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.

Is There a Danger From A Nondirect IRA Rollover?

I have come to the conclusion that I do not like for folks to receive a check when they do an IRA rollover.

What are we talking about?

Say that you have an IRA at Fidelity and you want to transfer it to Vanguard. Another example is that you have a 401(k) with a previous employer, and you have decided to move out of the 401(k). In each case you are transferring money into an IRA, whether from another IRA or from an employer plan.  

There are two ways to do this:

(1)  Instruct Fidelity to send the monies directly to Vanguard. This is sometime referred to as a “trustee-to-trustee” or a “direct” rollover. Notice that you ever see the money, although you may feel the breeze as it rushes by.

(2)  Instruct Fidelity to send you a check and then you in turn will send the money to Vanguard.

Option two is fraught with danger, beginning with convincing Fidelity not to withhold taxes. They do not “know” that you are actually rolling the monies, and they do not want to be holding the bag if the IRS comes looking. If they withhold $1,000, as an example, you are going to have to reach into your wallet to transfer the full amount to Vanguard. Otherwise you will be $1,000 short, meaning that $1,000 will be taxable to you when it is time to file your taxes.

An equal or bigger danger is that the IRS allows you only 60 days to send that check on to Vanguard. Miss that deadline and the IRS will say that you flubbed the rollover, taxes (and perhaps penalties) are due and thanks for playing.

How do you get out of it? Well, you are going to have to formally ask the IRS for a waiver, and wait on the IRS to give it. This process is referred to as a “private letter ruling.” The IRS is issuing a ruling to you, and it is to you and you only (that is, “private.”)

Is expensive? It can be, not the least for a CPA’s time in drafting the thing. Depending upon the issue, the IRS might also charge you money, and that cost can go into the thousands.

How can you miss the 60 days? There seems to be an endless variety. One can get sick, have family emergencies, the financial institution can make a mistake. I have lost track of how many of these I have read over the years.

And now I am reading another. Let’s talk about it, as I can see this story sneaking up on someone.

The taxpayer – by the way, taxpayers in private letter rulings are anonymous. We need to give “anonymous” a name for this discussion, so we will call him Sam.

Anyway, Sam wants to move his IRA. He meets with an advisor, who cautions him that the “new” IRA trustee will charge for rolling the IRA. Sam would be much better off having the old trustee reduce everything to cash, and then sending the cash to the new trustee.

OBSERVATION: While the PLR does not dwell on it, there obviously are some difficult-to-sell assets in Sam’s IRA. It does not have to be anything esoteric – like platinum-plated gold from the moon. It could be something as simple as a non-traded REIT.

Sam contacts a representative of the old trustee and explains that he is rolling over his IRA.  He has opted to pursue option (2) above, and would they be so kind as to help him with the process. Not a problem, they say, although it might take a few months to reduce the IRA to cash.

And there is the first big red flag.

Sure enough, old trustee sends Sam checks – plural. Six checks in total, over a period of more than 60 days.

Second red flag.

Sam was clever though. Sam did not cash any of the checks, figuring that if he did not cash the check then the 60-day period did not start.

Sam finally sends all the checks over to new trustee, who realizes that there is a problem. What problem? The problem that the 60-day period does not work the way Sam thought.

New trustee contacts old trustee and requests that they issue a stop payment on the checks.

Good job.

You see, the stop payment means that the checks could not be cashed, rendering them not much of a check at all. Since they could not be cashed, the monies could never leave Sam’s old IRA, and the issue of a rollover becomes null and void.

There is one more step: getting the IRS to agree with the above line of reasoning.

Which Sam did with his private letter ruling (PLR).

And I suspect that the professional and filing fees for the PLR may approximate what the new trustee was going to charge for handling the transfer in the first place.

By the way, do you know how this should have been handled? By instructing the old trustee not to send a check until everything has been reduced to cash, and then to send one and only one check for the entirety of the account.

I know that, and you know that. But somewhere sometime someone will repeat this story. Which brings me to the conclusion that people should not do option (2) rollovers unless there is no other alternative.

It just isn’t worth the risk.

2012 Loophole on Age 70 ½ IRA Charity Contributions

I had a call last week on what the rules are for the 70 ½ IRA owner making a direct distribution to a charity.

You may recall that – if you are a certain age – you can make distributions – up to a limit - from an IRA directly to a charity. The age is 70 ½ and the limit is $100,000. Why would you do this? There are several reasons:

(1) The first, of course, is that you are charitably inclined and have the means to do so.

(2) Second, the distribution counts toward your minimum required distribution (MRD). You have to pull the money out anyway.

(3) Third, you get to omit the distribution from income.

(a) This doesn't increase your adjusted gross income, which could have bad side effects (such as raising your Medicare premiums).

(4) Fourth, there is no charitable deduction.

(a) Which is OK, as you leave-off both the income and the deduction. In fact, you are ahead in a state that does not allow for itemized deductions.

What is the issue here? The issue is that the IRA/charity option was one of those tax law provisions extended with the most recent tax bill - the one signed in January 2013. People may have intended to make a direct distribution to charity but did not do so, waiting for clarification on 2012 tax law.

There is a surprise in the tax bill. You can still write a check by January 31, 2013 to a charity and have it count toward 2012. Let's say that you took out $26,000 from your IRA in December and made contributions of $10,000 before year-end. You can write checks for the balance ($16,000) and recast the entire $26,000 as a direct distribution in 2012.

2013 becomes 2012? I am thinking time travel, and that makes me think of....

What if you distributed in 2012? There are two possibilities:

(1)   You distributed directly to the charity

This is the best answer. You leave both the income and deduction off your return.

(2)   You distributed to yourself

            Oh oh. There are again two possibilities:

(1)   You distributed to yourself in December

                                   

As long as you write a check to charity by January 31, the IRS will consider this a direct distribution in 2012.

(2)   You distributed to yourself before December

There is nothing you can do. You will have income and a corresponding deduction. Hopefully there will be no harm, no foul. In Ohio, however, there is harm, as Ohio does not allow for itemized deductions.

There will be yet another consideration in 2013. Remember the new ObamaCare taxes (the 0.9% Medicare and the 3.8% investment income)? Those kick-in at $200,000 or $250,000 of income, depending on whether one is single or married. Now you have a very real reason to leave that IRA distribution off your income for 2013. You DO NOT WANT your adjusted gross income to hit that $200,000 or $250,000 stripe.