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© 2010 Thompson Coburn LLP Back to Basics The Role of Generation Skipping Transfer Taxes in Everyday Estate Planning Presentation for The Chicago Estate Planning Council, May 25, 2010 Jason S. Ornduff Thompson Coburn LLP 55 E. Monroe Street, 37 th Floor Chicago, Illinois (312)
© 2010 Thompson Coburn LLPDisclosures/Disclaimers Thompson Coburn LLP Disclaimer This presentation, including any oral comments of or questions answered by the speaker, does not constitute legal or tax advice. Each person’s personal legal and tax situation is unique and requires a thorough analysis of the facts and circumstances of that person. Thompson Coburn LLP only renders legal advice to and provides legal representation for those parties that enter into express client relationships with the firm as evidenced, outlined and limited by signed legal representation agreements. IRS Circular 230 Disclosure Under U.S. Treasury Department guidelines, we inform you that: (1) any tax advice contained in this communication is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, (2) no part of any tax advice contained in this communication is intended to be used, and cannot be used, by any party to market or promote any transaction or matter addressed herein without the express and written consent of Thompson Coburn LLP (3) Thompson Coburn LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein, and (4) any fees, if any, otherwise payable to Thompson Coburn LLP in connection with this written tax advice are not refundable or contingent on your realization of federal tax benefits from the advice contained herein.
© 2010 Thompson Coburn LLP The Trinity of the GST Tax System TransferorTransferor –Person who has disposed of property (or spouse if gift split) –Person who exercises, releases or lets lapse a taxable power over property Property Interest Being TransferredProperty Interest Being Transferred –Direct Skips –Taxable Terminations –Taxable Distributions Skip Person TransfereeSkip Person Transferee –Natural person 2 or more generations below that of transferor –Trust whose interest is held only by skip persons or that cannot make distributions other than to skip persons Transferor Skip Person Property Interest
© 2010 Thompson Coburn LLP Generation Assignment Everyone in the world is assigned to a generation in relation to the transferor: Transferor’s Generation: spouse, siblings (and spouses), first cousins (and spouses), unrelated persons no more than 12.5 years younger One Generation Below: children (and spouses), nephews/nieces (and spouses), children of first cousins (and spouses), persons more than 12.5 but not more than 37.5 years younger Two Generations Below: grandchildren (and spouses), grandnephews/nieces (and spouses), grandchildren of first cousins (and spouses), persons more than 37.5 but not more than 62.5 years younger (even younger is next generation down)
© 2010 Thompson Coburn LLP A GST Love Story Vickie Lynn Marshall (a/k/a Anna Nicole Smith) and former husband J. Howard Marshall (63 years older than her) Before Marriage: Anna is a skip person (not related to Marshall and more than 37.5 years younger) After Marriage: Anna is not a skip person (moves up to the generation of her husband, despite age difference)
© 2010 Thompson Coburn LLP Predeceased Ancestor Rule In general, death in intermediary generation causes persons from lower generation to move up (if death is before transfer) Transferor Living Child Deceased Child Grandchildren (not skip persons) Grandchildren (skip persons) Grandchildren (move up)
© 2010 Thompson Coburn LLP Types of GSTs Direct SkipsDirect Skips –Outright gifts (during life or at death) to skip persons Taxable TerminationsTaxable Terminations –Termination of interest unless: (A)Immediately after termination non-skip person has interest, or (B)At no time after termination may a distribution be made to a skip person Taxable DistributionTaxable Distribution Distribution of property from a trust to a skip person (except when this can be a direct skip or a taxable termination)
© 2010 Thompson Coburn LLP Types of GSTs (cont.) Direct Skips: Main issue arises when elderly person leaves a bequest at death to a non-related person more than 37.5 years younger (neighbor, friend, caregiver) Taxation of GSTs Direct Skips:Tax exclusive (tax paid by transferor on Form 706, Sch. R, or Form 709, Parts 2 and 3 and Sch. C) Taxable Distributions:Tax inclusive (tax comes out of transfer – reported by trustee (on Form 706-GS(D-1), reported and paid by recipient (on Form 706 GS(D)) Taxable Terminations: Tax inclusive (tax comes out of transfer – reported and paid by trustee on Form 706-GS(T))
