Selected Aspects of the Final Generation-skipping Transfer Tax Regulations-part I
| Jurisdiction | United States,Federal |
| Citation | Vol. 25 No. 7 Pg. 49 |
| Pages | 49 |
| Publication year | 1996 |
1996, July, Pg. 49. Selected Aspects of the Final Generation-Skipping Transfer Tax Regulations-Part I
This jointly sponsored article discusses the IRS's recently finalized generation-skipping transfer tax ("GSTT") regulations, which contain numerous changes to and clarifications of the proposed regulations. The two-part article will consider selected portions of the final regulations which, in the author's opinion, are particularly noteworthy. For the purpose of placing the regulations in context, background explanation, beginning with the following overview, precedes discussion of the regulatory provisions in this Part I. Part II, to be published in the August issue, will discuss the predeceased child exception, late allocations of GSTT exemption, disregard of interests, application of GSTT to nonresident aliens and other topics impacted by the final regulations.
In 1916, Congress, by enacting the federal estate tax, decided to tax gratuitous transmissions of wealth. Until 1932, when the predecessor of the modern-day gift tax was enacted, an individual could easily circumvent the estate tax by making lifetime gifts. After 1932, transfers of property that were subject to either the estate tax or the gift tax could provide benefits to successive generations of beneficiaries without being subject to any further transfer tax.(fn1) In other words, provided that beneficiaries of trusts did not hold interests in the trusts that would cause trust property to be taxed on their death, distributions of trust property could be made to multiple generations of beneficiaries for as long as a trust could exist under state law.
This potential to transmit wealth to successive generations on a transfer-tax-free basis came to be viewed as abusive, and Congress attempted to plug this perceived loophole by enacting the 1976 generation-skipping transfer tax ("GSTT"). The 1976 GSTT was extremely complex, conceptually flawed and considered by many practitioners to be unworkable. As a result, the Tax Reform Act of 1986 retroactively repealed the 1976 GSTT and replaced it with a new GSTT, which is Chapter 13 of the Internal Revenue Code ("Code"). Subsequent legislation made technical corrections and other amendments to the tax.(fn2)
On December 24, 1992, the Internal Revenue Service ("IRS") issued proposed GSTT regulations.(fn3) The proposed regulations constituted a major step in the evolution of the GSTT. On the positive side, the regulations cleared up several unresolved issues and provided a set of operational rules that better enabled practitioners to plan transactions. However, the unavoidable complexity of the rules was the likely cause of ambiguities and inconsistencies in the regulations in their proposed form. Certain portions of the proposed regulations also had the potential of creating harsh results that were, at least arguably, beyond the authorization of the Code.
The GSTT regulations were finalized on December 27, 1995,(fn4) and the "substantive rules" (as opposed to the "effective date rules") apply to generation-skipping transfers made on or after December 27, 1995.(fn5)
As with the federal estate tax (Chapter 11 of the Code) and the federal gift tax (Chapter 12 of the Code), Chapter 13 of the Code imposes a tax on the transfer of wealth. Although Chapter 13 often relies on and references provisions of the estate and gift tax law, it levies a separate tax, and the events that give rise to its imposition are often not events that would cause the imposition of estate tax or gift tax.
Generation-skipping transfers involve the disposition of property to a person who is assigned to a generation at least two generations below (younger than) the generation assignment of the transferor of the property. Persons who are at least two generations below the generation assignment of the transferor are referred to as "skip persons," and all other persons are referred to as "non-skip persons."(fn6) A trust can be a skip person if all of the interests in the trust are held by skip persons.(fn7)
The event giving rise to the imposition of the GSTT is a generation-skipping transfer. There are three types of generation-skipping transfers: direct skip, taxable termination and taxable distribution.(fn8)
A direct skip is a transfer to a skip person, which is subject to either gift tax or estate tax.(fn9)
Example: Grandparent gave Grandchild cash in the amount of $100,000. The next year, Grandparent died and devised $100,000 to a trust, the beneficiaries of which are grandchildren and great-grandchildren.
