Part 3-Estate Tax Repeal? Generation Skipping Relief
Deeply buried in the estate tax repeal legislation is significant relief from some of the complexities and traps inherent in the generation skipping tax (GST). Unfortunately, despite Congress’ good intentions, the new rules do not cover all situations and could give you a false sense of security.
So, if you have (or plan to create) trusts that might some day benefit your grandchildren, grandnieces and grandnephews, or people more than 37.5 years younger than you (other than your spouse), these new provisions merit attention.
The Time Bomb
In this column way back in February 1993, I described a potential problem with gifts to trusts that could someday benefit your grandchildren. A common scenario is a trust that is primarily for the kids for their lives, with the remainder passing to your grandchildren.
Gifts to these trusts plant a potentially devastating time bomb that will explode in the future either when a child dies or when distributions are made to a grandchild. Why? Those are two events that trigger the GST tax. Those events deem property to pass from you to the grandkids, “skipping” your kids in the process. The particularly nasty fact is that the tax (currently 55%) will be based upon the value of the trust at the time of the triggering event, not the historical value of your gifts, potentially including decades of income and appreciation.
These trusts often are structured to qualify for the gift tax annual exclusion, so many people tend to ignore them and just add $10,000 per year per donee. Life insurance trusts often follow this pattern when you pay the annual premiums on behalf of the trust. Unfortunately, thanks to a devious Congress in 1988, these trusts rarely qualify for the GST annual exclusion. Unless you take action, each year’s gift adds more blasting powder to the GST time bomb.
The way to avoid the GST is to allocate part of your $1.06 million GST exemption each time you make a gift to the trust. The problem is that you must affirmatively elect to allocate the exemption by filing a statement in a gift tax return each year. The election statement is necessary even though the gift tax annual exclusion otherwise precludes the need for a gift tax return.
If you discover the problem years after the gift, you can make a “late” exemption allocation election. However, the late election eats up exemption based upon the potentially much higher value of the trust’s assets at the time you file it.
Defusing the Bomb
Recognizing that many people are blissfully unaware of the problem (and the resulting huge bucks at stake), the American Institute of CPAs fought for years to get legislative relief for failures to allocate the exemption. Thanks to their efforts, the recent tax bill offers some relief.
The new law reverses the election concept for gifts to some trusts beginning this year. Now, your GST exemption will be allocated automatically to gifts to some trusts that have children and more remote descendents (technically, “skip” and “non-skip” persons) as potential beneficiaries.
However, Congress decided that the new automatic allocation should apply only if there is a likelihood that a significant portion of the trust will pass beyond the kids. The idea is to reduce the risk of wasting exemption if the trust likely will benefit only kids. Therefore, the automatic allocation does not apply if the trust instrument requires more than 25% of the assets to be distributed to the kids before age 46 (or meets certain other technical requirements).
This arbitrary restriction on automatic allocation means that many trusts remain unprotected. Examples include:
Trusts created by people who think the kids will require more than 45 years of maturity before being entrusted with more than 25% of their largess;
Trusts that require more than 25% to be distributed to the kids before age 46, but that retain some assets ultimately passing to grandkids;
Trusts created before 2001 if you did not allocate exemption previously and the trust might pass to the grandkids (because the new law does not cure the problem for pre-2001 gifts); and
Charitable lead and charitable remainder trusts.
To Allocate or Not to Allocate
You waste your GST exemption if you elect to allocate (or the new law automatically allocates) it to a trust and nothing ultimately passes to your grandkids. This creates an interesting dilemma for gifts to a trust that will distribute to your child at, say, age 35. Chances are that he will live that long so allocating the exemption likely would waste it. On the other hand, if the actuaries are wrong and he dies before 35, Uncle Sam will confiscate the lion’s share of the grandkids’ inheritance.
The new law helps with this dilemma, but with many “ifs.” If. . .
You did not allocate exemption for past gifts to a trust,
Your child(ren) and grandchild(ren) are potential beneficiaries, and
Your child dies while you are still alive.
. . . . .then you may elect to retroactively allocate your exemption as if you had done so at the time the gifts were made. The problem is that you must survive your child for this relief to be available. So, the allocation remains a dice roll, but the odds are slightly more in your favor.
The new law directs the IRS to be more understanding when taxpayers ask for relief from past GST mistakes. If granted, “relief” means that you may retroactively allocate GST exemption to prior years’ gifts based upon the date-of-gift value as compared to a late election’s current asset value.
The relief takes two forms. First, good-faith efforts to allocate exemption will be accepted even though election technicalities, like the form was improperly prepared, were deficient. Second, the IRS is authorized to grant relief if “relevant circumstances” (such as the terms of the trust instrument) indicate that you intended the trust to benefit the grandchildren and, therefore, would have wanted to allocate GST exemption had you known about the issue.
This relief is supposed to be available for pre-2001 failures to allocate exemption. You should act promptly to address the need to request relief, since the IRS probably will require the request to be filed within a reasonable time after you discover a problem.
Severing Stops Bleeding
There are a few additional goodies that give attorneys and accountants goose bumps. For example, the new law allows trustees to sever a trust that is partially GST exempt and partially nonexempt. Division into two parallel trusts (one exempt and one non-exempt) can greatly improve the ability to plan for and reduce GST taxes. It is relevant to people who do not have enough GST exemption to cover all their gifts and bequests to trusts.
By the way, if all this talk about grandkids makes you worry about the family’s ability to qualify for the 15-year payout of estate taxes, you can rest easy. Congress has increased to 45 (from 15) the number of shareholders (in addition to your family line) that your company may have and still qualify for the extended payout term. So, you can encourage your kids and siblings’ kids to give you more. (Grandkids, grandnieces and grandnephews, etc. that is!)
Naturally, all of these rules are complex, so check with your advisors.
This and my previous two columns hit most of the highlights of the estate tax repeal legislation. Stay tuned next month for some practical (and maybe not so practical) thoughts and tips about what to do with what Congress hath wrought.