tax-exclusive tax base. However, if the transferor does paythe GST Tax on the direct skip, the tax paid is considered to be an additional taxable giftby the transferor. IRC § 2515. For example, assuming a GST rate of 45%, if T makes a$1,000,000 gift to GC and allocates no GST Exemption to it, a $450,000 GST Tax is due.In addition, a gift tax will be imposed on the transfer of $1,470,000 by T. Assuming a45% gift tax, the gift tax due would be $652,500, resulting in total transfer taxes of$1,102,500.

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Note that if T had wished instead to provide a net $1,000,000 to GC via ataxable termination trust, T would have to fund the trust with $1,818,182. The$1,818,182 would have been subject to an initial gift tax of $818,182, and at C's death the$1,818,182 in the trust would be subject to a taxable termination tax, resulting in a net toGC of $1,000,000. Thus, to make this transfer of $1,000,000, it would take $2,454,545.

VIII. GST TAX ON TRANSFERS BY NON-RESIDENT ALIENS (NRAs)

Under the proposed regulations, it was possible for a transfer of non-U.S. situsproperty by an NRA (which would not be subject to gift or estate tax) nonetheless to besubject to GST Tax. The final regulations indicate that transfers by NRAs will be subjectto GST Tax only if they are subject to U.S. estate or gift tax. Treas. Regs. § 26.2663-2(b).

IX. THE EFFECTIVE DATE RULES

In general

1. All transfers after 10/22/86. The GST Tax applies to all generation-skipping transfers made after the date of enactment, October 22, 1986, subject to theexceptions noted at VII.A.3 below.

2. Lifetime Transfers after 9/25/85. In addition, the GST Tax applies tolifetime transfers occurring after September 25, 1985.

3. Exceptions. The GST Tax does not apply to:

(a) Transfers from trusts which were irrevocable on 9/25/85, to theextent not made out of principal added after that date or out of income on principal addedafter that date.

(b) Transfers under wills and revocable trusts in existence on 10/22/86if the decedent died before 1/1/87.

(c) Transfers from a person under a mental disability to change thedisposition of his property on 10/22/86, if he did not regain competence before death.

(d) "Gallo exclusion" transfers to a grandchild of the transferor madebefore 1/1/90, up to $2,000,000 per grandchild.

X. DYNASTY TRUSTS

A. Dynasty Trusts in general.

A “Dynasty Trust” is a trust designed to be effectively perpetual, thus benefitingmany generations. Such a trust is designed to obtain the greatest benefit from the donor’sapplicable exemption amount and lifetime exemption from the Generation-SkippingTransfer Tax.

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B. Trust situs.

In most of the 50 states, trusts are subject to the “Rule Against Perpetuities.” TheRule Against Perpetuities provides that a trust must terminate twenty-one years after thedeath of the last person who was alive at the creation of the trust. When the Rule AgainstPerpetuities requires that a trust terminate, the trust property comes into the hands of thethen living beneficiaries and becomes subject to transfer taxation in their estates and totheir creditors.

Several states, including Alaska, Arizona, Colorado, Delaware, Florida, Illinois,Idaho, Maryland, Maine, New Jersey, Ohio, Rhode Island, South Dakota, and Wisconsin,have effectively abolished their version of Rule Against Perpetuities.

C. Division of the Dynasty Trust.

The trust should eventually divide along family lines, and should continue todivide as each family line gets larger. This will allow for the appointment of trusteeswho are more familiar with the needs of each family line. This should also reduce therisk of family conflicts.

Most Dynasty Trusts provide that the initial trust will divide at the deaths of thefirst generation, and the trustee may also direct the trustee to divide the trust at any earliertime. At that time, a new subtrust will be created.

Each subtrust typically has a “Beneficiary” who is the head of the family line forwhom the new trust is created. Each trust is for the benefit of one Beneficiary and his orher descendants. Each trust divides into new trusts when the Beneficiary dies.

As the client’s descendants get older, they will likely gain increasingresponsibility over the administration of the trust established for their own family line.The client may wish to provide that each Beneficiary will become co-trustee of his or hertrust upon reaching certain ages. However, as discussed below in the “Flexibility”section, the clients can change these provisions (including the ages at which theBeneficiary would acquire these rights) at any time.

