The Skip Tax - Part Two

 

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.

 

Spotting The Skip Tax - Part One

I was reviewing something this week we may not have discussed before. Mind you, there is a reason we haven’t: it is a high-rent problem, not easy to understand or likely to ever apply to us normals. If you work or advise in this area (as attorney, CPA, trustee or so on), however, it can wreck you if you miss it.

Let’s talk a bit about the generation skipping tax. It sometimes abbreviated “GST,” and I generally refer to it as the “skip.”

Why does this thing even exist?

It has to do with gift and estate taxes.

You know the gift tax: you are allowed to make annual gifts up to a certain amount per donee before having to report the gifts to the IRS. Even then, you are spotted an allowance for lifetime gifts. While there may be paperwork, you do not actually pay gift tax until you exhaust that lifetime allowance.

You know the estate tax: die with enough assets and you may have a death tax. Once again, there is an allowance, and no tax is due until you exceed that allowance. The 2024 lifetime exemption is $13.6 million per person, so you can be wealthy and still avoid this tax.

As I said, we are discussing high-end tax problems.

Then there is the third in this group of taxes: the generation skipping tax. It is there as a backstop. Without it, gift and estate taxes would lose a significant amount of their bite.

Why Does the Skip Exist?

Let go through an example.

When does the estate tax apply (setting aside that super-high lifetime exemption for this discussion)?

It applies when (a) someone with a certain level of assets (b) dies.

How would a planner work with this?

Here is an idea: what if one transfers assets to something that itself cannot die? Without a second death, the estate tax is not triggered again.

What cannot die, without going all Lovecraftian?

How about a corporation?

Or – more likely – a trust?

When Does The Skip Apply?

It applies when someone transfers assets to a skip person.

Let’s keep this understandable and not go through every exception or exception to the exception.

A skip person is someone two or more generations below the transferor.

          EXAMPLE:

·       A transfer to my kid would not be a skip.

·       A transfer to my grandchild would be a skip.

What Constitutes a Transfer?

There are two main types:

·       I simply transfer assets to my grandchild. Perhaps she finishes her medical degree, and I buy and deed her first house.

·       I transfer assets through a trust.

The first type is called a direct skip. Those are relatively easy to spot, trigger the skip immediately and require a tax filing.

You already know the form on which the skip is reported: the gift tax return itself (Form 709). The form has additional sections when the skip tax applies.

          EXAMPLE:

·       I give my son a hundred grand. This is over the annual dollar limit, so a gift tax return is required. My son is not a skip person, so I need not concern myself with the skip tax sections of Form 709.

·       I give my grandson a hundred grand. This is over the annual limit, so a gift tax return is required. My grandson is also a skip person, so I need to complete the skip tax sections of Form 709.

What Is the Second Type of Transfer?

Use a trust.

Here is an example:

• Create a trust in a state that has relaxed its rule against perpetuities (RAP).

a.     This rule comes from English common law, and its intent was to limit how long a person can control the ownership and transfer of property after his/her death.

• Fund the trust at the settlor’s death.

a.     If that someone is Jeff Bezos or Elon Musk, there could be some serious money involved here.

•   The settlor’s children receive distributions from the trust. When they die, the settlor’s grandchildren take their place.

• When the grandchildren die, the great grandchildren take their place, and so on.

What we described above BTW is a dynasty trust.

The key here is - before the skip tax entered the Code in the 1970s - the then-existing gift and estate tax rules would NOT pull that trust back onto anyone’s estate return for another round of taxation.

Congress was not amused.

And you can see why a skip is defined as two generations below the transferor. Congress wanted a bite into that apple every generation, if possible.

How Does Skipping Through A Trust Work?

There are two main ways: 

EXAMPLE ONE: Say the trust has a mix of skip and nonskip beneficiaries, say children (nonskip) and grandchildren (skip). The IRS chills, because the trust might yet be includable in the taxable estate of a nonskip person. Say the last nonskip person dies (leaving only skips as beneficiaries) AND nothing is includable in an estate return somewhere. Yeah, no: this will trigger the skip tax. To make things confusing, the skip refers to this as a “termination,” even though nothing has actually terminated.   

EXAMPLE TWO: The trust again has a mix of skip and nonskip beneficiaries. This just like the preceding, except we will not kill-off the nonskip beneficiary. Instead, the trust simply distributes to a skip or skips (say the grandchildren or great-grandchildren). This triggers the skip tax and is easier to identify and understand.

If Skipping Through A Trust, When Is the Tax Due?

Look at Example One above. This could be years – or decades – after the creation of the trust.  