Results: Both transfers are direct skips. The transfer to the trust is a transfer to a skip person.
A taxable termination is defined as the termination by death, lapse of time, release of power or otherwise of an interest in property held in trust unless, immediately after such termination, a non-skip person has an interest in such property.(fn10)
Example: Grandparent transferred property to a trust. Income and principal of the trust may be paid to Child during Child's life. On Child's death, the trust property is to be distributed to Grandchild. Child died in 1996.
Result: A taxable termination occurred at Child's death.
A taxable distribution is any distribution from a trust to a skip person other than a taxable termination or a direct skip.(fn11)
Example: Grandparent died in 1995. All of Grandparent's property passed to a trust. The trustee has discretion to pay income and principal, from time to time, to Grandparent's children and grandchildren. In 1996, the trustee made a $25,000 distribution to a grandchild.
Result: A taxable distribution occurred in 1996 because Grandchild is a skip person. A generation-skipping transfer did not occur at the time of Grandparent's death.
With some exceptions, property is valued at the time of the generation-skipping transfer for purposes of determining GSTT.(fn12) The tax is computed by using a flat rate, which is the maximum federal estate tax rate (currently 55 percent); however, the actual rate (referred to as the "applicable rate") is determined by multiplying the "inclusion ratio" times the maximum federal estate tax rate.(fn13) The inclusion ratio is computed by subtracting the "applicable fraction" from one. The numerator of the applicable fraction is the GSTT exemption allocated to the trust (or transfer in the case of a direct skip), and the denominator is the value of the property transferred.(fn14) These concepts are illustrated in the example set forth below.
Every individual possesses a $1 million GSTT exemption that may be allocated by the individual or the individual's personal representative to any property of which the individual is the transferor.(fn15) GSTT planning will often involve the allocation of GSTT exemption to transfers in such a manner that the transfer or trust that will benefit skip persons will have an inclusion ratio of zero (that is, exemption will be allocated so that no GSTT will be incurred with respect to the gift or trust). Certain automatic GSTT exemption allocation rules apply in the absence of a decision to allocate or not to allocate exemption.(fn16) Other rules prevent the effective allocation of GSTT exemption in special circumstances.(fn17)
Example: Grandparent transferred $2 million to the "X" trust. Income and principal may be paid to Child and Grandchild during Child's life. On Child's death, trust property is to be distributed to Grandchild. Grandparent has not previously utilized any GSTT exemption. All ($1 million) of Grandparent's GSTT exemption was timely allocated to the trust.(fn18)
No GSTT was payable when Grandparent transferred the $2 million to the "X" trust because a generation-skipping transfer did not occur at that time.
If the trustee distributed $100,000 to Grandchild, a taxable distribution will have occurred and GSTT will be determined as follows: $100,000 x 27.5% = $27,500.
Assume instead that Child died when the value of the trust property was $3 million. In this case, a taxable termination will have occurred and GSTT would be determined as follows: $3,000,000 x 27.5% = $825,000.
Lastly, assume instead that Grandparent transferred only $1 million to the "X" trust and the other $1 million was transferred to the "Y" trust. Grandparent allocated all exemption only to the "X" trust. In this case, the inclusion ratio for the "X" trust would be zero, the applicable rate would be zero and no GSTT would be due on taxable distributions and taxable terminations.
There are several exceptions that allow transfers of property to pass to skip persons without the imposition of generation-skipping transfer tax. Certain trusts are grandfathered because the transfers to the trust occurred prior to the effective date of Chapter 13.(fn19) Other transfers are exempt (no GSTT exemption allocation is necessary) from the imposition of GSTT, provided the requirements are met. The exceptions include certain outright transfers as well as certain transfers in trust.(fn20)
With those underlying concepts in mind, the balance of this article deals with selected aspects of the final GSTT regulations and background discussion pertinent thereto.
Perhaps the most controversial aspect of the proposed regulations was the "ETIP" (estate tax inclusion period) rules. The ETIP rules prevent...
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