D. Distributions.

In general, there are two possible standards for the distribution of trust property ina Dynasty Trust: (1) the trustee may make distributions for the beneficiary’s health,education, support, and maintenance, and (2) the trustee may make distributions in hisdiscretion. A trustee who is also a beneficiary may only make distributions pursuant tothe first, more limited, standard. This limitation on the scope of the trustee’s discretion isnecessary to keep the trust property out of the trustee’s taxable estate (when the trustee isalso a beneficiary), but the trustee’s discretion is still broad enough to cover most, if notall, of the distributions that a client would want to make if he were able to control thedistribution of trust property. An independent trustee may also make distributions underthe second, broader standard.

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Although the first, limited, standard permits a trustee who is also a beneficiary tomake distributions, there are certain disadvantages to including this standard in a DynastyTrust. For example, because this standard is a more objective one, it can invite litigationin which beneficiaries sue the trustee to force a distribution they believe is required fortheir “health, support, or education.” In addition, creditors of the beneficiaries may beable to force the trustees to make distributions for the creditor’s benefit, on the theory thatit is part of the “support” of the beneficiary. Thus, there are advantages anddisadvantages of this distribution standard further. However, if the client wishes hisdescendants to be able to act as sole trustees, it will probably be necessary to include thismore limited standard.

E. Incentives.

The client may also include incentive provisions that instruct the trustee to beconservative in distributions and encourage the beneficiaries to remain self-supporting.The client may wish to simply make a statement of his intent to that effect, or mayinclude a variety of more rigid incentive provisions (e.g., a provision in the trust requiringthe trustee to “match” the earnings of the beneficiary by making an annual distribution tothe beneficiary equal to his earned income).

F. Flexibility.

Flexibility in a Dynasty Trust is absolutely necessary, because the trust isessentially perpetual.

1. Succession Plans

The first generation could be given the power in the Dynasty Trust to create plansof succession for the trustees of the trust. With some necessary restrictions (for taxreasons), this power would allow them to remove and replace trustees. These plans canbe very detailed, and can essentially amend the trustee succession provisions currently inthe trust. For example, they could change the ages at which a beneficiary becomes atrustee. Subject to the clients’ consent, beneficiaries might have the power to create theirown plans of succession for the trustee.

2. Trust Protector

A Dynasty Trust may provide that the trust may be amended by a specialfiduciary known as a “Trust Protector.” This fiduciary can be given very broad (or verynarrow) powers to change the terms of the trust. Using these powers, the Trust Protectorcan amend the trust to take into account any future changes in the tax laws, for example.In addition to certain amendment powers, the trust document might give the TrustProtector the ability to change the trust situs (for example, to move it to anotherjurisdiction if advisable).

3. Powers of Appointment

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A Dynasty Trust can provide additional flexibility by virtue of testamentarypowers of appointment granted to the grantor’s spouse (if she is a beneficiary) and theclients’ descendants. The spouse’s power often permits her to appoint any portion of thetrust to a charity or to one or more of the grantor’s descendants, either directly or in atrust for the descendants’ benefit.

The testamentary powers held by the client’s descendants ordinarily apply only tothe property held in their own subtrusts. Thus, if a beneficiary concludes that the trust isno longer serving his or her family’s interests, he or she can exercise that power ofappointment by will to make the Beneficiary’s share of the trust pass to the Beneficiary’schosen appointees (either directly or to separate trusts for their benefit, with terms chosenby the beneficiary).

4. Adding Beneficiaries

The Trust Protector is often given the power to add charities as beneficiaries ofthe trust. This power adds a great deal of flexibility, but also vests a great deal of powerin the Trust Protector.

XI. HEALTH AND EDUCATION TRUST

A. General description.

A Health and Education Trust (or “HEET”) is a perpetual trust with many of thesame characteristics as a Dynasty Trust. However, it is a Dynasty Trust that is notexempt from generation-skipping tax.

B. Non-exempt Dynasty Trust.

Because the trust is not exempt from GST tax, it is potentially subject to aconfiscatory 45% GST Tax. This tax would normally be incurred in only in twosituations:

1. Taxable termination.

As discussed above, a taxable termination would normally occur at the death of thelast member of the second generation.

2. Taxable distribution.

A taxable distribution could occur if the HEET made a distribution to any skipperson.