The trustee is supposed to recognize that there has been a skip “termination” of the trust. The trustee would file the (Form 709) tax return, and the trust would pay the skip tax.

And – yes – in the real world it is a problem. What if the trustee (or attorney or CPA) misses the termination as a taxable event?

Malpractice, that’s what. An insurance company will probably be involved.

What About Example Two?

This is a backstop to the first type of transfer. In the second type there is still a nonskip beneficiary, meaning that the trust has not “terminated” for skip purposes. The trust distributes, but the distribution goes to a skip.

Say the trust distributes a 1965 Shelby Mustang GT350 R.

First, nice.

Second, the skip tax is paid by the beneficiary receiving the distribution. The trust does not pay this one.

Third, the trustee may want to warn the beneficiary that he/she owes skip tax on a car worth at least $3.5 million.

Fourth, realistically the trust is going to pay, whether upfront or as a reimbursement to the beneficiary. The tax paid is itself subject to the skip tax if it comes out of the trust.

How Much Is the Skip Tax?

Right now, it is 40 percent.

It changes with changes to the gift and estate tax rates.

That 1965 Shelby GT 350R comes with a skip tax of at least $1.4 million. It takes a lot of green to ride mean.

How Do You Plan for This Tax?

The skip is very much a function of using trusts in estate planning.

Trust taxation can be oddball on its own.

Introduce skip tax and you can go near hallucinatory.

This is a good spot for us to break.

We will return next post to continue our skip talk.

Ducking Taxes With A Dynasty Trust

Dynasty trust are back in the news. Dynasty trusts are the province of the ultrawealthy, and are not likely to impact you or me much.

However, allow one or two favorable turns of fate and you or I might find ourselves interested in such things. Let’s hope for the best.

What sets up the discussion is three main issues:

(1)  Estate taxes

(2)  Generation-skipping taxes

(3)  The rule against perpetuities

Estate taxes are also called death taxes and apply to your net worth (everything you own less everything you owe) at death. If you own too much, you owe estate tax – short and sweet. Granted, it is getting harder and harder too own too much. The threshold for 2017 is $5.49 million per person, or almost $11 million per married couple.

I would say that – if you have accumulated $11 million – you have done well.

The estate tax intends for every generation to pay tax.

Let’s say that you are worth $15 million. The estate tax will apply. Your assets go to your child. Let’s presume that the assets inherited bounce back to $15 million (remember: there were taxes at your death) and the exemption remains at $5.49 million. The estate tax presumes that your child will pay tax again, repeating a virtuous cycle.

Well, an advisor can break that cycle pretty quickly: have some of the assets go to the grandkids. That skips the estate tax on (at least some of) the assets upon your child’s death.

Congress figured this out too and introduced the generation-skipping tax (GST). Its purpose was straightforward: to tax the assets that skipped tax when your child died. Those assets would otherwise have “skipped” a generation of estate tax.

A favored and common way to transfer assets across multiple generations is through use of a trust. There are more varieties of trusts than there are flavors of  Baskin Robbins ice cream. We however are looking at one trust and one only: the shy and elusive dynasty trust, which has rarely been captured on camera.

Tax archeologists believe that the dynasty trust evolved in response to state liberalization of the rule against perpetuities. Trusts themselves are created under state law, and all 50 states used to prohibit a trust from existing more than 21 years after the death of the last beneficiary who was alive when the trust was created.

To rephrase: the law (1) looked at the beneficiaries born when the trust was created; (2) took the youngest beneficiary; (3) waited until his/her death; and (4) said “All right, boys and girls, you have 21 years to finish this”

The point is that the trust had to eventually wrap up its affairs. It could not be “perpetual.”

In that context, the estate tax – GST tax value meal worked relatively well in identifying and taxing transfers of intergeneration wealth. No matter how complex, trusts simply had to give up the ghost eventually.

However, several states have since either modified or abolished their rule against perpetuities (Alaska and Nevada come to mind). A trust created in one of these jurisdictions can last for … who knows how long.

This has tax implications.

Because the trust is not required to terminate, tax planners can more easily get around the estate and GST combo that worked well enough in an earlier, simpler era.

It is relatively easy to avoid the estate tax issue: the planner simply does not give the beneficiary so much authority that the trust would be pulled into the beneficiary’s estate at death. While a minefield, it is a relatively well-trod minefield.

The GST is a bit more complicated.

I now go where many tax nerds would refuse to go: to give a quick overview of how a dynasty trust and the GST interact. We are venturing to the Mordor of tax practice.

