Diagnosing and Treating GST Exempt / Grandfathered Trusts Julie M. Kwon McDermott Will & Emory Menlo, CA Nathan R. Brown Proskauer Rose Boca Raton, FL Brandon A.S. Ross Loeb & Loeb Washington, DC James F. Hogan Andersen Tax Washington, DC
Introduction This presentation is intended to provide the practitioner with a roadmap for Determining whether a trust is GST exempt, GST nonexempt or partially GST exempt and Cleaning-up mixed inclusion ratio trusts or non-exempt trusts that were intended to (or should) be exempt. General knowledge of the GST tax rules is assumed. 2
Determining GST Status Why does it matter? GST Exempt Trust Distributions from the trust will be wholly exempt from GST tax. GST Non-Exempt Trust Taxable distributions and taxable terminations will be subject to GST tax at a 40% rate. Mixed Inclusion Ratio Trust Taxable distributions and taxable terminations will be subject to GST tax at a reduced rate (i.e., the 40% GST tax rate x the trust s inclusion ratio). 3
GST Exempt Trusts A trust can be exempt from GST tax in one of the following ways: The trust is a grandfathered trust pursuant to Treas. Reg. Section 26.2601-1(b). GST exemption was affirmatively allocated to the trust pursuant to IRC Section 2631. GST exemption was automatically allocated to the trust pursuant to IRC Section 2632(b) (direct skips) or IRC Section 2632(c) (indirect skips to GST trusts). Transfers to the trust were excluded from GST tax under IRC Section 2642(c) (the GST tax annual exclusion ). The Gallo Trust Exception applied to the transfer. 4
Grandfathered Trusts Any trust that became irrevocable on or before 9/25/85. Trust executed after 9/25/85 cannot be a grandfathered trust. Trust executed on or before 9/25/85 need to determine date of irrevocability. 5
Determining Irrevocability A trust is a grandfathered trust unless: Settlor held power with respect to trust that would result in gross estate inclusion under IRC Section 2038. Trust holds life insurance policy with respect to which the insured possessed incidents of ownership that would result in gross estate inclusion under IRC Section 2042. 6
Determining Irrevocability Revocable Trusts and Wills Executed before 10/22/86 No amendments after 10/21/86 resulting in creation of or increase in amount of a GST No addition made after 10/21/86 resulting in creation of or increase in amount of a GST Decedent died before 1/1/87 7
Additions to Grandfathered Trusts Generally, taxable distributions from and taxable termination of interests in grandfathered trusts are not subject to GST tax. However, if an addition is made to a grandfathered trust after 9/25/85, a portion of all subsequent GSTs from the trust will be subject to GST tax. Chapter 13 Portion Non-Chapter 13 Portion 8
Beware of Constructive Additions General Powers of Appointment Release, exercise or lapse of GPOA in excess of 5 or 5 amount results in constructive addition. Limited Powers of Appointment Exercised to postpone vesting beyond the rule against perpetuities. 9
Modifications and Safe Harbors Regulations set forth rules for determining whether a grandfathered trust will retain its GST exempt status following a modification, judicial construction, settlement agreement or other action by the Trustees. Effective Date 12/20/2000 10
Decanting Caveat IRS has not issued guidance on decanting. (1) Either AND (a) Terms of governing instrument authorize decanting without consent or approval of beneficiary or court, or (b) At time trust became irrevocable, state law authorized decanting (2) Terms of new trust do not extend time for vesting beyond 21 years after the death of any life in being at the time the grandfathered trust became irrevocable. 11
Settlement A court approved settlement of a bona fide issue regarding the administration of the trust or construction of terms of the governing instrument will not cause an exempt trust to be subject to GST tax if: The settlement is the product of arm s length negotiations; AND The settlement is within the range of reasonable outcomes under the governing instrument and applicable state law addressing the issues resolved by the settlement. 12
Judicial Construction A judicial construction of a governing instrument to resolve an ambiguity in the terms of the instrument or to correct a scrivener s error will not cause an exempt trust to be subject to GST tax if: The judicial action involved a bona fide issue; and The construction is consistent with applicable state law that would be applied by the highest state court. 13
Other Changes Modification is valid under state law. Modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person or persons who held the beneficial interest prior to the modification. Modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. 14
