Generation-Skipping Transfer Taxes
The federal government imposes transfer taxes on gratuitous transfers, primarily in the form of gift and estate taxes. The government's objective was to impose transfer taxes on each generation, but before 1987, wealthy people avoided such transfer taxes by funding a dynasty trust, which would distribute income to its beneficiaries and even principal according to an ascertainable standard for generation after generation in perpetuity or until the rule against perpetuities ended the life of the trust. Although transfer taxes were imposed on the money to fund the trust, once they were paid, no additional transfer tax liability was incurred for as long as the trust persisted.
To prevent the above scenario, Congress, in the Tax Reform Act of 1986, enacted the generation-skipping transfer tax. The generation-skipping transfer (GST) tax (sometimes abbreviated as GSTT) is an additional transfer tax imposed on any transfer where the number of generations between the donor and the donee is greater than 1, as for instance, when a grandparent gives a grandchild a substantial gift, either while still alive or by will. The GST tax is additional, because it is in addition to the gift or estate tax.
Because the GST tax is an additional tax and is equal to the highest estate tax rate, the total tax paid can actually be greater than the amount given.
Generation Assignment: Skip or Non-Skip Person
To more effectively communicate the idea of the GST tax, the IRS Code distinguishes between a skip person and a non-skip person. A skip person is a donee who is 2 or more generations younger than the donor:
- in the case of a lineal descendent, a skip person would either be a grandchild or younger generation;
- for a collateral relative, the generation of the donee would be determined by subtracting the number of generations between the donee and the grandparent of the donor, who is also an ancestor of the donee minus 2;
- Example: a gift to your brother's grandchild would be considered to be a generation-skipping transfer because the grandchild is 4 generations below your grandparent who is also an ancestor of the donee, so 4 - 2 = 2.
- if the donor and donee are unrelated, then any donee who is at least 37½ years younger than the donor is considered to be a skip person.
A non-skip person is simply anyone who is not a skip person, and generally includes everyone in the donor's generation or one generation younger. However, special rules specify that anyone who was ever married to the donor is also considered to be in the donor's generation or any grandchildren whose parents are deceased at the time of the gift.
If the donee is a trust or estate, partnership, corporation, or some other entity, then the generation of the ultimate donee will determine if the gift is a generation-skipping transfer.
If 2 or more generation assignment rules pertain to an individual, then that individual will be classified to the youngest generation. Thus, if the grandparent adopted a grandchild, then the grandchild will still be considered a skip person, even though legally the grandchild is now the child of the grandparent.
Predeceased Ancestor Rule
The predeceased ancestor rule moves a skip person up one generation so that if the moved-up generation is within one generation of the donor, then there is no GST tax liability for any transfers to that person. The predeceased ancestor rule has the following provisions: IRC §2651
- Both the deceased parent and the child must be lineal descendents of the donor or the donor's spouse or the donor's previous spouse.
- Unless the donor has no lineal descendents in which case the deceased parent and child must be lineal descendents of the donor's grandparents.
- Example: a childless great aunt gives the daughter of her dead brother a gift that will be free of GST tax liability.
- Unless the donor has no lineal descendents in which case the deceased parent and child must be lineal descendents of the donor's grandparents.
- The deceased parent must have been dead at the time of the gift, even if the child only receives the gift later as a taxable termination or distribution from a trust.
Generation Assignment for Trusts
Any transfers to a trust that is considered to be a skip person is a direct transfer to a skip person, and therefore, the donor is subject to GST tax when the transfers are made.
The trust will only be considered to be a skip person if no non-skip person has a beneficial interest in the trust. For GST tax purposes, a trust interest is considered to be the right to receive principal or income or is a permissible current recipient. However, the interest in the trust rule cannot be circumvented if there is a negligible probability that a distribution will be made to that person or the interest is granted to an individual with the sole purpose of either postponing or avoiding the GST tax. A non-skip person will be treated as having an interest in the trust if either income or principal is used to satisfy that person's support obligation to a skip person and the disbursements to the skip person are mandatory. United States Code: Title 26,2651. Generation assignment
GST Exclusions and Exemptions
Generation-skipping transfers have the same exclusions as gifts. There is an annual exclusion that applies to all gifts that are less than the exclusion amount, which, in 2011, was $13,000. This exclusion amount is adjusted for inflation in $1000 increments. There is also an unlimited exclusion that applies to medical or educational services provided for the donee if the donor pays it directly to the providers of the service. Giving inter vivos gifts with values within the annual exclusion is an effective way to reduce gift, estate and GST taxes.
