Beware the GST tax when preparing gift tax returns.
The Sec. 2601 GST tax is imposed on gifts to individuals two or more generations younger than the person making the gift. For example, a gift to a grandchild or more remote descendant is subject to both gift and GST taxes. Sec. 2613 refers to such individuals as "skip persons." Under Sec. 2613(a)(2), a trust can also be a skip person, if all of the trust interests are held by such persons. However, gifts to such a trust can present several difficulties (discussed below).
Generational lines can also be determined by other than family relationships. Gifts to unrelated parties are subject to the GST tax if the donee is more than 37 1/2 years younger than the donor, according to Sec. 2651(d)(2). Thus, if a gift is made to a family member, the relationship between the donor and the donee must be known to determine if the transfer is subject to the GST tax. If the donee is not related to the donor, the ages of both the donor and donee must be obtained to make the determination.
Gifts to skip persons are referred to as "direct skips" under the Code, as defined in Sec. 2612(c)(1).They must be reported on Form 709, Schedule A, Direct Skips (assuming the gift exceeds the annual exclusion). Gifts that are direct skips are subject to both the gift tax and GST tax in the year given.
Gifts can be sheltered from the GST tax in two ways. The gift may be eligible for the GST tax annual exclusion under Sec. 2642(c); however, the exclusion is limited and does not follow the same rules as the Sec. 2503(b) gift tax annual exclusion. Also, a gift may qualify for the gift tax annual exclusion, but not the GST tax annual exclusion.
Gift tax annual exclusion: The gift tax annual exclusion is generally available for outright gifts and gifts to trusts if the beneficiary has a present interest in the trust (such as a Crummey, withdrawal right). According to Sec. 2642(c), the GST annual exclusion is available for outright gifts and gifts to trusts only if the trust has only one beneficiary and the trust's assets are includible in the beneficiary's gross estate. Thus, if a trust gives Crummey withdrawal rights to multiple beneficiaries, trust contributions could be sheltered from the gift tax via the gift tax annual exclusion; however, the GST annual exclusion would not be available.
GST allocation: The other way to shelter a gift from the GST tax is through an allocation of the Sec. 2631 GST tax exemption. The exemption can be used during life (any unused balance at death can be used on the estate tax return). For 2005, the GST exemption is $1.5 million. It increases to $2 million in 2006-2008 and $3.5 million in 2009. Note: The Sec. 2505 gift tax unified credit remains at $1 million.
As further discussed below, the GST exemption is automatically allocated to gifts (1) that are direct skips and (2) to certain trusts. If sufficient GST exemption is allocated to the trust to shelter it fully from the GST tax, trust distributions (including appreciation) will escape the tax. It is also possible to elect to opt out of the automatic allocation rules.
Gifts to Trusts
Although it is easy to determine whether an outright gift is subject to GST tax, gifts to trusts are more problematic and present a potential danger, especially when relying only on the automatic allocation rules. As stated above, only gifts to trusts that are deemed skip persons are subject to current GST tax in the year given. Trusts that are not skip persons may be subject to GST tax when future distributions are made from the trust. Accordingly, when preparing Form 709 to report a gift to a trust, consideration must be given to whether the trust is intended to benefit grandchildren or other skip persons, and to the proper completion of Part 2 of Schedule C (GST Exemption Reconciliation (Section 2631) and Section 2652(a)(3) Election), which deals with the allocation of the GST exemption.
Automatic allocation: Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the GST exemption was automatically allocated only to direct skips. In the case of other than direct skips, the donor had to affirmatively allocate the GST exemption to the trust on Form 709 to shelter future trust distributions from GST tax.
However, Congress realized that tax advisers were often failing to properly allocate the GST exemption to trusts ultimately intended to benefit skip persons. In an attempt to remedy the problem, the EGTRRA provided allocation rules under which the GST exemption is automatically allocated not only to direct skips, but also to gifts to certain trusts (called GST trusts). A transfer of property to a GST trust is referred to as an "indirect skip" under Sec. 2632(c)(3)(A). Sec. 2632(c)(3)(B) broadly defines a GST trust as one that can have a GST. Sec. 2632(c)(3)(B) (i)-(vi) then sets forth a number of exceptions, in an attempt to prevent the GST exemption from being automatically allocated to trusts not intended to benefit skip persons.