Here goes:

(1)  You have a GST exemption equal to your estate tax exemption. Therefore, if the estate exemption is $5.49 million, your GST exemption is the same amount.

(2)  Meaning you can transfer $5.49 million across as many generations as you like without triggering the GST.

(3)  Rule (2) is not interpreted the way you expect when using a trust.

a.     One would think that trust distributions over $5.49 million to a skip beneficiary would trigger the GST tax.

b.    But not necessarily. The planner instead applies the $5.49 million test at a different point in time. Instead of waiting until the trust actually writes checks to a grandkid or great-grandkid decades from now (that is, the distribution date), the planner measures at the moment the settlor puts money into the trust.

c.     Here is an example. Say your great-grandkid is 15 months old, and you put $5.49 million into a dynasty trust. You next burn your $5.49 million GST exemption on the trust.

d.    We calculate a ratio: GST Exemption Used/Total Gift. Let’s give the ratio a name. We will call it “Jackson.” In our example, Jackson is $5.49 million/$5.49 million or “1.0.”  

e.    We next calculate a second ratio: 1.0 – Jackson. We will call this the “inclusion ratio.” Our inclusion ratio is 1.0 – 1.0 or zero (-0-).

f.      Tax nirvana is an inclusion ratio of zero (-0-).

                                                              i.     The magic to an inclusion ration of zero (-0-) is that future distributions from this trust are exempt from any more GST. That happens because you are multiplying [it doesn’t matter the number] by zero.

                                                            ii.     If the inclusion ratio was 45%, then 45% of future distributions from the trust would be subject to GST.

g.     To press the point, if the trust is worth a quantazillion dollars decades from now but has an inclusion ratio of zero (-0-), it is still exempt from GST.

                                                              i.     There are of course ways to ruin this outcome. One way is to put more money into the trust. The result would be to increase the denominator with no increase in the numerator. The resulting inclusion ratio would not be zero. A tax planner would tell you to NOT DO THAT.

To recap, the change in some states concerning the rule against perpetuities allowed planners to devise near-immortal trusts.

And the estate, gift and GST exemptions have been increasing every year and are now at $5.49 million per person. A married couple can of course double that.

Take the near-immortal trusts, stir in the big-bucks exemption, add a few spices (like family limited partnerships or remainder annuities) and you have a very nice tax tool for keeping wealth within the family across generations.

Marty McFly and Future Interests In A Trust

Let’s talk about gift taxes.

Someone: What is an annual gift tax exclusion?

Me: The tax law allows you to gift any person on the planet up to $14,000 a year for any reason without having to report the gift to the IRS. If you are married, your spouse can do the same – meaning you can team-up and gift up to $28,000 to anybody.

Someone: What if you go over $14,000 per person?

Me: It is not as bad as it used to be. The reason starts with the estate tax, meaning that you die with “too many” assets. This used to be more of an issue a few years back, but the exclusion is now north of $5.4 million. There are very few who die with more than $5.4 million, so the estate tax is not likely to impact ordinary people.

Someone: What does the gift tax have to do with this $5 million?

Me: Congress and the IRS saw gifting as the flip side of the coin to the estate tax, so the two are combined when calculating the $5.4 million. Standard tax planning is to gift assets while alive. You may as well (if you can) because you are otherwise going to be taxed at death. Gifting while alive at least saves you tax on any further appreciation of the asset.

Someone: Meaning what?

Me: You will not owe tax until your gifts while alive plus your assets at death exceed $5.4 million.

Someone losing interest: What are we talking about again?

Me: Riddle me this, Batman: you transfer a gaztrillion dollars to your irrevocable trust. It has 100 beneficiaries. Do you get to automatically exclude $1,400,000 ($14,000 times 100 beneficiaries) as your annual gift tax exclusion?

Someone yawning: Why are we talking about this?

Me: Well, because it landed on my desk.

Someone: Do you make friends easily?

Me: Look at what I do for a living. I should post warnings so that others do not follow.

Someone looking around: How about hobbies? Do you need to go home to watch a game or anything?

Me: There is a tax concept that becomes important when gifting to a trust. A transfer has to be a “present interest” to qualify for that $14,000 annual exclusion.

Someone resigned: And a “present interest” is?

Me: Think cash. You can take it, frame it, spend it, make it rain. You can fold it into a big wad, wrap a hundred-dollar bill around it and pull the wad out every occasion you can.

Someone: What is wrong with you?

Me: Maybe it’s just me that would do that.

Me: I tell you what a “present interest” is not: cash in a trust that can only be paid to you when some big, bad, mean trustee decides to pay. You cannot party this weekend with that. You may get cash, but only someday … and in the future.

