Sooner or later, every estate planner comes face to face with the generation-skipping transfer tax (GSTT). Many practitioners do not feel up to the challenge because this particular tax has a reputation for being as treacherous as the sea. But after you boil down all the complications, you’re left with a fairly direct set of circumstances to watch for. This article is meant to help you identify situations that subject clients to the generation-skipping transfer tax and advise them appropriately.
The GSTT is the government’s defense against an end run around estate and gift taxes. It imposes a flat tax on gifts and bequests above the estate/lifetime gift exclusion that avoid gift or estate tax by skipping one or more generations, such as to grandchildren. It is relatively straightforward in its provisions, but financial advisers need to be aware of recent and ongoing changes in exemption amounts, allocations and tax rate and the corresponding implications for estate plans. One important planning element is the optimal use of the lifetime exclusion in tandem with the annual gift exclusion, along with other common estate planning mechanisms.
REINING IN LIFE ESTATES
The GSTT is a simplified version of a tax originally instituted in 1976. Back then, Congress explained that the tax was designed “to remedy the perceived abuse of using a trust to benefit several generations while avoiding Federal Estate Tax during the term of the trust.”
Here’s the abuse they saw: Wealthy families were going to estate planners who created a life estate in their assets for their kids, followed by a life estate in the assets for their grandkids, followed by a life estate in the assets for their great-grandkids and so on. Since life estates are not subject to the federal estate tax, these plans effectively moved incredible amounts of wealth from generation to generation without any risk of the estate tax. Less wealthy families were paying more in estate tax than more wealthy families, who could afford to engage in sophisticated estate planning. The initial GSTT that Congress created, however, was so widely criticized that the Tax Reform Act of 1986 retroactively repealed the 1976 version and implemented the current version.
The 1986 Act imposed a tax equal to the highest estate tax rate on any generation- skipping transfer, with a $1 million exemption per taxpayer. In 1995, the exemption was indexed for inflation in $10,000 increments. In 2001, the exemption was increased to match the estate tax exemption. This change, along with scheduled increases in the exemption amount culminating in the scheduled repeal of the estate and GST taxes, was included in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).
Currently, a taxpayer’s GSTT exemption is $3.5 million, and both the GSTT and the estate tax are scheduled for repeal in 2010. The 2001 EGTRRA changes are then scheduled to sunset on Jan. 1, 2011, and the estate and GSTT exemptions drop back to their 2001 levels, as indexed for inflation. The Obama administration and some in Congress, however, have indicated their desire to avoid repeal of the estate tax and preserve the exemption at its current level. Although they have not specifically addressed the GSTT, it is considered likely to be included in any upcoming estate tax changes (see sidebar, “Forecasting the Estate Tax,” below).
The EGTRRA also introduced another significant GSTT change. Prior to the EGTRRA, a taxpayer’s GSTT exemption was automatically applied only to direct skips. After the EGTRRA, the exemption will also be automatically allocated to indirect skips (defined below) in certain circumstances unless the taxpayer (or the taxpayer’s executor) elects out of the automatic allocation rules. Automatic allocation to indirect skips under the EGTRRA is limited, though: The transfers must be in a GST trust (one that fits the criteria of IRC § 2632(c)(3)(B), which prevents allocation to most charitable trusts as well as trusts in which non–skip persons essentially have more than 25% of the beneficial interest) that’s subject to the gift tax and an estate tax inclusion period that ends after the EGTRRA’s effective date. This automatic allocation is also scheduled to sunset with the other EGTRRA provisions. It is unclear whether it will be retained, but if it is, strategies for electing out under these circumstances, in addition to direct skips, could well be valuable beyond next year
EXECUTIVE SUMMARY
Despite its fearsome reputation, the generation-skipping transfer tax (GSTT) is straightforward in its provisions and worth the attention of CPA planning advisers, especially in the currently unsettled political climate.
The GSTT is imposed on asset transfers that avoid estate or gift tax and skip one or more generations, such as by a grandparent to a grandchild, or if to an unrelated person, to someone more than 37½ years younger than the transferor. It is imposed on direct transfers and transfers via trust. The tax rate and exemption amount are those of the estate tax.
Electing out of an automatic allocation of the GSTT exemption to direct skips and paying any applicable GSTT is advised for preserving the exemption for the trust’s future taxable distributions or termination (“indirect skips”).
Late allocations may be made, but they may adversely affect the amount of the exemption allocated to trust assets for any transfer under a pre-established inclusion ratio, depending on whether assets have appreciated since the allocation date.
For couples, a reverse qualified terminable interest property (QTIP) election may allow allocation of any remaining exemption amount of the first spouse to die if only a portion of it was allocated to a bypass trust.
Allocations may also come into play for irrevocable life insurance trusts and complex trusts..
Full Article At: The Generation-Skipping Transfer Tax: A Quick Guide