Exceptions: Under Sec. 2632(c), the GST exemption is not automatically allocated when the trust instrument provides that:
1. More than 25% of the trust corpus must be distributed to, or may be withdrawn by, one or more individuals who are nonskip persons before the date such individual attains age 46, on or before one or more dates specified in the trust instrument that will occur before the individual attains age 46, or on the occurrence of an event reasonably expected to occur before the date such individual reaches that age (Sec. 2632(c)(3)(B)(i)); or
2. More than 25% of the trust corpus must be distributed to, or may be withdrawn by, one or more individuals who are nonskip persons living on the date of death of another person identified in the instrument who is more than 10 years older than such individual (Sec. 2632(c)(3)(B)(ii)); or
3. If one or more individuals who are nonskip persons die on or before the date(s) described in #1 and 2 above, more than 25% of the trust corpus must be distributed to the estate(s) of such individual(s) or is subject to a general power of appointment exercisable by one or more such individual(s) (Sec. 2632(c)(3)(B)(iii)); or
4. Any portion of the trust is includible in the gross estate of a nonskip person (other than the transferor) if such person died immediately after the transfer (Sec. 2632(c)(3)(B)(iv)).
Additional exceptions to the general rule deal with certain charitable trusts (and are beyond this item's scope).
Although Congress enacted the automatic allocation rules to help advisers, the highly technical nature of the exceptions causes problems. While the rules probably do correct the failure to properly allocate the exemption to trusts meant to benefit skip persons, they can also result in wasting the GST exemption, by automatically allocating it to trusts not intended to benefit skip persons.
For example, it is common for a trust to provide for a grantor during his or her life and, on death, to provide that the trust assets be held in further trust until the grantor's child reaches a prescribed age. Although it would be easy to assume that the trust was not a GST trust, because it met the exceptions under either #1 or 2, above, this would be incorrect. The trust does not meet the test in exception l, because the death of an individual's parent may not be reasonably expected to occur before such individual reaches age 46. The trust does not meet the test in exception #2, because the trust assets are not automatically distributed outright to the child on his or her parent's death but, rather, are held in further trust. Thus, the trust is a GST trust; unless an election is made on Form 709 to opt out of the automatic allocation rules, the GST exemption would be automatically allocated to the trust (and wasted, as the trust is not intended to benefit skip persons). The election to opt out of the automatic allocation rules for gifts that are indirect skips is made by checking the box in Form 709, Schedule A, Part 3, Indirect Skips, Column C, and by attaching an opt-out notice.
Another common example of a trust that is a GST trust by definition, but not intended to benefit skip persons, occurs when a trust provides that, at the grantor's death, it will continue for the benefit of the grantor's spouse. At the spouse's death, the trust is divided into equal shares for the couple's children, with outright distributions to the children at prescribed ages (e.g., 25, 30 and 35). Initially, the trust would not appear to be a GST trust, because it requires distributions to nonskip persons (i.e., the children) before age 46. However, according to Sec. 2632(c) (3)(B), the trust is indeed a GST trust, because outright distributions are postponed until after the spouse's death. Thus, possibly, the children will not receive distributions until well after age 46. Again, unless an opt-out election is made, the GST exemption is automatically allocated to this type of trust (and wasted on a trust intended to benefit children).
The above examples show that tax advisers should not rely on the automatic allocation rules. Rather, they should analyze the trust instrument to determine whether the trust is intended to benefit skip persons. If so, the GST exemption should be affirmatively allocated on Form 709, Schedule C, Computation of Generation-Skipping Transfer Tax. Reliance on the automatic allocation rules does not allow clients and their advisers to trace readily the amount of the used exemption. The affirmative ongoing tabulation of the used and available exemption on Schedule C gives clients and their advisers the information needed for future GST planning. To ensure that the previously used GST exemption has been recorded accurately, prior-year returns should be reviewed to determine whether the GST treatment was proper, and the exemption used in prior periods was reported on Schedule C, Part 2, Line 2, Total exemption used for periods before filing this return.
If the trust is not intended to benefit skip persons, clients and their advisers should not assume that it fits into one of the exceptions to the automatic allocation rules. The safer course would be to opt out of the automatic allocation of the exemption. The opt-out election can be made on an annual or a permanent basis.
Whenever Form 709 is used to report a gift to a trust, tax advisers must ensure that the GST treatment is correctly reported. Failing to do so could result in wasting clients' GST exemptions, by applying them to transfers not intended to benefit skip persons, with resulting practitioner liability.
FROM SHARON GOODMAN, J.D., NEW YORK, NY
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|Title Annotation:||generation-skipping transfer tax|
|Publication:||The Tax Adviser|
|Date:||Apr 1, 2005|
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