5C.25 MODIFICATIONS TO GST GRANDFATHERED TRUSTS

Treas. Reg. §26.2601-1(b)(4) provides rules for determining when a modification, judicial construction, settlement agreement, or trustee action with respect to a GST grandfathered trust will not cause the trust to lose its GST tax exempt status. Safe harbors are provided for (1) certain distributions of trust principal from a GST grandfathered trust to a new trust or retention of the trust principal in a continuing trust (Treas. Reg. §§26.2601-1(b)(4)(i)(A) and 26.2601-1(b)(4)(i)(E), Examples 1 and 2); (2) certain court-approved settlements of bona fide issues regarding the administration of the GST grandfathered trust or the construction of terms of the trust (Treas. Reg. §26.2601-1(b)- (4)(i)(B)); (3) certain judicial constructions of the GST grandfathered trust to resolve ambiguities in the terms of the trust or to correct a scrivener’s error (Treas. Reg. §§26.2601-1(b)(4)(i)(C) and 26.2601- 1(b)(4)(i)(E), Example 3); and (4) certain modifications of the GST grandfathered trust by judicial reformation or non-judicial reformation (including a trustee distribution, conversion to a unitrust or an equitable adjustment between income and capital gains (Priv. Letter Rul. 200417014; Treas. Reg. §1.643(b)-1; Treas. Reg. §§26.2601- 1(b)(4)(i)(D)(2) and 26.2601-1(b)(4)(i)(E), Examples 8, 9, 11 and 12) settlement, or construction that does not satisfy items (1)—(3) immediately preceding) that are valid under applicable state law, provided the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in IRC section 2651) than the person(s) who held the beneficial interest before the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust (Treas. Reg. §§26.2601- 1(b)(4)(i)(D) and 26.2601-1(b)(4)(i)(E), Example 7).

5C.26 DELAWARE TAX TRAP AND GST GRANDFATHERED TRUSTS

If a non-general power of appointment in a GST grandfathered trust is exercised in a manner that may postpone or suspend the vesting of an interest in trust property beyond the period relating to the rule against perpetuities (i.e., beyond a life in being plus 21 years or beyond 90 years), this will result in the exercise being treated as a constructive addition to the GST grandfathered trust, and will change the identity of the transferor for GST purposes even if the exercise of the power is not treated as a taxable transfer for estate or gift tax purposes (i.e., because the state law has a longer perpetuities period).¹ Treas. Reg. §§26.2601-1(b)(1)(v)(A) and (B). See also, IRC sections 2041(a)(3) and 2514(d). Additionally, if the period for vesting is the “longer of a life in being plus 21 years or 90 years,” this too will cause the GST grandfathered trust to lose its GST tax exempt status, except where state law prohibits the use of the longer of the two periods. Treas. Reg. §26.2601-1(b)(1)(v)(D), Examples 6 and 7. See, sections 3.16 and 4.7, above concerning the Delaware tax trap.

5C.26(a) Constructive Addition If GST Grandfathered Trust’s Liability Is Not Paid By The Trust

Where a GST grandfathered trust is relieved of any liability properly payable out of the assets of such trust, the person who actually satisfies the liability is considered to have made a constructive addition to the GST grandfathered trust in an amount equal to the liability satisfied by that person. The constructive addition occurs when the GST grandfathered trust is relieved of liability (e.g., when the right of recovery is no longer enforceable by the person who paid a tax on behalf of the GST grandfathered trust). Treas. Reg. §26.2601-1(b)- (1)(v)(C). The person satisfying the trust’s liability becomes the transferor (for GST tax purposes) of the satisfied amount. Special rules, however, apply with respect to payment of estate taxes on reverse QTIP property. Treas. Reg. §26.2652-1(a)(3). If the surviving spouse’s will waives the right to be reimbursed for estate taxes attributable to reverse QTIP property, the waiver (and payment of the estate taxes by the surviving spouse’s estate) does not constitute a constructive addition to the reverse QTIP trust. Treas. Reg. §26.2652-1(a)(5), Example 8.