© 2010 Thompson Coburn LLP Calculation of GST Tax GST Tax = Taxable Amount (TA) x Applicable Rate Applicable Rate = Maximum Federal Estate Tax Rate (45%) x Inclusion Ratio Inclusion Ratio = 1 – Applicable Fraction Applicable Fraction = GST Exemption Allocated to Transfer (GSTE)/Fair Market Value of Transfer (FMV) GST Tax = TA x [45% x (1 - (GSTE/FMV))]
© 2010 Thompson Coburn LLP The GST Exemption GST Exemption is a necessary component since you need to know the Applicable Fraction to calculate the tax owed, if anyGST Exemption is a necessary component since you need to know the Applicable Fraction to calculate the tax owed, if any Was $3.5 million in 2009, there is no GST tax in 2010 and it goes back to $1 million (adjusted for inflation) in 2011 if EGTRRA expires)Was $3.5 million in 2009, there is no GST tax in 2010 and it goes back to $1 million (adjusted for inflation) in 2011 if EGTRRA expires) Applies to both lifetime and testamentary transfersApplies to both lifetime and testamentary transfers Large GST Exemption is the main reason only 197 out of 38,373 estate tax returns in 2008 reported GST tax owed (.5% of returns filed)Large GST Exemption is the main reason only 197 out of 38,373 estate tax returns in 2008 reported GST tax owed (.5% of returns filed)
© 2010 Thompson Coburn LLP Automatic/Elective GST Exemption Allocations Automatic Allocations 1.Deemed allocation to lifetime direct skips and lifetime indirect gifts subject to gift tax (after 12/31/00) 2.No need to make election on gift tax return (but must expressly opt out of automatic allocation in timely filed gift tax return) 3.At death, automatic allocation first to testamentary direct skips, then to trusts Elective Allocations 1.Must report gift on timely filed return and allocate GST exemption to it 2.Instructions for how to make election found in Treas. Reg (b)(4) 3.Late allocation can be made (but value of transfer at time of election, not transfer, is value at issue) 4.Retroactive allocation allowed in limited circumstances
© 2010 Thompson Coburn LLP Correcting Allocation Mistakes Mistakes are made to GST exemption allocations (or opting out of them) all the timeMistakes are made to GST exemption allocations (or opting out of them) all the time Section 9100 ReliefSection 9100 Relief –Must apply for private letter ruling (streamlined procedure in certain circumstances) –IRS makes decision (if yes, retroactive to time of transfer) Five circumstances IRS considersFive circumstances IRS considers 1.Relief request comes prior to IRS discovery 2.Election not made due to circumstances beyond taxpayer control 3.Despite reasonable diligence, taxpayer unaware of necessity 4.Taxpayer relied on written advice of IRS 5.Tax professional error (most common reason given in request)
© 2010 Thompson Coburn LLP Calculation Examples Example 1 – Direct Skip Facts: Grandfather died in 2009, leaving outright gift of $3.5 million to grandchildren (parents alive). Grandfather had previously used $700,000 of GST exemption (so $2.8 million of exemption left). Taxable Amount: $3.5 million Applicable Fraction: 4/5 ($2.8 million/$3.5 million) Inclusion Ratio:1/5 (1 – 4/5) Applicable Rate: 9% (45% x 1/5) GST Tax: $315,000 ($3.5 million x 9%)
© 2010 Thompson Coburn LLP Calculation Examples Example 2 – Taxable Termination Facts: Grandfather died in 2009, leaving gift in trust of $10.5 million for benefit of son, outright to his grandchildren at son’s death. Grandfather has not previously used GST exemption (so $3.5 million of exemption is left). Son dies a year later, and trust is worth $11 million. Taxable Amount: $11 million Applicable Fraction: 1/3 ($3.5 million/$10.5 million) Inclusion Ratio:2/3 (1 – 1/3) Applicable Rate: 30% (45% x 2/3) GST Tax: $3.3 million ($11 million x 30%)
© 2010 Thompson Coburn LLP Calculation Examples Example 3 – Taxable Distribution Facts: Same facts as Example 2, except distributions can be made to grandchildren during the life of son as son appoints by special power. As a result, a $10,000 distribution is made to grandson. Taxable Amount: $10,000 Applicable Fraction: 1/3 ($3.5 million/$10.5 million) Inclusion Ratio:2/3 (1 – 1/3) Applicable Rate: 30% (45% x 2/3) GST Tax: $3,000 ($10,000 x 30%)* * This example points to the problem of trusts with inclusion ratios of between 0 and 1. Had there been two trusts, one with $3.5 million and the full GST exemption, the other with $7 million and no exemption, the first trust could make GST tax-free distributions to the grandchildren and the other could make distributions to the son.