The federal government also provides a lifetime unified tax credit that exempts a specific amount from gift or estate taxes by offsetting the tax with the credit. A separate exemption (IRC §2631) is available for the GST tax that allows an amount of property to pass tax-free that is equal to the estate tax exemption, which, for 2010 only, is unlimited. In 2011 and 2012, the exemption amount is $5 million for gift or estate transfers, and an additional $5 million for generation-skipping transfers.
|For Gift Tax Purposes:||For Estate Tax Purposes:|
|2010||345,800||1,000,000||No estate tax, but no step-up|
in property basis.
|2006 - 2008||345,800||1,000,000||780,800||2,000,000|
|2004 - 2005||345,800||1,000,000||555,800||1,500,000|
|2002 - 2003||345,800||1,000,000||345,800||1,000,000|
The unified tax credit is unified because it applies to all gratuitous transfers by a donor. For instance, if the tax credit is used to exempt a gift, then this reduces the remaining credit that can be applied to later gift or estate transfers. However, a married couple can elect to split a gift, even if the actual gift is given by only 1 spouse, so that the exemptions of both spouses can be used.
Example — The Relationship Among the Gift, Estate, and GST Tax
In 2009, the exemption amount was $3,500,000 for estate and an equal amount for generation-skipping transfers, while the exemption for gift taxes remained $1,000,000. You give your grandson $3,513,000 as a gift. Because there is a $13,000 annual exclusion for gifts for every year and for each donee, even if the donee is a skip person, you can deduct it before applying your exemption and calculating your tax.
Case 1: You can use your GST exemption to avoid liability on the GST tax. However, because the gift tax exemption is only for $1,000,000, you must pay the gift tax rate of 45% on the remaining $2,500,000. Your grandson gets the $3,500,000, but you must pay $1,125,000 in gift taxes. You have no more exemptions for the GST tax, but you still have $2,500,000 exemption amount that can be applied to your estate when you die.
Case 2: You and your wife agree to split the gift of $3,500,000, even though all of the money comes from you. In this case, you and your wife have a total of $2,000,000 of exemptions available that can apply to the gift tax, so that you only have to pay the 45% gift tax on $1,500,000, which is equal to $675,000. You not only pay a lower tax, but if you had died in 2009, your estate would have had a $2,500,000 exemption that could be applied to your estate, allowing that much to pass free of estate tax. Your wife's exemption amount for estate taxes is also reduced by $1,000,000 because of the gift-splitting.
Case 3: In 2011, when the lifetime exemption amount for all transfer taxes is $5,000,000, Paul, who has not previously used any exemption credit, gives his granddaughter $10,000,000. The 1st $5,000,000 is exempt from gift taxes because of the unified credit and is also exempt from GST tax, using the GST credit. However, the 2nd $5,000,000 incurs both a gift tax and a GST tax. Paul dies in 2012 and leaves his grandson $10,000,000. The entire $10,000,000 is subject to both estate and GST taxes. There is no exemption for the estate tax because the unified credit was used for the inter vivos gift.
Allocating the GST Tax Exemption
The IRS provides deemed allocation rules that automatically apply the donor's GST tax exemption to direct skips unless the donor opts out by timely filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The allocation determination becomes irrevocable either after the due date for the return if the gift was taxable or when the election was made.
The automatic allocation rules also apply to gifts on the amounts over the annual exclusion.
Deemed allocation rules also apply to indirect skips to a GST trust, which is defined as any trust that could have a generation-skipping transfer unless at least 25% of the trust corpus is either distributable to non-skip persons or is included in their estate or is subject to a general power of appointment by a non-skip person.
If deemed allocation rules do not apply, then the donor can apply her GST exemption by filing the gift tax return for every year that a transfer is made to the trust and claiming the GST exemption and it's amount on the gift return, which must be done even if no gift tax return would otherwise be required.
A retroactive allocation of the GST exemption can also be made to trust property if the original beneficiary, who was not a skip person, has died and the donor changes the beneficiary to a skip person where both the decedent and the skip person must be lineal descendents of the grandparent of the donor, donor's spouse, or donor's previous spouse. Deemed allocation rules then apply to previous transfers to the trust that would've gone to the decedent. The retroactive allocation must be made on the gift tax return by the due date for the year when the decedent had died and the value of the transfer is the value when the property was transferred to the trust.
Because the GST tax exemption is applied to the property when it is transferred, any appreciation of the property is also covered by the GST exemption. Thus, if the property is placed in a trust for later distributions to skip persons, then any appreciation of the property is also covered by the GST exemption.