5C.27 PRESERVATION OF ALLOCATION OF GST TAX EXEMPTION TO ILIT PROPERTY INCLUDED IN GRANTOR’S GROSS ESTATE

If the grantor’s GST tax exemption is allocated to an ILIT while the ILIT was not subject to an ETIP, and if the life insurance proceeds are included in the grantor’s gross estate, the inclusion ratio remains unchanged and the trust property remains exempt from GST tax. Treas. Reg. §26.2642-4(a)(3). No re-calculation of the inclusion ratio will occur so long as the property does not revert to the grantor’s estate.

Practice Point: The use of a Reverse QTIP marital deduction trust (where there is a surviving spouse and the deceased grantor is the only insured under the ILIT) to receive the included life insurance proceeds, with the surviving spouse’s will waiving any right of reimbursement under IRC section 2207A, will preserve the property’s inclusion ratio and minimize its depletion by death taxes. See, Paragraph 5.1(A)(8) of Sample ILIT.

Practice Point: Consider the effect of estate tax apportionment against the life insurance proceeds and its impact on trust property with a zero (0) inclusion ratio. Should death taxes be apportioned away from the zero (0) inclusion ratio property?

5C.28 REVERSE QTIP MARITAL DEDUCTION ELECTION

The reverse QTIP election allows the decedent, rather than the surviving spouse, to be treated as the transferor for GST tax purposes of property for which the QTIP marital deduction election is made under IRC section 2056(b)(7). IRC section 2652(a)(3). Since the reverse QTIP election is not available for an IRC section 2056(b)(5) estate tax marital deduction general power of appointment trust, care must be taken to make sure the QTIP trust does not give the surviving spouse any powers that would result in an IRC section 2056(b)(5) general power of appointment trust.

Marital deduction trusts are used in ILITs where (i) the life of only the grantor (and not the grantor’s spouse) is insured, (ii) the grantor’s surviving spouse is a beneficiary of the ILIT, and (iii) there is a possibility that the transfer of property to the ILIT (such as a life insurance policy) may be included in the grantor’s gross estate under the three-year inclusion rule of IRC section 2035.

Practice Point: The reverse QTIP election is important if the grantor has allocated his or her GST tax exemption to the ILIT and wants to preserve the zero (0) inclusion ratio of the ILIT property included in his or her gross estate. In such instance, the ILIT should direct the trustee to allocate any GST tax exempt ILIT property included in the grantor’s gross estate that qualifies for the marital deduction to a reverse QTIP trust for the surviving spouse. When the surviving spouse dies, any federal estate tax attributable to the reverse QTIP property should be paid out of either the surviving spouse’s own property (provided the beneficiaries of the surviving spouse’s estate and the remainder beneficiaries of the reverse QTIP trust are the same) or out of the nonreverse QTIP trust property. Payment of estate taxes by the surviving spouse does not constitute an impermissible constructive addition to the reverse QTIP trust. Treas. Reg. §26.2652-1(a)(5), Example 8. See, Paragraph 5.1 of Sample ILIT.

5C.28(a) Partial Reverse QTIP Election Not Permitted

A partial reverse QTIP election is not permitted. Treas. Reg. §26.2652-2(a). It is therefore extremely important for the governing instrument to divide the QTIP marital trust into two separate trusts, one trust equal to the remaining GST tax exemption amount (if any) of the first spouse to die, and one trust for assets in excess of that GST tax exemption amount. See, Paragraph 5.1(A)(8) of Sample ILIT. To the extent applicable, it is also important that the QTIP marital trust be divided in a manner that fulfills the requirements of the GST separate trust rule under Treas. Reg. §26.2654-1(b) (or the qualified severance rule under IRC section 2642(a)(3)), and the GST valuation rules under Treas. Reg. §26.2642-2.

5C.29 ALLOCATION OF GST TAX EXEMPTION TO ILIT DURING TRANSFEROR’S LIFETIME

When allocating a transferor’s GST tax exemption to a trust, the allocation of GST tax exemption must be made to the entire trust rather than to specific trust assets. If, however, a transfer is a direct skip to a trust (see section 5.29(a), below concerning direct skips), the allocation of GST tax exemption to the transferred property is treated as an allocation of GST tax exemption to the trust. Treas. Reg. §26.2632-1(a).