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C. Avoiding Taxable Terminations

The tax is imposed only when all “non-skip” beneficiaries are gone. To avoidthis, the HEET includes a perpetual non-skip beneficiary: a charity is an income andprincipal beneficiary (usually receives at least one-half of annual income).

D. Avoiding Taxable Distributions

Direct distributions from the HEET for health and education are exempt from tax(i.e., distributions that would qualify for the “med-ed” exclusion if they were madedirectly by a donor). Other distributions are permissible, but will be taxed if not to non-skip person.

Rather than make a distribution, the HEET could also make the capital of trustavailable in the form of loans and direct equity investments (the “Family Bank” or“Family VC Fund”).

XII. The Impact of the Tax Relief, Unemployment Insurance Authorization andJob Creation Act of 2010 (referred to in this outline as TRA 2010) on GenerationSkipping Planning and Compliance

A. Brief Summary of TRA 2010’s Transfer Tax Provisions

1. For 2010 decedents, the Act creates a “default rule” and an “optout rule.”

a. Under the default rule:

i. The estate tax rate is 35 percent.

ii. The estate tax exemption is $5 million.

iii. The estate’s assets received a stepped up basis equalto their fair market value as of the date of death (or thealternate valuation date) under the rules of IRC sec. 1014.TRA 201, sec. 301(a).

iv. Section 2664 of the Code, which repealed the GSTtax, is itself repealed; instead, the GST tax applies but at azero percent rate and with a $5 million GST exemption.

b. Under the opt out rule, the decedent’s executor can electout of the default rule, with the following results:

i. The estate tax does not apply to the estate.

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ii. The estate is subject to the modified carryover basisrules of Code sec. 1022. Those rules are as follows:

(A) “With respect to property acquired orpassing from the decedent,” such property is subject to carryover basis rather than astepped up basis at death.

(B) The executor may elect to add up to $1.3million of additional basis to such assets.

(C) With respect to such property passing to asurviving spouse or to a trust which would qualify as QTIP property for the survivingspouse, the executor may elect to add up to another $3 million of additional basis.

(D) The executor is required to file Form 8939(the “carryover basis report”) detailing the allocation of additional basis to the estateassets by the due date of the decedent’s final income tax return. IRC sec. 6075(a).

iii. The GST tax continues to apply to the estate, butwith a zero percent rate and a $5 million GST exemption. In addition, section 301(c) ofTRA 2010 provides, in substance, that, notwithstanding the opt out election, the decedentwill continue to be treated as the GST transferor of the estate assets for purposes of2652(a)(1) of the Code. This appears to have the following impact on 2010 decedents:

(A) It no longer appears possible to fundtestamentary dynasty trust with unlimited amounts of assetswithout the imposition of a current or future GST tax.Under EGTRRA 2001 prior to the enactment of TRA 2010,the estate of a decedent dying in 2010 was not subject tothe estate tax. Therefore, at least arguably, when a 2010decedent transferred assets to a dynasty trust, the trust hadno “transferor” for GST tax purposes and distributions fromthe trust could never be subject to GST tax, as described inthe footnote below.13

13 The transferor is the person who transfers property and with respect to whom such property was mostrecently subject to tax under Chapter 11 (estate tax) or Chapter 12 (gift tax). IRC sec. 2652(a)(1). Ifthe estate tax did not apply to the decedent’s estate, the property transferred by him at death was notsubject to an estate tax under chapter 11 and, therefore, the decedent fails to meet the definition of theterm “transferor” under code section 2652(a)(1). If a trust has no “transferor” then it is impossible forthe trust to have beneficiaries who are “skip persons” because a skip person is a person assigned to thesecond or more remote generation below the “transferor.” And, finally, if a trust has no skip persons asbeneficiaries, distributions from the trust can never be taxable distributions, taxable terminations ordirect skips for GST tax purposes.

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(B) Construction of GST formula bequestsunder wills of 2010 decedents will continue to beproblematic. If the language of the bequest gives “anamount equal to my unused GST exemption”, the bequestwould appear to be $5 million (for a decedent who has usedno GST exemption during life). On the other hand if thelanguage of the bequest gives “that amount which willproduce no GST tax,” the bequest arguably could be of theentire estate.

iv. The Act does not specify a due date for making theopt out election. It simply says that the election is to be made “at such time and in suchmanner” as the IRS shall prescribe. TRA sec. 301(c). One might assume that the duedate would be the same as the due date for the estate tax return under the default rule (see“c” below).

c. For decedents dying before December 17, 2010, TRA2010, sec. 301(d) extends various due dates as follows:

(i) The Act extends the due date for the estate taxreturn and for the payment of the estate tax until September 19,2011. The Act did not extend the time for filing the carryoverbasis report. Accordingly, that report continues to be due on thedue date for the decedent’s final income tax return.

