AICPA's legislative solution to the GST tax exemption allocation trap.
The revised proposal provides an automatic allocation of the GST tax exemption, with an elect-out option (as in the original proposal), as well as Regs. Sec. 301.9100 relief and substantial compliance provisions for taxpayers who inadvertently miss the allocation but intended to apply it. The proposal would allow retroactive allocations when there has been an unnatural order of death and severing of trusts into exempt and nonexempt shares when appropriate.
Congress should enact this proposal to improve taxpayer fairness and equity as well as efficient administration of the tax system, and reduce serious problems confronting taxpayers and their advisers. Currently, missed allocations create significant potential GST tax, trapping both taxpayers and practitioners alike. Taxpayers and their families may not discover a missed allocation for many decades, at which point, the excessive GST tax liability that the family incurs may have also increased exponentially. Many practitioners consider gift tax return preparation to be too risky for the fees involved, because of these GST issues, thus possibly depriving taxpayers of reasonably priced professional advice. This can also seriously affect the IRS's administration abilities.
A GST tax is imposed on transfers outright or in trust to beneficiaries more than one generation below the transferor's generation at the maximum gift and estate tax rate (currently 55%). To determine the rate applicable to a particular transfer, the 55% rate is multiplied by the inclusion ratio (a fraction based on the GST exemption amount allocated to the transfer). A trust with a zero inclusion ratio is exempt from GST tax. Every individual is allowed a $1 million GST tax exemption (indexed for inflation), which may be allocated to any property subject to estate or gift tax. Married couples may treat transfers as made one-half by each spouse, in effect giving them a combined $2 million GST tax exemption. If a GST exemption is allocated to a lifetime transfer to a trust on a timely filed gift tax return, the portion of the trust protected is generally based on the property's value at the time of the transfer. However, if the allocation is not made on a timely filed gift tax return, the portion of the trust protected is based on the property's value at the time of the allocation. Except in limited cases, a GST tax exemption allocated after a GST taxable transfer has occurred will not reduce the GST tax on that transfer. The planning necessitated by the GST tax exemption rules is extremely complex. For example, a GST tax exemption should be allocated to certain, but not all, transfers qualifying for the annual gift tax exclusion. This may require that a gift tax return be filed solely for the purpose of allocating a GST tax exemption. In addition, a trustee cannot sever a trust subject to GST tax into two separate trusts, one exempt and one nonexempt, after the trust has been created. Taxpayers who can afford sophisticated advisers create multiple exempt and nonexempt trusts.
Reasons for Change
The following three examples demonstrate expensive "traps" for both taxpayers and practitioners that current GST tax rules create:
Example 1: P, a parent, transfers $10,000 a year for 10 years to a discretionary trust for a child, C, and such descendants of C, which will terminate and distribute to C when C reaches age 35. If C dies before attaining age 35, the trust is distributable to the descendants of C. If C dies before age 35 with issue when the trust assets are worth $100,000, a taxable termination occurs. Unless P allocates a GST tax exemption before C dies, the GST tax would be $55,000. If an amendment is made to give an opportunity to retroactively allocate the exemption when appropriate, the GST tax can be avoided.
Example 2: P transfers $1 million of stock to a trust to pay income to C for life, remainder to P's grandchild, G. If the full $1 million GST tax exemption is allocated to this transfer on a timely filed gift tax return, and the stock's value is $5 million at the time the property passes to G, no GST tax results. However, if the GST tax exemption is not allocated until the property has grown to $5 million, a $2.2 million GST tax would result if the property that passes is still worth $5 million when it passes to G.
Example 3: P transfers $1 million to a trust to pay income to C until C's 35th birthday, at which time the trust property will be paid to C. If C dies before his 35th birthday, the trust property is paid to C's children. If C dies before attaining age 35 at a time when the trust is worth $5 million and there was no (;ST tax exemption allocated before C's death, there would be no opportunity to allocate such exemption and a $2.75 million GST tax would be imposed. If an amendment is made to give an opportunity to allocate a GST tax exemption and the valuation date is not retroactive to the date of the original transfer, a $2.2 million GST tax would be imposed. By contrast, had the donor allocated a GST tax exemption on a timely filed return, no GST tax would be due.
Example 1 illustrates the common mistaken belief that if transfers do not exceed $10,000 per year, a GST tax will not be applicable. Example 1 also illustrates that the GST tax can be imposed even when transfers are much smaller than the amount of the GST tax exemption.
As shown in Example 2, if a GST tax exemption is intended to be allocated but is not, and substantial appreciation occurs before the failure to allocate is discovered and corrected, the economic damage suffered by the family can be great.
Even when the need to make an exemption allocation is known, the manner and method for making an appropriate allocation is not intuitive and not readily discernable from the gift tax return and its instructions. Gift tax returns are frequently prepared erroneously. In some cases (such as in Example 3), a transfer subject to a GST tax is not expected. Taxpayers should not be penalized for failing to anticipate the premature death of a child. In some cases, the failure to allocate a GST tax exemption or the possibility of a transfer subject to a GST tax may not be discovered for many decades. Missed GST tax exemption allocations create significant potential GST tax liabilities. The compounding factor and the impact of inflation can increase the GST tax liability exponentially. As a result, even where there has been a good-faith effort to comply with the law, taxpayers are faced with punishing tax consequences, and practitioners with enormous malpractice claims.
