Knowing Generation-Skipping 'Rules' is Key

From the December 11, 2000 Massachusetts Lawyers Weekly
By Leo J. Cushing

As the end of another year approaches, effective estate planners will encourage their clients to begin (or hopefully continue) a lifetime gift-giving program.

This year, with the precipitous drop in the stock market, gift giving can be a particularly effective estate planning technique since gifts are valued for tax purposes at fair market value on the date of the gift.

Unfortunately, too often gift-giving programs are limited to the annual exclusion amount of $10,000 per year per donee. While certainly this is better than nothing, clients should consider giving much larger amounts -- perhaps up to and including their full applicable exclusion amount of $675,000 per donor.

Remember, once an individual's wealth exceeds this exemption amount, a wealth transfer tax will be assessed in the form of either a gift tax (in the case of lifetime gifts) or an estate tax (in the case of assets, which are transferred upon death) beginning at a rate of 37 percent and increasing to 55 percent (for transfers in excess of $3 million).

Once the decision is made to begin a gift-giving program, consideration should be made to making gifts that skip one or more generations since the wealth transfer tax is imposed each and every time property is transferred from one generation to the next.

Perhaps the property should be transferred directly to grandchildren or into an Irrevocable Dynasty Trust.

Even in Massachusetts, which is not a particularly asset-protection friendly state, a Dynasty Trust can be established for either a term of 90 years from the date of creation, or for a term that is no later than 21 years after the death of individuals alive when the interest is created. G.L. c. 184A, Sect. 1.

This so-called "rule against perpetuities" limits the duration of such trusts, but numerous other jurisdictions have eliminated the rule against perpetuities so that property can remain in trust forever.

While this is a great idea, unfortunately a rather draconian generation skipping transfer tax (GST) of 55 percent provides a limitation to this technique, as well as horribly unfortunate results if not properly taken into consideration.

'Disastrous Consequences'

While an understanding of these so-called GST rules can provide tremendous planning opportunities, a failure to understand them can likewise have disastrous consequences.

Consider the recent case of Simches v. Simches, 423 Mass. 683 (1996).

In Simches, a Massachusetts resident undertook a rather common, highly effective (so effective Congress would like to repeal it) technique called a Qualified Personal Residence Trust (QPRT).

Following carefully the provisions of IRC Sect. 2702 governing QPRTs, the individual established an irrevocable trust in which she retained the right of exclusive use of the property for a 10-year period and then transferred her vacation home on the Cape to the trust.

At the end of the 10-year term of the QPRT, the residence would be distributed to a nominee trust entitled the "N&R Nominee Trust."

The beneficiaries of the nominee trust were four other trusts established exclusively for the benefit of each of the individual's four grandchildren. In essence, the vacation home would pass to the grandchildren at the expiration of the 10-year term.

A QPRT can provide significant estate and gift tax advantages since the value of the gift is the value of the remainder interest, which is determined by subtracting the actuarially determined value of the 10-year retained interest from the fair market value of the property on the date of the gift.

In Simches, it was stipulated that even though the property was valued at $2.5 million on the date of the gift, the value of the property transferred (the remainder) for gift tax purposes was only $968,275.

Since this amount exceeded the individual's then unified credit amount of $600,000, a gift tax of approximately $140,000 was paid, but the real benefit sought was in the nature of skipping the children's generation.

If the property value doubled in 10 years to $5 million (which is not unrealistic given the appreciation of property on the Cape and the Islands), the gift tax of $140,000 was a small price to pay, since it was thought that the transfer would skip the children's generation and pass directly to the grandchildren's trusts without any additional wealth transfer taxes.

Unfortunately, the estate planner was not aware of a rather obscure but extremely important provision of the GST tax code dealing with the so-called Estate Tax Inclusion Period (ETIP).

According to IRC Sect. 2642(f), even though the transfer was "completed" for gift tax purposes, the transfer was considered incomplete for GST tax purposes until the end of a so-called estate tax inclusion period.

Since the fair market value of the vacation home would be includible in the donor's estate if the donor died within the 10-year term of the trust, the end of the estate tax inclusion period would not be until the termination of the trust (i.e., 10 years from the date of creation).

For GST purposes, at that time the donor would be deemed to have made a transfer of the property at the then-fair market value (in this example, $5 million) to her grandchildren.

The GST tax due at that time would be approximately $2.2 million computed by subtracting the donor's GST tax exemption from the value of the property and multiplying the difference by 55 percent.

(Every donor is entitled to a $1.03 million GST tax exemption, which may be allocated to any property gifted to grandchildren as to which such individual is the transferor. IRCSect. -- 2631. This exemption will increase each year based on a cost of living adjustment.)

In Simches, the court found that the QPRT would owe $1,375,000 in GST taxes upon termination of the donor's interest in 10 years -- even if the property did not appreciate.

The court also noted that the GST tax could have been avoided completely simply by naming the children as beneficiaries rather than her grandchildren's trusts, since the transfer would not skip a generation.

The Simches case is significant not only from the perspective of the magnitude of the error and its discussion of the estate tax inclusion period, but also for the solution afforded the donor.

Fortunately, the parties were able to persuade the Supreme Judicial Court to "reform" the document by substituting the children in place of the grandchildren as beneficiaries of the QPRT on the grounds of "unilateral mistake" since there was "full, clear and decisive proof" of the mistake.

The court noted that the sole purpose of establishing the QPRT was to transfer the vacation home in such a way as to reduce the resulting estate tax liability, while allowing the individual to remain in possession of the residence for the term of the trust (10 years).

