Last-minute estate planning for 2009: focus on the GST.

• Author: Hoffman, Michael J.R.
• Position: Generation-skipping transfer tax

EXECUTIVE SUMMARY

* Congress enacted the generation-skipping transfer tax to prevent avoidance of the estate or gift tax through bequests or gifts that skip a generation. The GST subjects generation-skipping transfers to an additional tax that approximates the gift or estate tax that would have been due had a generation not been skipped.

* Transfers to a "skip person" are potentially subject to the GST. A skip person for these purposes is anyone assigned to a generation more than one generation below that of the transferor (donor or decedent).

* A lifetime GST exemption is allowed for transfers that would otherwise be generation-skipping transfers. Under the provisions of EGTRRA, the GST exemption is tied to the estate tax exemption amount--$3.5 million in 2009.

* Due to the upcoming changes in the GST rules, planning should be done in 2009 in order to best allocate a taxpayer's available GST exemption to any transfers that are potentially subject to the GST that may or are expected to occur in 2010 or after.

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This article focuses on estate planning opportunities relating to the generation-skipping transfer tax (1) (GST) that practitioners and taxpayers should consider for implementation in 2009. Admittedly, the GST affects a relatively few high-net-worth individuals; however, for those who are affected, the impact can be severe. In many cases, these severe consequences can be mitigated or avoided entirely by means of careful estate planning.

GST and Estate Planning in Uncertain Times

In 2010, the estate tax and the GST are scheduled to be repealed--but only for that one year, 2010. After 2010, the entire set of rules put in place by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (2) sunsets, and the transfer taxes revert to the system that was in place prior to EGTRRA. In his budget proposal for fiscal 2010, President Obama signaled his intent to continue the estate tax as it exists in 2009--presumably meaning the maximum marginal transfer tax rate will be 45% and the exemption amount for the estate tax will be $3.5 million. However, the 134-page budget proposal is light on details, so we are left to assume that, when the budget proposal states "the estate tax is maintained at its 2009 parameters," (3) this also pertains to the GST. Further, this is just the initial budget proposal. As the fiscal 2010 budget moves toward conference, practitioners can only speculate whether the estate tax and the GST will make the final cut.

For several reasons, 2009 is a critically important year for estate planners. First, the amount of the GST exemption is at its historic high of $3.5 million. Second, the value of financial assets is at a low not seen for a decade or more. (4) Finally, the form the GST will take after its one-year repeal in 2010 is uncertain. One possibility is that the GST will revert to its parameters under permanent (pre-EGTRRA) law. The most dramatic aspect of this possibility is that the GST exemption will revert to an inflation-adjusted $1 million. Combined with the return of the 55% maximum estate tax rate in 2011, advisers would be hard pressed to explain to their clients why they had not taken advantage of the GST planning opportunities in 2009. Even if the GST returns in 2011 as incarnated in 2009, hopefully the economic recovery will be underway by then, which will mean that trust values will have somewhat recovered from the lows of 2009. As trust values recover, the efficiency of GST exemption allocations is reduced.

Overview of the GST

The purpose of the GST is to "backstop" the gift and estate tax. The intent of the gift and estate tax is to subject wealth to taxation as it passes from generation to generation. Obviously, if a taxpayer makes gifts or bequests in such a way that a generation is skipped, an otherwise taxable transfer is avoided. Before the enactment of the GST, (5) this approach was a viable strategy for mitigating the impact of the estate tax. However, the GST subjects such generation-skipping transfers to an additional tax that approximates the gift or estate tax that would have been due had a generation not been skipped. Because a single transfer is being subjected to two transfer taxes--i.e., the gift or estate tax and the GST--the tax burden on the transfer can seem punitive. Indeed, the effective tax rate on a generation-skipping transfer can exceed 100% when both transfer taxes are considered.

Exemptions from the GST

There are two important exemptions from the GST. First, a gift that does not exceed the gift tax annual exclusion (6) ($13,000 in 2009) is usually sheltered from the GST. (7) Similarly, exempt gifts for educational or medical purposes under Sec. 2503(e) are also exempted from the GST. (8) In addition, a lifetime GST exemption is allowed for otherwise generation-skipping transfers. Under the provisions of EGTRRA, the GST exemption is tied to the estate tax exemption amount--$3.5 million in 2009. (9) Under (pre-EGTRRA) permanent law, the GST exemption was an inflation-adjusted $1 million. (10)

Generation-Skipping Transfers

Transfers that are potentially subject to the GST are transfers in which the recipient is a "skip person," (11) which is anyone assigned to a generation more than one generation below that of the transferor (donor or decedent). Thus, one's child would not be a skip person but one's grandchild (or lower generation) would. The rules for determining generation assignment also address collateral relationships (e.g., nephew versus grandnephew), in-law relationships, and unrelated individuals. (12) It is possible for a person to be assigned to more than one generation for GST purposes--e.g., a grandnephew who has been adopted by the transferor. In this case, it is the youngest generation that applies. Thus, an adopted grandnephew would still be a skip person because the biological relationship trumps the legal (adoptive) relationship. (13)

Three types of transfers are subject to the GST--direct skips, taxable terminations, and taxable distributions. (14) In most cases, a direct skip involves a transfer directly from a donor or decedent to a skip person. A transfer in trust where all beneficiaries of the trust are skip persons is also considered a direct skip. A key element of a direct skip is that the transfer is subject to either the gift or estate tax. (15)

With respect to property held in trust, a taxable termination occurs when all interests in the trust property shift to members of a skip generation. (16) For example, the terms of a trust hold that the primary beneficiary is the trustor's child (not a skip person). In the event that the primary beneficiary dies before the trust is terminated, the primary beneficiary's interest in the trust will pass to his or her issue by right of representation. In that event, regardless of whether the trust actually terminates upon the death of the primary beneficiary, a taxable termination occurs for GST purposes because all interests in the trust pass to a skip generation (i.e., the trustor's grandchild). (17) In a direct skip or a taxable termination, the transferor (i.e., the donor in the case of a gift, the decedent's estate in the case of a bequest, or the trust in the case of a taxable termination) is responsible for paying the GST. (18)

The third type of transfer subject to the GST is a taxable distribution, which is defined as any distribution by a trust to a skip person that is not considered to be either a direct skip or a taxable termination. (19) For example, a trust might have beneficiaries in both nonskip and skip generations. A distribution to a skip person from such a trust would be a taxable distribution. In contrast to the other transfers subject to the GST, in a taxable distribution the transferee is responsible for paying the GST. (20)

Predeceased Parent Rule

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