A legislative solution is needed to address these concerns and bring fairness and equity to this area of the law. Complex planning and drafting is necessary now to avoid the GST tax even when no GST is expected. Under current rules, to get the full benefit of a GST tax exemption, separate trusts can be created, of which one is entirely exempt from GST tax and the other is not. However, once a trust is created, a taxpayer cannot sever it into exempt and nonexempt trusts. For example, if a taxpayer creates a trust for his five children and one child dies, the regulations do not allow the trust to be severed so that a GST tax exemption can be allocated to the one-fifth of the trust that will primarily benefit the deceased child's children. However, if five separate trusts had been created instead of one, this problem could have been avoided. Such a pointless exercise engenders disrespect for the tax system and also encourages taxpayers to create multiple trusts, something Congress has sought to discourage in the past. If the rules were more user-friendly, the costs, complexities and need for drafting and administering multiple trusts could be significantly reduced.
Automatic allocation of GST tax exemption. The task force proposes that GST tax exemption allocations should be automatic (as most taxpayers would want them). This is similar to the Sec. 453 installment sales rules, which provide an automatic election of the installment sale treatment to all taxpayers unless a taxpayer elects out under Sec. 453(d). Similarly, under this proposal, taxpayers and practitioners may elect out of a automatic GST tax exemption allocation (on the gift tax return) if such action is appropriate. The automatic allocation of the GST tax exemption would be less of a burden on taxpayers and preparers. In addition, the automatic allocation rule would not apply to the following types of trusts, unless a taxpayer elects it:
* A trust providing that more than 25% of the trust corpus must be distributed to or may be withdrawn by one or more individuals who are non-skip persons: (1) before such individual attains age 46 or on one or more dates specified in the trust instrument that occurs before such individual reaches age 46, (2) if such individual is living on the date of death of another person who is more than 10 years older than such individual or (3) on the occurrence of an event (such as graduation from college) that, in accordance with regulations, may be reasonably expected to occur before such individual reaches age 46; or
* A trust providing that if one or more individuals who are non-skip persons is deceased on or before the date or age described in (1), above, or on or before an event described in (2) or (3), above, more than 25% of the trust corpus either must be distributed to such individual's estate or is subject to a general power of appointment exercisable by such individual; or
* A portion of the trust property would be included in the gross estate of a non-skip person (other than the transferor) if he died immediately after the transfer; or
* A charitable lead annuity trust or a charitable remainder trust.
The automatic allocation of a GST tax exemption is simple and fair to all taxpayers and reduces compliance costs.
Regs. Sec. 301.9100 relief and substantial compliance. The GST proposal also includes Regs. Sec. 301.9100 relief for GST tax exemption allocations for those taxpayers who did not make an election because of an inadvertent failure to timely file the appropriate return. If the relief is granted, the ,allocation would be treated as if it were made as of the date of transfer. If necessary, on granting Regs. Sec. 301.9100 relief, an adjustment would be made to any intervening allocations. The substantial compliance doctrine would be made explicit; allocation of a GST tax exemption would be effective if the taxpayer demonstrates intent to have a zero inclusion ratio for a trust. Evidence of that intent would include all relevant facts, including (but not limited to) correspondence or other documentation relating to the creation of any generation-skipping trust.
Severance. Severing trusts into two or more separate trusts would be permitted. Allowing the severance of a trust with an inclusion ratio between zero and one into two separate trusts--one with an inclusion ratio of zero and the other with an inclusion ratio of one--on a fractional basis, would result in shorter wills and revocable trusts, less complicated and less expensive estate planning, less frequent drafting and administration errors, and fewer trusts.
Retroactive allocation. Late or retroactive GST tax exemption allocations would be allowed when there is an unnatural order of death. For example, when a child who is intended as the trust remainder beneficiary, dies before the parent who created the trust, retroactive application is appropriate, because the trust was not primarily designed to benefit skip persons.
This proposal simplifies an extremely complex area of the tax law and the AICPA and the task force believe there is widespread support for this change. The Institute expects favorable consideration by Congress on this matter and hopes to have it included in tax legislation enacted this year or next.
In June 1998, several task force members met with technical government representatives from the Treasury, IRS, Joint Tax Committee, House Ways and Means Committee and Senate Finance Committee, to discuss this GST tax exemption allocation proposal. The government representatives generally thought the proposal had merit and offered a few suggestions, which the task force has taken into consideration. The task force is now planning additional meetings with other government officials and seeking a legislative sponsor and co-sponsors for the proposal.
Editors Note: This department is written by the AICPA Tax Division's professional staff. It is designed to heighten awareness of the Division's work and keep readers apprised of Tax Division activities involving tax policy, technical issues and other practice support matters.
The authors' views, as expressed in this column, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specified committee procedures, due process and deliberation.
If you would like additional information about this article, contact Ms. Sherr at (202) 434-9256 or firstname.lastname@example.org.
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|Title Annotation:||generation skipping tax|
|Author:||Sawyers, Roby B.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1998|
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