Estate Tax Inclusion Period (ETIP)
Certain transfers that are direct skips, but where the donor has retained an interest in the property, receive special treatment. If the transferred property would have been includible in the donor's estate if the donor had died immediately after the transfer (for a reason other than the donor having died within 3 years of making the gift), the direct skip will be treated as having been made at the end of this estate tax inclusion period (ETIP) rather than at the time of the actual transfer. So, for instance, no GST exemption can be applied to any property in a grantor-retained interest trust.
For example, if A transferred her house to her granddaughter, B, but retained the right to live in the house until her death (a retained life estate), the value of the house would be includible in A's estate if she died while still holding the life estate. In this case, the transfer to B is a completed gift, since it is a transfer of a future interest, but the GST portion of the transfer would not be reported until A died or otherwise gave up her life estate in the house.
GST Tax Rate, Applicable GST Exemption, and GST Tax Liability
The GST tax is equal to the maximum estate tax rate, which, in 2009, was 45%, and for 2011 - 2012, it will be 35%, then 40% for 2013 and thereafter:
|2011 - 2012||35%|
When the donor transfers the property as a gift, then the donor is liable for the GST tax, which, like the gift tax, is tax-exclusive — the donor pays the tax separately from the gift. However, a taxable termination or taxable distribution from a trust is tax-inclusive, in that it is taxed in the same way as the estate is taxed — the tax amount is included in the value of the property taxed.
The GST tax is levied when the distribution to the skip person is made. In the case of a direct skip, where the donee receives the gift directly from the donor, the tax liability is incurred when the transfer takes place. However, if the donee is only to receive the gift in the future, then the tax liability is incurred when the donee receives the gift and the tax is paid by the skip person. There are 2 types of transfers that are considered to be indirect skips, which are subject to GST tax: taxable terminations of a property interest, where a termination of a property interest causes the property to transfer to a skip person, and taxable distributions from a trust to a skip person.
The trustee is liable for the payment of the GST tax for a taxable termination. However, the beneficiary is liable for the payment of a taxable distribution, which is assessed on the amount that is distributed to the beneficiary. If the trust pays the GST tax, then that amount is added to the distribution to the beneficiary.
The applicable GST tax rate for a taxable termination or distribution is the tax rate in effect when the distribution is made. However, the GST exemption amount is the amount that was current when the trust became irrevocable, usually when the donor died.
Calculating the GST Tax Using the Inclusion Ratio and Applicable Fraction
The GST tax rate is applied on the amount of the property that has not been allocated the GST exemption by the donor or by deemed allocation rules. The IRS uses the following calculations to determine the GST tax for transferred property worth more than the GST exemption:
(1) Determine the applicable fraction, which is the fraction of the property that the GST exemption is applied to, and, therefore, is not subject to GST tax.
|Applicable Fraction =||Allocated GST Tax Exemption|
Property Value - Estate Taxes Paid on Property - Allowable Charitable Deductions
(2) Determine the inclusion ratio, which is the property value that will be subject to the GST tax, by subtracting the applicable fraction from 1.
Inclusion Ratio = 1 - Applicable Fraction
(3) Calculate the GST tax by multiplying the property value times the inclusion ratio times the GST tax rate. Note that by subtracting estate taxes paid on the property plus allowable charitable deductions from the property value in the denominator increases the applicable fraction, which decreases the inclusion ratio and, therefore, the GST tax.
GST Tax = Property Value x Inclusion Ratio x GST Tax Rate
- Estate taxes include both state and federal estate taxes.
- For property placed in a trust for eventual distribution to a skip person, the proportion of the property to which the GST exemption will apply will remain the same even if the property appreciates.
- Example: in 2008, $4 million is placed into a trust for a skip person and the donor applies the $2 million GST exemption at the time the trust is funded. In 2012, the trust property has appreciated to $8 million when it is distributed to the beneficiary. Since 50% of the trust property was covered by the GST exemption when it was originally funded, the GST exemption still applies to 50% of the property when it is distributed in 2012; hence, only $4 million in the trust property will be subject to GST tax.
- The applicable GST tax rate is the rate that was in effect when the skip person receives the property — not when the property was transferred to the trust. So, in the above example, the skip person pays the 35% GST tax rate that was in effect in 2012 rather than the 45% rate that was in effect in 2008 when the trust was funded.