Additional Considerations Effect of safe harbors on non-grandfathered GST exempt trusts? Modifications prior to effective date of safe harbors? 15
Withdrawal Powers Many trusts contain withdrawal powers to qualify for the gift tax annual exclusion. The GST tax annual exclusion has more qualification requirements than the gift tax annual exclusion for transfers to trusts. 16
GST Tax Annual Exclusion Additional requirements for GST tax annual exclusion: Trust must be for a single beneficiary who is a skip person; and If the beneficiary dies during the term of the trust, the trust assets must be included in the beneficiary's gross estate. Most trusts don t meet these requirements, necessitating affirmative GST allocations to make the trust GST exempt. 17
Other Withdrawal Power Issues Application of ETIP and spousal withdrawal powers. Not only review the withdrawal provisions, but also the provisions for lapse. Is there a hanging Crummey withdrawal power? Does the transferor shift? Any taxable lapses? 18
Prior Transfer/Additions to Trust Inclusion ratio is determined upon the initial contribution to the trust and again with each addition to the trust. Ask client. Gift tax returns filed? 19
Checking Gift Tax Returns Were prior contributions reported on Form 709? Was GST exemption allocated? Was there an election in or out of the automatic allocation rules? Any late allocations? Were gifts split? Were allocations and reconciliations correct? 20
Transfers Not Affecting GST Status Did trust receive assets via a decanting or other exercise of limited power of appointment? Were assets sold to trust? If not adequate consideration, then check for affirmative or automatic allocations of GST exemption to gift portion. Any issue with valuation, creating an inadvertent gift? 21
No Gift Tax Returns Is the trust a GST trust to which automatic allocations of GST exemption apply? A GST trust is a trust from which a taxable distribution or taxable termination is likely to occur in the future. Does the trust meet one of the six exceptions to the definition of a GST trust? 22
Exceptions to GST Trust Different names are used for the exceptions to a GST trust, but here are the six categories: Age 46 trust; Ten year age difference trust; Partial estate tax inclusion trust; Non-skip person estate tax inclusion trust; CLAT or CRT; and CLUT. 23
No Gift Tax Returns Filed Aside from using the trust agreement to determine if the trust is a GST trust to which GST exemption would be automatically allocated, bank statements and other trust records may be used to help determine the trust s GST status (i.e., inclusion ratio). 24
Transfers at Death The decedent s executor may allocate the GST exemption that the decedent did not use during his or her lifetime. Schedule R of Form 706 shows the trusts to which the decedent s GST exemption was allocated at death. Any reverse QTIP elections? 25
Automatic Allocations at Death The decedent s remaining GST exemption, not allocated by the decedent during life or the decedent s executor at death, is automatically allocated: First, to direct skips; and Next, to trusts from which a taxable termination or distribution may occur. If GST exemption is insufficient to exempt the trusts, the allocation would be allocated pro rata to the trusts. 26
Determining Trust s Inclusion Ratio The inclusion ratio affects the rate of the GST tax because the inclusion ratio reduces the rate of the tax. Inclusion ratio = 1 applicable fraction. Applicable fraction = Amount of GST exemption allocated to trust Value of trust property Inclusion ratio = 1 Amount of GST exemption allocated to trust Value of trust property 27
Additions to Trust Were additions to the trust properly considered and the results computed corrected? To re-determine the inclusion ratio at the time of the addition: Nontax portion of trust = Current value of trust including new assets x applicable fraction. New applicable fraction = Amount of GST exemption allocated + nontax portion from above Current value of trust including new assets New inclusion ratio = 1 applicable faction. 28
Other Issues with Inclusion Ratio Any allocations of GST exemption during ETIP will not be effective until the end of the ETIP. Exception for the spousal 5 X 5 withdrawal power. Separate portions for GST tax purposes. Partial nontaxable gifts to 2642(c) trusts; Grandfathered trusts with non-chapter 13 and chapter 13 portions; and Multiple transferors. 29
Relief Provisions There are various ways to make a non-exempt trust exempt or to fix a mixed inclusion ratio trust: 9100 relief. Simplified method under Rev. Proc. 2006-46. Late allocation of GST exemption. Retroactive allocation. Qualified severance. 30