Eighth Circuit allows exception to GST tax.

In Simpson, 7/23/99, the Eighth Circuit ruled that a transfer to grandchildren made in 1993 under a trust that was irrevocable on Sept. 25, 1985, was not subject to the 55% generation-skipping transfer (GST) tax. Crucial to this ruling was the exercise (as opposed to the lapse) of a general power of appointment over the entire portion of the trust subject to the power. Therefore, Simpson is important because affected taxpayers must take appropriate action to avoid the GST tax.

First enacted in 1976, the GST tax was repealed retroactive to 1976 by the Tax Reform Act of 1986 (TRA '86). However, the TRA '86 contained a new version of the GST tax, which taxes GSTs at the highest estate and gift tax rate (currently, 55%).The GST tax and the estate or gift tax can apply to the same transfer. Sec. 2611 (a) specifies three types of GSTs--taxable distributions, terminations and direct skips. All three involve "skip persons," who are natural persons two or more generations below the transferor (Sec. 2613(a)(1)). There is a $1 million exemption per transferor, indexed for inflation after 1998 (Sec. 2631). The rationale for the GST tax is to tax transfers that try to avoid estate and gift taxes by skipping a generation.

The GST tax generally applies to transfers made after Oct. 22, 1986. However, under Section 1433(b)(2)(A) of the TRA '86, it does not apply to any transfer under a trust that was irrevocable on Sept. 25, 1985, "but only to the extent that such transfer is not made out of corpus added to the trust after September 25, 1985." This grandfather provision protects the reliance interests of trust settlers who established irrevocable trusts before the legislative introduction of the GST; the prohibition on additions prevents abuses. Temp. Regs. Sec. 26.2601-1(b)(1)(v)(A) also prohibits constructive additions. The regulation states, "where any portion of a trust remains in the trust after the release, exercise, or lapse of a [general] power of appointment over that portion of the trust...the value of the entire portion of the trust subject to the power that was released, exercised, or lapsed will be treated as an addition to the trust." (This does not apply to special powers of appointment; see Temp. Regs. Sec. 26.2601-1 (b) (1) (v) (B).)

Example: In June 1980, H established a $500,000 irrevocable trust, providing income to his wife W for life and the remainder to their grandchild. W has a general power of appointment over half of the trust assets, which were valued at $1,500,000 at her death in 1989. W did not exercise the power. This lapse is treated as if $750,000 was distributed to W and then transferred back to the trust on the day she died. Because this constructive addition occurred after Sept. 25, 1985, it is subject to the GST tax (Temp. Regs. Sec. 26.2601-1 (b)(1) (v) (D), Example 1).

In the only prior case on Temp. Regs. Sec. 26.2601-1(b)(1)(v)(A) (Peterson Marital Trust, 102 TC 790 (1994), aff'd, 78 F3d 795 (1996)), Peterson's will created a trust that provided income to his wife, Eleanor, and the remainder to his grandchildren. Eleanor received a general power of appointment by will over the trust corpus. She exercised the power only to pay estate taxes. Peterson died in 1974, and Eleanor died in 1987. The Tax Court ruled that, because Eleanor did not exercise her general power of appointment in full, the unexercised (or lapsed) portion of the trust, which passed to the grandchildren, was subject to the GST tax as a post-Sept. 25, 1985 constructive addition. The court also ruled that the regulation was valid. The Second Circuit affirmed.

In Simpson, Simpson's will created a trust that provided income for life and a general power of appointment by will to his wife, Mary. She exercised the power over the entire trust corpus in favor of her grandchildren. Simpson died in 1966, and Mary died in 1993. The district court first ruled that Mary's exercise of her general power of appointment was not a constructive addition to the trust corpus, because her exercise of the power left nothing in the trust. Nevertheless, the court then ruled that the TRA '86's grandfather provision did not apply, because Mary could have exercised the power in favor of nonskip persons until her death in 1993. Therefore, the trust property was not irrevocably required to be distributed to the grandchildren on Sept. 25,1985, and the transfer to the grandchildren was subject to the GST tax. (Given this ruling, it is unclear in what situation the district court would allow the grandfather provision.)

The Eighth Circuit reversed. The court first ruled that the grandfather provision applies to a trust that was irrevocable on Sept. 25, 1985, not a GST that was irrevocable on Sept. 25, 1985. Therefore, the fact that Mary could have given the property to nonskip persons after Sept. 25,1985 was irrelevant. The court then ruled that the lapse of the power in Peterson was distinguishable from the exercise of the power in Simpson. There was no portion of the trust remaining after Mary's exercise of her power, and no regulation governs the exercise of a power that transfers the entire corpus. Therefore, the TRA '86's grandfather provision exempted the transfer to Mary's grandchildren from the GST tax. Because trust property was transferred to grandchildren under general' powers of appointment in Peterson and Simpson with opposite GST tax consequences, Temp. Regs. Sec. 26.26011 (b)(1)(v) (A) illustrates form over substance.

Trusts irrevocable on Sept. 25, 1985 that contain a general power of appointment are affected by Simpson if trust property is distributed to skip persons. In the Eighth Circuit, if the power is exercised over the entire corpus, the constructive addition problem is avoided, and the TRA '86'S grandfather exemption is allowed. In other circuits, it is uncertain whether the Eighth Circuit's opinion would be adopted or the court would apply "irrevocable" to the GST. All circuits would almost certainly apply Peterson to GSTs in which the power lapsed.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN--WHITEWATER, WHITEWATER, WI (NOT ASSOCIATED WITH AFAI).