Someone: Hence the “future?”

Me: Exactly, Marty McFly.

Someone surprised: Hey, there’s no need ….

Me: Have you ever heard of a Crummey power?

Someone scowling: Good name for it. Fits the conversation.

Me: That is the key to getting a gift to a trust to qualify as a present interest.

Someone humoring: What makes it crummy?

Me: Crummey. That’s the name of the guy who took the case to court. Like a disease, the technique got named after him.

Someone looking at watch: I would consider a disease right about now.

Me: The idea is that you give the trust beneficiary the right to withdraw the gift, or at least as much of the gift as qualifies for the annual exclusion. You also put a time limit on it – usually 30 days. That means – at least hypothetically – that the beneficiary can get his/her hands on the $14 grand, making it a present interest.

Someone: I stopped being interested ….

Me: Have you heard of a “in terrorem” provision?

Someone: Sounds terrifying.

Me: Yea, it’s a great name, isn’t it? The idea is that – if you behave like a jerk – the trustee can just cut you out. Hence the “terror.”

Someone: I cannot see a movie coming out of this.

Me: Let’s wait and see what Ben Affleck can do with it.

Me: I was looking at a case called Mikel, where the IRS said that the “in terrorem” provision was so strong that it overpowered the Crummey power. That meant that there was no present interest.

Someone: Can you speed this up?

Me: The transfer to the trust was over $3.2 million ….

Someone: I wish I could meet these people.

Me: The trust also had around 60 beneficiaries.

Someone: 60 kids? Who is this guy – Mick Jagger?

Me: Nah, his name is Mikel.

Someone: I was being sarcastic.

Me: Mikel was Jewish, and he put a provision in the trust that beneficiary challenges to a trustee’s decision would go to a panel of 3 persons of Orthodox Jewish faith, called a beth din.

Me: I suppose if the beth din sides with the trustees, the beneficiary could go to state court, but then the in terorrem provision would kick-in. The beneficiary would lose all rights to the trust.

Someone: So some rich person gets cut-off at the knees. Who cares?

Me: The IRS said that the in terrorem provision was strong enough to make the gift a future interest rather than a present interest. That meant there was no $14,000 annual exclusion per beneficiary. Remember that there were around 60 beneficiaries, so the IRS was after taxes on about $800 grand. Not a bad payday for the tax man.

Someone: Sounds like they can afford it.

Me: No, no. The Court disagreed with the IRS. The taxpayer won.

Someone backing away: What was the court’s hesitation?

Me: The Court felt the IRS was making too many assumptions. If the beneficiaries disagreed with the trustees, they could go to the beth din. The beth din did not trigger the in terrorem. The beneficiaries would have to go to court to trigger the in terrorem. The Court said there was no reason to believe the beth din would not decide appropriately, so it was unwilling to assume that the beneficiaries were automatically bound for state court, thereby triggering the in terrorem provision.

Someone leaving: Later Doc.

Joe Kennedy and Generation-Skipping Trusts

We recently had an issue with the generation-skipping tax (GST). What is it? First of all think gift or estate tax. Pull your thoughts away from income taxes. Gift or estate tax is assessed when you either (a) gift property or (b) die with property. One would think would be sufficient, but there was a loophole to the gift and estate tax that Congress wanted to fix. That fix was the generation-skipping tax.

Let’s explain the loophole through a story. Joseph P. Kennedy (1888-1969) was a bank president by age 25. He made his chops through insider trading before the government ever thought of a Securities and Exchange Commission (SEC). He had the foresight to unload his stocks before 1929, and then added to his fortune by shorting stocks during the Great Depression. Frankly, this guy was THE Gordon Gekko of his time. Today he would be in jail with Bernie Madoff. In an example of the irony that is Washington D.C., he became the first chairman of the SEC.

Let’s continue. By the mid-thirties his fortune was closing in on $200 million. Joe had a problem: he wanted to pass the money on to his descendants, but the estate taxes were usurious. For much of his wealth years, estate taxes were 70% or more. Granted, there was an exclusion amount, but Joe had long since accumulated substantially more than any exclusion amount. What was Joe to do?

Here is what Joe did: he had multiple generations skip the estate tax entirely. How?

Joe did this by using trusts. In 1926 Joe set up his first trust for Rose and the children. He created another in 1936, and then another in 1949. This last trust was the one through which Joe would transfer to his 28 grandchildren. We have talked about dynasty trusts in the past, and Joe was apparently a believer. A dynasty trust will run as long as state law will allow (there is a legal doctrine called the “rule against perpetuities”). A dynasty trust can go to the grandkids, then the great-grandkids, then the great-great…. Well, you get the idea.

