Minimizing the generation-skipping transfer tax with thoughtful use of the $1 million GST exemption.

The generation-skipping transfer tax (GSTT) may apply to certain transfers - at rates up to 55% - in addition to gift tax, and even in situations in which a gift tax exemption exists. One tax-saving grace of the GSTT is that each individual has a $1 million generation-skipping tax (GST) exemption that allows him to Transfer up to $1 million of property and any future appreciation on the property) free from GSTT. Using the GST exemption presents complexities as well as tax planning opportunities. The planning ideas discussed here focus on using the GST exemption in connection with a transfer to an irrevocable life insurance trust.

Generally, the GSTT applies when property is transferred and is received by a "skip person," either as a direct transfer, by termination of someone else's interest in the property or by distribution from a trust. Generally, a "skip person" is an individual more than one generation below the transferor (e.g., a grandchild). A trust is a skip person if (1) all trust beneficiaries who can presently receive distributions from the trust are skip persons or (2) no individual has a present right to receive distributions from the trust and future distributions may be made only to skip persons.

The $1 million GST exemption may be allocated by the transferor or the transferor's executor at any time on or before the due date for filing the transferor's Federal estate tax return (including extensions actually granted).

Any available GST exemption is automatically allocated to lifetime "direct skips," unless the transferor elects out of the automatic allocation (Sec. 2632(b)). A "direct skip" is a transfer of property to a skip person that is subject to Federal estate or gift tax. A direct skip may be a direct transfer from the transferor to an individual or it may be a transfer to or from a trust.

Prop. Regs. Sec. 26.2632-1(b)(1) provides that the election out of the automatic allocation must be made on a timely filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax

Return; once made, it is irrevocable. Allocations of GST exemption to lifetime transfers that are not direct skips are also made on Form 709. An allocation on a timely filed Form 709 (or an automatic allocation) is effective from the date of the transfer to which it relates. An allocation on a latefiled Form 709 is effective on the date the Form 709 is filed (or if filed by the donor's executor, on the date of the donor's death) (Prop. Regs. Sec. 26.2632-lib)(2)).

The irrevocable life insurance trust is a common technique used to transfer wealth to younger generations. Typically, an individual funds such a trust with the amounts needed to pay the premiums on a life insurance policy on that grantor, with the proceeds of the policy on the grantor's death ultimately going to the trust beneficiaries. Such trusts typically are not structured to avoid imposition of the GSTT. Therefore, to fully shelter the future insurance proceeds, it is generally necessary to file a gift tax return each year a transfer is made to an irrevocable life insurance trust and allocate a portion of the transferor's GST exemption.

Leveraging the GST exemption

Once a transfer is exempt from GSTT, it will remain exempt regardless of the transferred property's future value. Accordingly, significant transfer tax savings can be achieved by allocating the $1 million GST exemption to property that will appreciate significantly after it has been transferred. This "leveraging" of the GST exemption is particularly advantageous when used with irrevocable life insurance trusts established for the benefit of skip persons, since the trust's property (i.e., an insurance policy) is expected to appreciate significantly on the death of the insured. The benefit of leveraging the GST exemption is illustrated by the following examples, which assume tax is imposed at the maximum 55% rate.

Example 1: Grandfather, GF, who has already made taxable transfers in excess of $3,000,000 to his daughter, transfers $3,000,000 (outright) to his granddaughter, GD. After applying GF's $1,000,000 GST exemption and the $10,000 annual exclusion, GF must pay $1,094,500 of GSTT on the $3,000,000 transfer [($3,000,000 - 1,000,000 - 10,000) x 0.55], Gift tax is also imposed on the $3,000,000 transfer plus the $1,094,500 of GSTT. After applying the S10,000 annual exclusion, GF's taxable gift equals $4,084,500 ($3,000,000 - $10,000 + $1,094,500) and the related gift tax equals $2,246,475 ($4,084,500 x 0.55). Thus, the total transfer taxes equal S3,340,975 and, as a result, it costs GF S6,340,975 to make a S3,000,000 gift to GD.

Example 2: GF, from Example 1, instead transfers $400,000 to an irrevocable life insurance trust that will be used to pay the premiums on a $3,000,000 life insurance policy on his life, with GD the trust beneficiary. GF pays gift tax of $220,000 on the $400,000 transfer. By allocating $400,000 of his $1,000,000 GST exemption to the transfer, the trust is fully sheltered from GSTT. By using life insurance, GF can save $3,120,975 in transfer taxes on the $3,000,000 gift to GD.

Late allocation

The GST exemption can be further leveraged by using life insurance and making a late allocation of the GST exemption. A late allocation is effective on the date the gift tax return is actually filed. Therefore, if the value of the transferred property has declined at the time a delinquent gift tax return is filed, less GST exemption will be needed to shelter the property fully from GSTT.

Example 3: GF, from Example 1, transfers $20,000 to an irrevocable life insurance trust for the benefit of his children and grandchildren, which will be used to pay premiums on a $1,000,000 life insurance policy on his life. GF does not timely allocate any part of his $1,000,000 GST exemption to the transfer. [Because all beneficiaries of the trust are not skip persons, the transfer is not a direct skip and there is no automatic GST exemption allocation.) One month before the next annual premium payment is due, the cash surrender value of the policy is $2,000 and the value of the unexpired premium is $1,000 (the other $17,000 being consumed by commissions and the cost of insurance coverage). GF files an untimely allocation of his GST exemption, and needs to apply only $3,000 of it to shelter fully the $20,000 transfer.

Making a late allocation of GST exemption can backfire, however, if the insured dies after the due date for making a timely allocation and before the late allocation is made. In such a case, the fair market value of the life insurance policy would be subject to GSTT, unless there is sufficient GST exemption remaining to apply against it. With proper planning, however, even these potential negative consequences can be virtually eliminated.

From Rick J. Taylor, CPA, and Mark T. Watson, CPA, Washington, D.C.