(ii) The Act extends the time for making disclaimersuntil September 19, 2011.

(iii) The Act extends the due date for filing a returnreporting a “generation skipping transfer” made in 2010 underCode sec. 2662 until September 19, 2011. This would include areturn to make a timely allocation of GST exemption (or to opt outof the automatic allocation of GST exemption) to a direct skip ortaxable termination, but apparently would not include a return toallocate (or opt out of automatic allocation) to an “indirect skip”since an indirect skip is not a “generation skipping transfer”.

2. Also for 2010:

a. The gift tax exemption is $1,000,000.

b. The GST exemption is $5,000,000.

3. For 2011 and 2012:

a. The estate, gift and GST tax rate is 35 percent.

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b. The estate, gift and GST tax exemption is $5 million.

c. Estates are subject to the step up in basis rules of Code sec.1014.

d. There is portability of estate and gift tax exemptionsbetween spouses. Note that the GST exemption is not subject to the portability rules.

4. For 2013 and future years (unless Congress changes the law):

a. The estate and gift tax exemption reverts to $1,000,000.

b. The GST exemption reverts to $1,000,000, indexed forinflation.

c. The top transfer tax rate increases to 55 percent.

d. The helpful provisions of EGTRRA 2001 relating to theGST tax “sunset.”

B. Generation Skipping Planning and Compliance After TRA 2010

1. Zero Percent Rate. Section 2664, which had provided that thegeneration skipping tax would not apply to generation skipping transfers made in 2010, iseliminated. Instead, section 302(c) of TRA 2010 now provides that, for 2010 only, theGST tax rate is zero percent.

a. What is the difference between section 2664 – stating thatthe GST tax will not apply to generation skipping transfers in 2010—and TRA sec.302(c)—stating that the GST tax will apply, but at a zero percent rate? The keydifference is that section 302(c) makes clear that the transferor move-down rule shallapply to generation skipping transfers made in 2010. This eliminates an issue that hadbeen presented by former section 2664, as shown in the following example:

b. Suppose T died in 2010. His will made a bequest of assetsto a trust for the benefit of T’s grandchildren and more remotedescendants. Compare the tax results of T’s transfer to the trust: (i) underold section 2664 of the Code, and (ii) under TRA 2010.

i. Under Old Section 2664 (prior to TRA 2010).Under old section 2664 of the Code, there would have been noGST tax on T’s transfer to the trust because the GST tax did notapply to generation skipping transfers in 2010. Less clear,

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however, was the GST impact of a distribution to the grandchild ina year after 2010. A taxable distribution is a distribution from atrust to a “skip person.” IRC § 2612(b). Therefore, if thegrandchild is a skip person, the distribution is taxable. A skipperson is a person assigned to the second or more remotegeneration below the “transferor.” IRC § 2613(a). The“transferor” is the decedent “in the case of any property subject tothe tax imposed by chapter 11” and the donor “in the case of anyproperty subject to the tax imposed by chapter 12.” The propertytransferred to the trust was clearly subject to the tax imposed bychapter 12 (the gift tax), so the donor is the transferor. Therefore,generally speaking the distribution from the trust to the grandchildwould be a taxable distribution. However, an exception applies torelieve the distribution from tax if the “transferor move down rule”of IRC § 2653(a) applies. Under that section, if (a) there is a“generation skipping transfer of any property” and (b) immediatelyafter such transfer such property is held in trust then for purposesof applying chapter 13 to subsequent transfers from the trust, thetrust will be treated “as if the transferor of such property wereassigned to the 1st generation above the highest generation of anyperson who ha an interest in such trust immediately after thetransfer. Applying these principles to the example under pre-TRA2010 law yielded the following results:

A. The original gift of property to the trustwould appear to be a “generation skipping transfer” in thatit appears to meet the definition of a direct skip. A directskip is a transfer of property subject to estate or gift tax to askip person. The transfer is subject to gift tax and the trustwould be a skip person because all of its beneficiaries areskip persons.

