How does one work with the skip?
In my experience, the skip is usually the realm of the
tax attorneys, although that is not to say the tax CPA does not have a role.
The reason is that most skips involve trusts, and trusts are legal documents. CPAs
cannot create legal documents. However, let that trust age a few decades, and
it is possible that the next set of eyes to notice a technical termination or taxable
distribution will be the CPA.
Let’s pause for a moment and talk about the annual
exclusion and lifetime exemption.
The gift tax has an annual exclusion of $18,000 per
donee per year. There is also a (combined gift and estate tax) lifetime exemption
of $13.6 million per person. If you gift more than $18 grand to someone, you
start carving into that $13.6 million lifetime exemption.
The skip tax has the same exclusion and exemption limits
as the gift tax.
The problem is that a gift and a skip may not happen
at the same time.
Let’s take two examples.
(1)
A
direct skip
That is the
proverbial gift to the grandchild. Let’s say that it well over $18 grand, so
you must file a return with the IRS.
You gift her a
$100 grand.
The gift is
complete, so you file Form 709 (the gift tax return) with your individual tax
return next year.
The transfer immediately
dropped at least two generations, so the skip is complete. You complete the
additional sections in Form 709 relating to skips. You claim the annual exclusion
of $18 grand, and you apply some of the $13.6 million exemption to cover the
remaining $82 grand.
Done. Directs
skips are easy.
(2) An
indirect skip
Indirects are
another way of saying trusts.
Remember we discussed
that there is a scenario (the taxable termination) where the trust itself is
responsible for the skip tax. However, there is no skip tax until the exemption
is exhausted. The skip may not occur for years, even decades, down the road. How
is one to know if any exemption remains?
Enter something
called the “inclusion ratio.”
Let’s use an
example.
(1) You fund a trust with $16 million, and you have $4 million of (skip) lifetime exemption remaining.
(2)
The
skip calculates a ratio for this trust.
4 divided by 16 is
25%.
Seems to me that
you have inoculated 25% of that trust against GST tax.
(3)
Let’s
calculate another ratio.
1 minus 25% is 75%.
This is called the
inclusion ratio.
It tells you how
much of that trust will be exposed to the skip tax someday.
(4) Calculate the tax.
Let’s
say that the there is a taxable termination when the trust is worth $20
million.
$20 million times 75%
equals $15 million.
$15 million is
exposed to the skip tax.
Let’s say the skip
tax rate is 40% for the year the taxable termination occurs.
The skip tax is $6
million.
That trust is permanently tainted by that
inclusion ratio.
Now, in practice this is unlikely to
happen. The attorney or CPA would instead create two trusts: one for $4 million
and another for $11 million. The $4 million trust would be allocated the entire
remaining $4 million exemption. The ratio for this trust would be as follows:
4
divided by 4 equals 1
1
minus 1 equals -0-.
The
inclusion ratio is zero.
This
trust will never have skip tax.
What about the second trust with $11 million?
You have no remaining lifetime exemption.
The second trust will have an inclusion ratio of one.
There will be skip tax on 100% of something in the future.
Expensive?
Yep, but what are you going to do?
In practice, these are sometimes called Exempt and Nonexempt
trusts, for the obvious reason.
Reflecting, you will see that a direct skip does not
have an equivalent to the “inclusion ratio.” The direct skip is easier to work
with.
A significant issue involved with allocating is missing
the issue and not allocating at all.
Does it happen?
Yes, and a lot. In fact, it happens often enough that
the Code has default allocations, so that one does not automatically wind up
having trusts with inclusion ratios of one.
But the default may not be what you intended. Say you
have $5 million in lifetime exemption remaining. You simultaneously create two
trusts, each for $5 million. What is that default going to do? Will it allocate
the $5 million across both trusts, meaning that both trusts have an inclusion
ratio of 50%? That is probably not what you intended. It is much more likely that
you intend to allocate to only one trust, giving it an inclusion ratio of zero.
There is another potential problem.
The default does not allocate until it sees a “GST
trust.”
What is a GST trust?
It is a trust that can have a skip with respect to the
transferor unless one or more of six exceptions apply.
OK, exceptions like what?
Exception #1 – “25/46”
exception. The
trust instrument provides that more than twenty-five percent (25%) of the trust
principal must be distributed (or may be withdrawn) by one or more persons who
are non-skip persons before that individual reaches age forty-six (46) (or by a
date that will occur or under other circumstances that are likely to occur
before that individual reaches age forty-six (46)) (IRC §2632(c)(3)(B)(i)).”
Here is another:
Exception #2 – “25/10” exception. The trust instrument
provides that more than twenty-five percent (25%) of the trust principal must
be distributed (or may be withdrawn) by one or more persons who are non-skip
persons and who are living on the date of the death of another person identified
in the instrument who is more than ten (10) years older than such individual
(IRC §2632(c)(3)(B)(ii)).”
Folks, this is hard terrain
to navigate. Get it wrong and the Code does not automatically allocate any exemption
until … well, who knows when?
Fortunately, the Code does allow you to override the default
and hard allocate the exemption. You must remember to do so, of course.
There is another potential problem, and this one is
abstruse.
One must be the “transferor” to allocate the exemption.
So what, you say? It makes sense that my neighbor
cannot allocate my exemption.
There are ways in trust planning to change the “transferor.”
You want an example?
You
set up a dynasty trust for your child and grandchildren. You give your child a testamentary
general power of appointment over trust assets.
A general power of appointment means that the child
can redirect the assets to anyone he/she wishes.
Here is a question: who is the ultimate transferor of trust
assets – you or your child?
It is your child, as he/she has last control.
You create and fund the trust. You file a gift tax
return. You hard allocate the skip exemption. You are feeling pretty good about
your estate planning.
But you have allocated skip exemption to a trust for
which you are not the “transferor.” Your child is the transferor. The allocation
fizzles.
Can you imagine being the attorney, CPA, or trustee
decades later when your child dies and discovering this? That is a tough day at
the office.
I will add one more comment about working in this area: you would be surprised how legal documents and tax returns disappear over the years. People move. Documents are misplaced or inadvertently thrown out. The attorney has long since retired. The law firm itself may no longer exist or has been acquired by another firm. There is a good chance that your present attorney or CPA has no idea how – or if – anything was allocated many years ago. Granted, that is not a concern for average folks who will never approach the $13.6 million threshold for the skip, but it could be a valid concern for someone who hires the attorney or CPA in the first place. Or if Congress dramatically lowers the exemption amount in their relentless chase for the last quarter or dollar rolling free in the economy.
With that, let’s conclude our talk about skipping.
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