© 2010 Thompson Coburn LLP Gifts Excluded from GST Tax Annual Exclusion GiftsAnnual Exclusion Gifts –Same rules apply as for annual exclusion from gift tax, except –Crummey powers do not work for trusts unless trust is for one beneficiary only and trust includable in estate of beneficiary for estate tax purposes (big issue with respect to insurance trusts) –Section 2503(c) Minor’s Trusts work as well (age 21 issue) Gifts to 529 College Savings PlansGifts to 529 College Savings Plans –Considered completed gifts (annual exclusion can apply) –Can front load gift to grandchildren (5 years in year 1) Qualified Medical and Tuition GiftsQualified Medical and Tuition Gifts –Same rules as gift tax exclusion –Key is to make payments directly to institution
© 2010 Thompson Coburn LLP Estate Tax Inclusion Period General Rule – GST exemption allocation not effective for transferred property interests until property is no longer subject to estate tax at transferor’s death (estate tax inclusion period – ETIP)General Rule – GST exemption allocation not effective for transferred property interests until property is no longer subject to estate tax at transferor’s death (estate tax inclusion period – ETIP) ETIP terminates when one of the following occurs:ETIP terminates when one of the following occurs: 1)Death of transferor 2)No portion of property included in transferor’s estate (other than by reason of Section 2035) 3)At the time of a GST, but only with respect to property involved in the GST 4)If ETIP because of power held by spouse of transferor, on the first to occur of spouse’s death or time property would not be included in the spouse’s estate (except for Section 2053) Classic ETIPsClassic ETIPs –Grantor Retained Trusts (GRATs/GRUTs) –Qualified Personal Residence Trust (QPRT)
© 2010 Thompson Coburn LLP Estate Tax Inclusion Period ETIP Problem – assume $1 million placed in a GRAT with a 10-year term, 5% payout and 6% annual growth, residuary at end of term to a GST trust for children and grandchildrenETIP Problem – assume $1 million placed in a GRAT with a 10-year term, 5% payout and 6% annual growth, residuary at end of term to a GST trust for children and grandchildren (April, rate of 3.2% used) –Value of gift ($422,190) –Value of property at end of term ($1,131,808) –If $422,190 in GST exemption is allocated to gift to start, inclusion ratio of GST trust will be 62.7% ($422,190/1,131,808 = 37.3%) (1-37.3% = 62.7%) –Conversely, if property earns less than payouts, GST exemption will have been wasted Possible solutions: (1) wait until end of ETIP to allocate, (2) formula allocationPossible solutions: (1) wait until end of ETIP to allocate, (2) formula allocation –Risk of waiting – death of transferor before allocation –Risk of formula – additional GST gifts during ETIP (what is available to allocate?)