B. Immediately after the transfer, the propertycontinues to be held in trust.

C. Therefore the requirements of the transferormove down rule appear to be met and any transfers fromthe trust to grandchildren should not be treated as taxabledistributions. (Note, however, that transfers from the trustto great grandchildren or more remote descendants wouldbe taxable distributions.)

D. However, under pre-TRA 2010 law, it waspossible that the transferor move down rule simply did not“exist” during 2010, by reason of section 2664 of the Code.Recall that, under section 2664 of the Code, “this chapter

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[chapter 13 of the Code] shall not apply to generation-skipping transfers after December 31, 2009.” If chapter 13in its entirety simply did not apply in 2010, then perhapsthe transferor move-down rule did not apply either.

ii. Under TRA 2010. Under TRA 2010, it is clear that thegeneration skipping transfer tax applies to transfers made in 2010. It is simply appliedwith a zero percent rate. As such, the transferor move down rule is clearly available and,therefore, a distribution to a grandchild from a direct skip trust funded in 2010 will notattract a GST tax. Note, however, that a distribution to a great-grandchild or more remotedescendant would attract a tax because such individuals would continue to be skippersons even after application of the transferor move down rule. This presents a planningopportunity for estates of 2010 decedents. For example, if the estate passes to a childwho does not need the entire inheritance, the child could consider disclaiming the assetsto grandchildren or to trusts for their benefit. TRA 2010 provides an extended period formaking such disclaimers, at least for purposes of federal disclaimer law.

2. “Temporary” $5 Million Exemption. For 2010, 2011 and 2012,the GST exemption is $5 million.

a. For 2010 outright direct skip gifts and taxable terminations,generally it will make sense to opt out of automatic allocation of GST exemption.Exemption allocated to such transfers in 2010 could be a waste of exemption.

b. For 2010 direct skip transfers in further trust, it may makesense to opt out of automatic allocation of GST exemption. For example, suppose Tmade a direct skip transfer to a trust for the benefit of his grandchildren and more remotedescendants in 2010. If an opt out election is made, the transferor move-down rule willprotect future distributions from the trust to the grandchildren from GST tax in the future.Distributions from the trust to great grandchildren and more remote descendants,however, would not be protected. Accordingly, the transferor (or his executor) will needto consider the purpose of the trust, and the likelihood of distributions to skip personbeneficiaries in determining whether or not to opt out of automatic allocation ofexemption.

c. It is now possible to allocate GST exemption to 2010transfers to indirect skip trusts. This was not possible prior to TRA 2010.

d. Given that the $5 million GST exemption may be availableonly for 2010, 2011 and 2012, planners should consider advising clients to allocateexemption to existing trusts now. For example, a client may have created a QPRT orGRAT in the past which has transferred assets to a long-term trust. Consider making alate allocation of GST exemption to such trust during 2011 or 2012 to “lock in” theexemption amount before it plummets in 2013.

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3. No Portability. While the estate and gift tax exemptions are “portable”between spouses, the GST exemption is not. Accordingly, married clients who wish tomake full use of their combined GST exemptions should ensure that (a) their estateplanning documents segregate the GST exempt amount of each spouse into anappropriate trust and (b) each spouse has assets in his or her name at least equal to the $5million GST exemption.

4. Temporary Extension of EGTRRA 2001’s Helpful GST ComplianceProvisions. The many helpful provisions of EGTRRA 2001 relating to the GST tax,including the automatic allocation rules for indirect skip transfers, the qualified severancerules and the availability of 9100-style relief for failure to make a timely allocation ofGST exemption are extended through December 31, 2012. Given that these rules areavailable only through December 31, 2012, planners should review client files beforeDecember 31, 2012 with the following in mind:

a. Consider filing qualified severances for trusts with mixed inclusionratios.

b. Consider making a 9100-style application for missed allocations ofGST exemption.

c. Consider retroactive allocations of GST exemption in appropriatecircumstances.

d. Warn clients of the possible demise of the automatic allocationrules as of January 1, 2013 and the need to file gift tax returns making anaffirmative allocation of exemption for 2013 and future years.

11029\12\2588756.1

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GENERATION SKIPPING TRANSFER TAX (GSTT) PLANNING First … · The Generation Skipping Transfer (GST) tax has been reinstated for tax year 2012 and beyond, but with certain changes