John F. Kennedy (JFK) was Joe’s son and a trust beneficiary. He was also the 35th President of the United States. JFK’s trust provided him income for life, as well as the right to withdraw up to 5% of the trust principal annually. It must have been a fairly sizeable income, as JFK donated his presidential salary to charity. Upon JF’s death, his interest in Joe’s trust was not taxable to his estate (which is pretty much the point of a skip trust). Joe’s trust then skipped to JFK’s children, John F. Kennedy Jr and Caroline Kennedy. By the way, JFK had never updated his will, and upon his death he left no provision for his children. It is possible that – had he lived – JFK would have settled his own skip trust, and then his children would have had TWO generations of skip trusts providing them income.

Eventually this technique came to Congress’ attention, and in 1976 they passed their first attempt at the GST. The law was very poorly drafted, and Congress kept postponing the law until they ultimately repealed it – retroactively – in 1986. In its place Congress substituted a new-and-improved GST.

What is it about the GST? First, it is not the easiest reading this side of Joyce’s Ulysses. Second, much of estate planning is done using trusts. This introduces trust techniques such as fractionalization (i.e., assets going to multiple individuals), control (i.e., the beneficiary can request but the trustee can reject), and timing (i.e., the grandchildren have to wait until the children are deceased).  Third, unlike the gift or estate tax, the GST may not be payable at the time of gift or death. The GST can spring up years later when the trust distributes or terminates. Try having that conversation with a client….

Let’s go through some examples.

(1)    You gift your grandchild $100,000 as a down-payment on a house.

a.       OK, that seems pretty simple. You have a skip.

b.      Let’s step through the taxation of this transaction:

                                                               i.      You are out the $100,000.

                                                             ii.      You paid the gift tax.

                                                            iii.      What happens if you pay the GST for your grandchild?

1.       SPOILER ALERT: The recipient (not the payer) is liable for the GST.

2.       Your payment of the GST is treated as an ADDITIONAL gift!

(2)    You set up a trust for your grandchild. You settle it with $100,000.

a.       On its face I would say you have a skip.

(3)    Let’s modify the trust. Say that you give a life estate to each of your two children. Your three grandchildren are residual beneficiaries.

a.       Is there a skip? Yep.

b.      How do you value the skip?

                                                               i.      Let’s do ourselves a favor and “skip” that question for a moment.

c.       When do you value it?

                                                               i.       At the time the trust is created?

                                                             ii.      When the children both pass away (leaving only the grandchildren)?

                                                            iii.      When the trust actually distributes to a grandchild?

ANSWER: at the death of the second-to-die child

(4)    Let’s press on. The grandchildren are not yet born when you fund the trust. Attorneys refer to them as “contingent” beneficiaries.

a.       Is there a skip? Probably.

                                                               i.      Probably? What kind of weasel answer is that?

1.       The truth is that there may never be grandchildren, or the grandchildren may not live long enough to benefit under the trust. In that situation, there is no skip. Otherwise there would be a skip.

b.      How do you value the skip?

                                                               i.      I tell you what I would do: I would allocate $100,000 of my GST exemption to the trust when settled. I would file a gift tax return and prominently announce to the IRS that I am allocating $100,000 of my exemption. This makes the trust GST exempt, now and forever. It will not matter how much the trust appreciates in the future, or if, when or to whom it distributes.

c.       When do you value it?

                                                               i.      If you followed my advice, when you funded the trust.

Now before you worry about the GST, remember that one has to skip a certain amount of money to even step onto the GST field. For 2012 you would have to skip more than $5 million. If there is no change in the tax law, in 2013 that amount will drop to $1 million. Still, $1 million will keep most of us out of GST trouble.

The estate tax was Congress’ effort to slow-down the accumulation of familial wealth, and the GST was an effort to close a loophole in the estate tax. Its purpose was to ensure that accumulations of great wealth were taxed at least once every generation. Congress did not want the establishment of an inherited class, somewhat like the House of Lords in England. How many Paris Hiltons – or William Kennedy Smiths – do we as a nation want to tolerate?

The irony of GST tax law is that wealthy had little incentive to establish dynasty trusts before 1986. There were several states, including Idaho and Wisconsin, which allowed trusts to be perpetual. Many states have since followed suit, liberalizing their state statutes to allow long-lived (although maybe not perpetual) trusts in an effort to attract the high-wealth investments out there. There was a study in the mid-2000s which estimated that more than $100 billion had flowed into states allowing these long-lived trusts. It appears that Congress has created a bit of a cottage industry.