© 2010 Thompson Coburn LLP Reverse QTIP Election General Rule: A person who exercises, releases or lets lapse a taxable power is the transferor for GST tax purposes is the transferor for GST tax purposes Problem: A surviving spouse has a taxable power over a QTIP marital trust, but if she is treated as the transferor, the surviving spouse must dip into her own GST exemption to pass QTIP assets to skip persons or GST trusts trust, but if she is treated as the transferor, the surviving spouse must dip into her own GST exemption to pass QTIP assets to skip persons or GST trusts Solution: Reverse QTIP election Elements: (1) made on estate tax return of first spouse to die (2) first spouse deemed to be transferor for GST purposes (2) first spouse deemed to be transferor for GST purposes (3) applies to all property in QTIP trust (3-trust structure) (3) applies to all property in QTIP trust (3-trust structure)
© 2010 Thompson Coburn LLP Reverse QTIP Election Husband ($6 million) (has already used $1 million of gift tax exemption for gifts to non skip persons) GST QTIP Trust ($1 million) GST Trusts for descendants (get $7 million) Children (get $1.375 million after taxes) Wife ($3.5 million) (broken green line) If no reverse QTIP election is made, then Wife is treated as transferor at her death, meaning she loses the ability to give all $3.5 million of her own assets to GST trusts for descendants GST Credit Shelter Trust ($2.5 million) Non-GST QTIP Trust ($2.5 million)
© 2010 Thompson Coburn LLP Grandfathered GST Trusts GST tax applies to transfers made on or after October 22, 1986, except those made from trusts that were irrevocable on or before September 25, 1985 and to which no subsequent additions have been made TIP: When in doubt, leave “grandfathered” GST trusts alone Two main issues with grandfathered GST trusts: 1)Modifications 2)Property Additions
© 2010 Thompson Coburn LLP Grandfathered GST Trusts Modifications Modifications that do the following cause a GST trust to lose its grandfathered status 1) shift of beneficial interest to a lower generation from the current beneficiary 2) modification extends time for vesting beyond that provided for in the original instrument In general, changing a traditional income interest to a unitrust or equitable apportionment scheme is not an impermissible modification
© 2010 Thompson Coburn LLP Grandfathered GST Trusts Property Additions Do not add property to a grandfathered trust (unless you allocate GST exemption to the addition) Issue of property addition is less about actual additions and more about constructive additions 1) payment of debts, taxes or other expenses of a grandfathered trust 2) exercise, release or lapse of certain powers that constitute taxable transfers for gift or estate tax purposes 3) nonqualified disclaimers (thus also a taxable gift)
© 2010 Thompson Coburn LLP When Do You Do GST Planning? We could say do GST planning in every estate, but that is impractical (author’s opinion only) Consider GST planning in the following circumstances: High net worth clients High net worth clients Children are already wealthy Children are already wealthy Children cannot be trusted Children cannot be trusted Grandchild’s needs are greater Grandchild’s needs are greater
© 2010 Thompson Coburn LLP GST Planning - Lifetime Gifts GST Gifting Mechanisms Outright Gifts Gifts to Section 2503(e) Minor’s Trusts Gifts to 529 College Savings Plans Qualified Medical and Tuition Gifts GST Trusts (lifetime and testamentary)
© 2010 Thompson Coburn LLP GST Planning - GST Trusts GST Trusts (trusts with current or potential skip person beneficiaries)GST Trusts (trusts with current or potential skip person beneficiaries) Goal is to provide for multiple successive generations free from estate tax to at least one of those generations GST trust issuesGST trust issues Mandatory or Discretionary Income Payouts (tax efficiency) Beneficiary/Third Party Rights Special v. general powersSpecial v. general powers Trustee replacement/removal powersTrustee replacement/removal powers Trust protectorsTrust protectors Perpetuity (Dynasty Trust) or Finite Term Grantor or Non-grantor Trust (tax exempt growth during life)
© 2010 Thompson Coburn LLP GST Planning - Use of Disclaimers Disclaimers and QTIP elections should be on every estateDisclaimers and QTIP elections should be on every estate attorney’s standard administration checklist –These are the post-death planning devices –Need to have a qualified disclaimer (9 months, don’t touch asset) Disclaimers allow non-GST gifts to become GST gifts if the conditions are rightDisclaimers allow non-GST gifts to become GST gifts if the conditions are right –Beneficiary who does not need or want all or some of inheritance –Instrument or intestate law says skip persons inherit if beneficiary dies (or disclaims) Ideal Situation for Disclaimer: Client engaging in annual gifting to children stands to inherit assets at death of parent (disclaimer can accomplish in one stroke what years of annual exclusion gifting cannot – sizeable tax free gifting)
