The IRS has issued proposed regulations [Prop. Treas. Reg. ?26.2632-1] that seem to add a little flexibility to making allocations of generation-skipping transfer (GST) tax exemption to trusts. The proposed regulations extend the rules so that a person generally can provide for allocations or nonallocation of GST exemption to trusts in any timely fashion. However, as discussed below, in most cases a simple all-or-nothing approach sticking to trusts with inclusion ratios of zero or one is all that is needed.

In general, the generation-skipping transfer tax applies to transfers to skip persons. A skip person is a person 2 or more generations younger than the transferor (e.g., grandchildren, great-grandchildren). A transfer to a trust is a direct skip if all trust beneficiaries are skip persons. Also, a taxable distribution occurs when distributions from a trust are made to skip persons when there are also nonskip beneficiaries (e.g., distributions to grandchildren while children are still beneficiaries). In addition, a taxable termination occurs when an interest in a trust ends (e.g., child?s income interest for life) and the remaining beneficiaries are all skip persons.

Each person has a GST exemption that can be allocated to transfers. In 2004, the GST exemption is $1,500,000. A married couple effectively has a GST exemption of $3,000,000 in 2004. Each time a contribution is made to a trust, an inclusion ratio is calculated for a trust that generally reflects how much of a trust is protected by GST exemption and how much is not.

The statutes provide for certain automatic allocations of GST exemption to direct skips and to indirect skips to GST trusts. An indirect skip is a transfer (other than a direct skip) subject to gift tax to a GST trust. The definition of a GST trust is a purely arbitrary list of certain trusts that Congress thought might be likely to result in generation-skipping transfers. The statutes also provided for certain elections.

As noted above, the proposed regulations extend those provisions so that a person generally can provide for allocations or nonallocation of GST exemption to trusts in any timely fashion. The regulations generally permit elections to allocate or not allocate GST exemption to individual transfers or to all transfers to a trust. An election with regard to all transfers to a trust can later be revoked with respect to future transfers to the trust. The regulations also permit elections with regard to individual transfers to a trust even where an election is in place with regard to all transfers to a trust.

While it is good that all this flexibility is available, it seems that the best strategy generally remains to make an election with regard to an entire trust to have the trust treated as either (1) a GST trust to which automatic GST exemptions allocations are made, or (2) other than a GST trust and to which GST exemption is not allocated. If need be, the election with regard to all transfers to the trust can be changed at a later time.

GST exemption can be allocated to trusts likely to benefit skip persons and not to trusts for the benefit of nonskip persons. Trusts can be maintained with inclusion ratios of zero (fully protected with allocations of GST exemption) and one (no allocations of GST exemption). Similarly, trustees can make distributions to skip persons from trusts with inclusion ratios of zero, and distributions to nonskip persons from trusts with inclusion ratios of one. And with this simple strategy, it is less likely that the transferor will make a mistake about allocation of GST exemption.

For example, a grandfather could create one trust for the primary advantage of a son and a daughter. Grandchildren may or may not be given secondary interests in this trust. The trust could be designated as other than a GST trust with no allocations of GST exemption to the trust. It would have an inclusion ratio of one.

The grandfather could create a second trust for the primary advantage of grandchildren and great-grandchildren. The children may or may not be given interests in this trust. This trust could be an irrevocable life insurance or dynasty trust. The trust could be designated as a GST trust with allocation of GST exemption to all transfers to the trust. It would have an inclusion ratio of zero.

When a trustee makes a distribution to the son or daughter, the distribution can be made from the first trust. Although the trust has an inclusion ratio of one, the son and daughter are not skip persons. When a trustee makes a distribution to a grandchild, the distribution can be made from the second trust. Even though the grandchild is a skip person, the trust has an inclusion ratio of zero. In either case, there is no GST tax.

The grandfather and his advisors should periodically review whether changes should be made. Elections can be changed, planned contributions to trusts can be changed or ended, new trusts can be created, and if a son or daughter were to predecease the grandfather, consideration might be given to a retroactive allocation of GST exemption to the first trust. And the trustee can continue to make distributions from the trusts in ways that minimize GST tax.

William J. Wagner, JD, LL.M, CLU, is an associate editor of Tax Facts, a National Underwriter Company publication.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.