- A trust can also be divided into 2 – one with property with an inclusion ratio of 1 and the other with an inclusion ratio of zero. In this case, the entire amount in the first trust is subject to GST tax and the entire amount in the 2nd trust is covered by the GST exemption. However, the division must be a qualified severance in which the trust is divided fractionally under the provisions of the trust document or state law and both resulting trusts provide for the same succession of interests of beneficiaries.
- United States Code: Title 26,2642. Inclusion ratio
Example — Calculating the GST Tax
A grandfather puts $4 million into a trust for his granddaughter in 2009, which is his total estate when he dies later that year. Both the $2 million tax exemption for estates and the $2 million exemption for the GST tax are applied to the trust property at the time death. His executor paid 45% of $2 million, or $900,000, in estate taxes to the federal government, leaving a total of $3,100,000 in the trust for the granddaughter. The granddaughter receives the property in 2011, when the GST tax rate was 35%.
|Inclusion Ratio = 1 -||$2,000,000|
$4,000,000 - $900,000
|= 1 -||$2,000,000|
|= 1 - 0.65 = 0.35|
GST Tax = $4,000,000 x 0.35 x 0.35 = $490,000
Granddaughter's Actual Gift = $3,100,000 - $490,000 = $2,610,000
Note that if the grandfather had no GST exemption to apply to the gift, then:
- Applicable Fraction = 0
- Inclusion Ratio = 1 - 0 = 1
- GST Tax = Transferred Value x GST Tax Rate = $4.000,000 x 0.35 = $1,400,000
- Granddaughter receives $3,100,000 - $1,400,000 = $1,700,000
If the grandfather also did not have the estate tax exemption to apply, then the granddaughter would have received significantly less:
- Estate Tax = $4,000,000 x .45 = $1,800,000
- GST Tax = $4,000,000 x .35 = $1,400,000
- Granddaughter receives:
- Original Estate Value - Estate Tax - GST Tax
- $4,000,000 - $1,800,000 - $1,430,000 = $770,000!
So, you can see why the wealthy try to avoid the GST tax!
Examples of Incurring and Paying the GST Tax
A donor, who has used up his lifetime gift and estate tax exemption and GST exemption, decides to give his grandchild $1 million in 2011. For cases 2 and 3, it is assumed that the executor or the trustee has enough funds to pay the estate tax, leaving $1 million to be distributed.
- Case 1: The donor gives the grandchild the gift directly. The grandchild receives $1 million and the donor pays $350,000 for the gift tax and $350,000 for the GST tax.
- Case 2: The donor, through his will, gives his daughter a life estate in property worth $1 million with the property going to his grandchild when she dies. The executor of the donor's estate must pay $350,000 for the estate tax on the value of the property. When the grandchild receives the property after his mother's death, he will have to pay $350,000 for the GST tax. However, there is no estate tax for the property when the mother dies, because she never actually owned it, since her interest in the property terminated with her death.
Note that in Case 1, the grandchild receives the entire $1 million because the donor pays the taxes (tax-exclusive), but in Case 2, the donee receives only $650,000, since he has to pay the GST tax out of what he received (tax-inclusive).
Example of Applicable GST Tax Rate and Exemption Amount
In 2008, the will of a donor, who has not used any exemptions, leaves an estate worth $10 million and creates a generation-skipping transfer trust to hold the property. The income will be paid to his daughter during her life and the trust principal will be distributed to his grandchild after her death. The daughter dies in 2011, then her son receives the trust principal.
Tax Analysis: In 2008, the estate and GST exemption amount was $2,000,000 and the top estate and GST tax rate was 45%. In 2011, the GST tax rate was 35%. To simplify, assume that there were no debts, expenses, or other deductions:
- Estate Tax Paid for 2008 = .45 x (10,000,000 - 2,000,000) = $3,600,000.
- GSTT Trust Fund = 10,000,000 - $3,600,000 = $6,400,000
- Inclusion Ratio = 1 - (2,000,000 / (10,000,000 - $3,600,000) = 1 - .31 = .69
- GST Tax Paid in 2011 by Trustee for Grandson = 10,000,000 x .69 x .35 = $2,415,000
- Grandson Gets $6,400,000 - $2,415,000 = $3,985,000
Note that even though the GST exemption amount in 2011 was $5 million, the grandson could only use the $2 million exemption since that was the applicable exemption amount when the trust was funded, but he only had to pay the 35% GST tax rate that was current when he received the property rather than the 45% rate that was in effect when the trust was funded. Because it was a taxable termination, it is the trustee's duty to pay the tax out of the trust funds. If the trust wasn't terminated, but simply distributed the amount to the grandson, then it would be the grandson's duty to pay the tax.