© 2010 Thompson Coburn LLP GST Planning – Life Insurance Planning Placing life insurance in a GST trust can greatly enhance wealth for future generationsPlacing life insurance in a GST trust can greatly enhance wealth for future generations Main problem, however, is Crummey powers that qualify gifts for the annual gift tax exclusion for gift tax purposes, but not for GST tax purposesMain problem, however, is Crummey powers that qualify gifts for the annual gift tax exclusion for gift tax purposes, but not for GST tax purposes SolutionsSolutions –One trust for each skip person (impractical for life insurance) –Use grandfathered GST trusts to purchase life insurance –Allocate GST exemption to gifts Issues to considerIssues to consider –Waiting for value of policy to decline (risk death of insured) –Do we apply GST exemption elsewhere (given that most policies lapse, perhaps it is best to apply GST exemption to other gifts) If using GST trust to hold life insurance, consider second-to- die policyIf using GST trust to hold life insurance, consider second-to- die policy
© 2010 Thompson Coburn LLP GST Planning – Avoiding GST Common inadvertent GST scenario: Gift to trust for minor child with payout at certain age and death of child before that age, with child’s children receiving assets in trust Best way to avoid inadvertent GST: Give all children, even minors, a testamentary general power of appointment (can appoint to selves, creditors, estates, creditors of estates) * Forces inclusion in child’s estate (child becomes transferor) * Since testamentary, however, spendthrift concerns are less
© 2010 Thompson Coburn LLP EGTRRA Expiration in 2011 EGTRRA expires at the end of 2010 Effect on GST Tax: 1.GST Exemption reverts to $1 million (indexed for inflation) 2.Loss of Automatic Allocations for Certain Lifetime Transfers under Section 2632(c) 3.Loss of Retroactive Allocations Under Section 2632(d) 4.Loss of Late Election 9100 Relief Under Section 2642(b)(2)(A) 5.Loss of Ability to Sever Trusts into Exempt and Nonexempt Trusts Under Section 2642(a)(3) Nightmare Thought: EGTRRA expiration language says to deem as if it never existed (what effect on existing GST trusts?)
© 2010 Thompson Coburn LLP GST Spotting - Questions to Ask Are any beneficiaries grandchildren (or other relatives of the same generation) or individuals more than 37.5 years younger than the decedent?Are any beneficiaries grandchildren (or other relatives of the same generation) or individuals more than 37.5 years younger than the decedent? What rights over the trust have been given to the trust beneficiaries (general or special powers)?What rights over the trust have been given to the trust beneficiaries (general or special powers)? If the trust was created and funded during life and gives benefits to skip persons (see first question), was GST exemption allocated to such gifts (get copies of gift tax returns)If the trust was created and funded during life and gives benefits to skip persons (see first question), was GST exemption allocated to such gifts (get copies of gift tax returns) Is the governing instrument older than September 25, 1985, and, if so, did the decedent die or lose the ability to amend it before that date as well?Is the governing instrument older than September 25, 1985, and, if so, did the decedent die or lose the ability to amend it before that date as well?
© 2010 Thompson Coburn LLP Things to Remember All GSTs require a skip person (no skip, no GST)All GSTs require a skip person (no skip, no GST) Every GST also is subject to gift or estate tax and use those exemptions as wellEvery GST also is subject to gift or estate tax and use those exemptions as well A property interest that avoids estate tax at death is probably a GST (the goal of the GST tax is to impose tax at each generation)A property interest that avoids estate tax at death is probably a GST (the goal of the GST tax is to impose tax at each generation)
© 2010 Thompson Coburn LLP Things to Remember If the client chooses consciously to engage in GSTs, document this decision for future generationsIf the client chooses consciously to engage in GSTs, document this decision for future generations Remember that GST exemption will be automatically allocated to most lifetime GST transfers (plan accordingly)Remember that GST exemption will be automatically allocated to most lifetime GST transfers (plan accordingly) Crummey powers generally will not work on the GST tax (do you apply GST exemption?)Crummey powers generally will not work on the GST tax (do you apply GST exemption?) When is doubt, never mess with a “grandfathered” GST trustWhen is doubt, never mess with a “grandfathered” GST trust
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