Generation-skipping transfer tax rules affect nonresident aliens.

The Tax Reform Act of 1986 enacted Chapter 13 of the U.S. Internal Revenue Code, dealing with the generation-skipping transfer tax (GST). The law directed the IRS to write regulations necessary or appropriate to carry out Chapter 13, including regulations providing for its application to transferors who are nonresidents and not U.S. citizens (i.e., nonresident aliens (NRAs)).

On Dec. 23, 1992, the Service issued Prop. Regs. Sec. 26.2663-2, dealing with the application of the GST to transfers by NRAs. The proposed regulations would have taxed NRAs under Chapter 13 in essentially two separate ways: 1. Transfers of U.S.-situs property by an NRA would have been subject to GST to the same extent those transfers were subject to estate and gift tax. 2. The GST would have applied to transfers by NRAs of foreign-situs property to or for the benefit of grandchildren or more remote descendants, if the grandchild was a U.S. resident or citizen at the time of the generation-skipping transfer and the parent of that grandchild was also a U.S. citizen or resident at the time of the initial transfer to the grandchild or into the trust for that grandchild.

Thus, for example, under the proposed regulations, a bequest of stock in a foreign corporation by a nonresident alien to a U.S. grandchild would have been subject to the tax if the parent of that U.S. grandchild was also a U.S. citizen or resident at the time of the transfer.

The proposed regulations were highly controversial. Commentators objected mainly to subjecting foreign-situs property to the GST rules.

Final Regulations Limit

Application of the Tax

In response to those comments, final Regs. Sec. 26.2663-2 limits the application of the GST to NRAs solely to transfers of property subject to U.S. gift or estate tax on the part of the NRA donor or decedent. The regulations essentially treat the portion of the trust property at the time of the transfer into the trust that was subject to U.S. estate or gift tax as the taxable portion of the trust, and the balance of the trust is treated as the exempt portion of the trust.

Therefore, an allocation of the $1 million statutory GST exemption available to all taxpayers is required under the final regulations only to the extent the value of the property at the time that the allocation is made is not nonexempt property.

Example 1: A NRA decedent transfers $500,000 of U.S.-situs property and $500,000 of foreign-situs property to a generation-skipping trust; $500,000 of the $1,000,000 exemption would need to be allocated to the trust for it to be completely exempt from the tax.

Under this regime, it is critical that an allocation of the $1 million exemption be made to the trust on a timely filed gift or estate tax return.

Example 2: An NRA donor makes a transfer by gift to a generation-skipping trust of $500,000 of U.S. real estate and $500,000 of foreign real estate and makes a timely allocation of the $1,000,000 exemption. Only $500,000 of that exemption would be needed to completely shelter the trust from the tax at any time in the future.

If an NRA donor does not make a timely allocation of the $1 million exemption at the time of the gift, a later allocation of the exemption would need to take into account changes in the value of the trust at that time.

Example 3: A trust's value at the time of a late allocation of the exemption several years after the gift is $1,500,000; $750,000 of the exemption (instead of $500,000, if the allocation had been made timely several years earlier) would need to be made to completely exempt the trust from GST Thus, as a result of the delay in allocating the exemption and the increase in the value of the trust corpus in the interim, more of the exemption would need to be allocated to the trust.

Regs. Sec. 26.2663-2(c)(3) also contains a special rule under which an allocation of the exemption is not treated as effective until the death of the NRA donor. This rule, known as the estate tax inclusion period (ETIP) rule, is quite complex. In its simplest form, however, the ETIP rule applies when, at the time of the initial transfer to the trust, it is possible that all or a portion of the trust will be includible in the gross estate of the NRA donor at his death because he retains certain rights or powers in the trust. In this case, the allocation of exemption is not effective until the NRA's death.

Effective Date

The final regulations are generally effective for generation-skipping transfers made after Dec. 26, 1995. However, under a special rule, taxpayers may opt to rely on die final regulations for generation-skipping transfers made, and for trusts that became irrevocable, after Dec. 23, 1992 (the date of the proposed regulations) and before Dec. 27, 1995. The final regulations also contain a special transition rule for situations in which an NRA made a generation-skipping transfer of U.S. property after Dec. 23, 1992 and before Dec. 27, 1995. In such a case, if a timely allocation of the $1 million statutory exemption was not made to the transfer at that time, an automatic allocation is deemed to be made in a certain prescribed order (so as to minimize any adverse GST consequences as to those transfers).

Planning

A review of NRA wills and trust documents may enable a tax planner to determine alternative structures to minimize GST. For example, with careful planning, it may be possible to convert U.S.-situs assets into foreign-situs assets before making a transfer to a generation-skipping trust, thereby eliminating potential exposure to the tax at a later date.