Not all planners will be as lucky and remember: The ETIP must be considered when planning for "hot" assets, such as when pre-Initial Public Offering (IPO) stock is transferred to a two-year Grantor Retained Annuity Trust (GRAT).

Another Overlooked Area

Another area where GST issues often are overlooked is with respect to transfers of money to irrevocable life insurance trusts. These gifts usually are in an amount less than the donor's $10,000 annual exclusion.

A typical insurance trust provides that during the lifetime of the donor, the trustee may, in the trustee's discretion, pay any portion or all of the income and principal to or for the benefit of the class consisting of the donor's issue of all generations. This is a "spray" trust.

As the donor makes contributions to the trust, usually in an amount sufficient to cover the cost of insurance, so-called "Crummey" notices are provided to the beneficiaries informing them of their right to withdraw a portion of the contribution for a limited period of time (usually 30 days).

This time-tested, well-established technique is designed to make the transfer of money to the trust a gift of a present interest rather than a gift of a future interest for gift tax purposes. No gift tax return is required to be filed and the gift is eligible for the donor's annual exclusion.

Once again, however, GST can raise havoc for the planner if the trustee makes distributions to grandchildren, or if the property upon termination of the trust passes directly to grandchildren.

In order to eliminate any GST tax problem, a gift tax return must be filed by the donor with a specific allocation of GST tax exemption if the donor intended the trust to be exempt from GST taxes, even though no such return is required for gift tax purposes.

Only a trust that complies with the specific requirements of IRC Sect. 2642(c)(2) avoids the need to file a gift tax return solely for the purpose of allocating GST exemption.

These rules require that the trust (or a trust share within a trust) be established for the benefit of only one individual and must provide that (1) during the life of such individual, no portion of the corpus or income of the trust may be distributed to (or for the benefit of) any person other than such individual, and (2) if the trust does not terminate before the individual dies, the assets of such trust will be includible in the gross estate of such individual.

Most life insurance trusts, unfortunately, do not meet this criteria and usually take the form of a general spray.

The potential GST problem created by failing to file timely gift tax returns can be corrected by filing a late gift tax return and allocating GST exemption.

Unfortunately, in allocating exemption on a late filed gift tax return, the exemption allocated must be equal to the value of the trust assets determined as of the date of the filing of the late return.

In the alternative, the donor is permitted to value assets as of the first day of the month in which the late filing occurs, but in the case of life insurance owned by the trust, the life insurance may be valued as of the first day of the month only if the insured is then living. Treas. Reg. Sect. 26.2642-2(a)(2).

If the trust consists entirely of term insurance where there is little or no value in the trust, a late allocation may even be beneficial since the value of renewable term insurance decreases following proportionately during the year and the gift would be equal to the unexpired portion of the premium.

Other Saving Feature

Another saving feature, which occurs more by accident than by planning, results from the fact that most life insurance trusts provide for termination upon the death of the donor, whereupon any assets remaining will be paid over directly to the children rather than the grandchildren.

Even basic marital deduction planning can have significant GST planning issues.

Consider the case of a couple with $2 million in assets with $1 million owned by each spouse payable to their respective revocable trusts.

Upon the death of the first spouse (let us assume the husband), the decedent's trust property would be divided into a marital trust and a by-pass trust. The by-pass trust will be funded with $675,000, the applicable exemption amount, and the marital trust will be funded with the difference of $325,000.

The marital trust provides that all income must be made payable to the surviving spouse (the "wife") and the surviving spouse may withdraw principal upon request.

The by-pass trust provides that income and/or principal may be made payable to the class consisting of the decedent's spouse and the decedent's issue of all generations in the independent trustee's discretion.

Focusing only on GST, $675,000 of the decedent's GST tax exemption, if any remaining, will be allocated to the decedent's by-pass trust established for the benefit of his family.

Since the by-pass share will be completely exempt from GST taxes, the trust can remain in effect for the maximum rule of perpetuities (90 years from the date of the donor's death).

For estate tax purposes, the marital share will not be taxable upon the death of the husband, but rather will be added to the assets of the wife and subject to estate taxes at that time.

If the wife's plan provides for a distribution of property to her grandchildren, the transfer will be subject to GST tax to the extent the amount transferred to the grandchildren exceeds the wife's GST tax exemption.

In this case, the wife will be unable to fully exempt the assets that are includible in the estate since the total estate would be $1,325,000, but she had only a $1,030,000 GST exemption.

This effectively prevents the wife from skipping a generation even though the family's combined estate was less than the combined GST exemption of $2.06 million, a result that could have been avoided with proper planning.

In this regard, the marital share established by the husband could have been established as a QTIP under IRC Sect. 2056(b)(7).

The trust should have provided that income was required to be paid to the surviving spouse, but principal would be payable to the surviving spouse either limited to an ascertainable standard or in the discretion of an independent trustee.

For estate tax purposes, no estate taxes would be due since the trust is eligible for the marital deduction.

Notwithstanding the deductibility of the QTIP trust for estate tax purposes, IRC Sect. 2652(a)(3) permits the husband's executor to "reverse" the QTIP solely for purposes of GST tax purposes.

This reverse QTIP is designed to treat the husband, rather than the wife, as the transferor for purposes of GST taxes, thereby allowing the decedent to fully utilize his $1.03 million exemption by blanketing all of the assets on his death from the GST tax.

Additionally, the wife will be treated as transferring only $1.03 million consisting of her own assets, which can be fully exempted from generation skipping by an allocation of her exemption.

None of these techniques are considered advanced, but each have significant GST issues that must be addressed. There is still time to give away assets this year and perhaps no better time than the present.

Leo J. Cushing is the founding partner of Cushing & Dolan, a Boston-based law firm concentrating on sophisticated estate planning techniques.