If a direct skip (see section 5.7, above) occurs during the transferor’s lifetime, the transferor’s unused portion² of GST tax exemption is automatically allocated to the value of the transferred property (but not in excess of the fair market value of the property on the date of the transfer, as finally determined for gift tax purposes) to the extent necessary to obtain a zero inclusion ratio. IRC section 2632(b). The transferor may prevent the automatic allocation of his or her GST tax exemption to the direct skip by filing a U.S. Gift Tax Return (IRS Form 709) and attaching a “Direct Skip GST Allocation Election Out Statement”³ concerning the direct skip. IRC section 2632(b)(3). In addition, a timely filed U.S. Gift Tax Return accompanied by payment of the GST tax (as shown on the return with respect to the direct skip) is sufficient to prevent an automatic allocation of GST tax exemption with respect to the transferred property. Treas. Reg. §26.2632-1(b)(1)(i).

Practice Point: There is no deemed allocation of the transferor’s unused portion of GST tax exemption to certain direct skip transfers that are non-taxable gifts, which have been statutorily granted a zero inclusion ratio by the Internal Revenue Code. IRC section 2642(c). See, section 5.7(C), above. However, if the IRC section 2642(c) gift exceeds the gift tax annual exclusion amount (other than a gift that qualifies for the unlimited annual gift tax exclusion under IRC section 2503(e) regarding the direct payment of medical expenses and tuition), an automatic allocation of the transferor’s unused portion of GST tax exemption will be allocated to the value of the direct skip gift tax that exceeds the gift tax annual exclusion amount.

The GST automatic allocation rules for intervivos transfers apply to both direct and indirect skips (see section 5.29(b), below concerning indirect skips) made during the grantor’s lifetime. IRC sections 2632(b) and (c).

The automatic allocation of a transferor’s GST tax exemption to a direct skip or indirect skip is effective as of the date of the transfer, and becomes irrevocable on the due date (including extensions actually granted) for filing the U.S. Gift Tax Return for the calendar year in which the transfer is made, whether or not a U.S. Gift Tax Return is actually filed. Treas. Reg. §§26.2632-1(b)(1)(ii) and 26.2632-1(b)- (2)(i).

5C.29(a) ILIT As A Skip Person

A direct skip is a transfer to a skip person that is subject to federal estate or gift tax (see section 5.7, above). If property is transferred to an ILIT, the transfer is a direct skip only if the trust itself is a skip person. Treas. Reg. §26.2612-1(a). A trust is a skip person if all the interests in the trust are held by skip persons (which is generally not the case in a traditional ILIT). Treas. Reg. §26.2612-1(d)(2)(i). Thus, if the ILIT is not a skip person it will be necessary for the grantor to allocate his or her GST tax exemption in order for the ILIT to be GST tax exempt. Before the 2001 Tax Act, the grantor had to allocate his or her GST tax exemption to such a trust by filing a timely U.S. Gift Tax Return (IRS Form 709) along with a “Notice of Allocation of GST Tax Exemption to Trust.”⁴ See, IRC section 2632(a)(2). As a result of the 2001 Tax Act (discussed in section 5.29(b), below), such notice may not be required. However, as also discussed below, it may be preferable for the grantor to still file a timely U.S. Gift Tax Return along with a “Notice of Allocation of GST Tax Exemption to Trust” rather than relying on the new automatic allocation rules of the 2001 Tax Act.

5C.29(b) “Indirect Skip” And “GST Trust” Defined

The 2001 Tax Act provides for automatic allocation of a transferor’s unused portion of GST tax exemption to certain lifetime transfers that are (i) subject to gift tax, (ii) not direct skips, and (iii) are made to an intervivos trust (such as an ILIT) that could subsequently have a generation-skipping transfer with respect to the transferor (“indirect skips”). Such a trust is referred to as a “GST Trust” under IRC section 2632(c)(3)(B). The rule applies to intervivos transfers made after December 31, 2000, and to ETIPs ending after December 31, 2000. IRC section 2632(c); Treas. Reg. §26.2632-1(b)(2). This new rule is in addition to the pre-2001 Tax Act automatic GST tax exemption allocation rules concerning lifetime direct skips under IRC section 2632(b) (see, the opening paragraphs of section 5.29, above). Thus, as a result of the new law, both lifetime direct skips and lifetime indirect skips are subject to the automatic GST-tax-exemption allocation rules. This new type of lifetime automatic allocation of GST tax exemption to an indirect skip is referred to as an “intervivos automatic GST exemption allocation,” which is in contrast to the “testamentary automatic GST exemption allocation” discussed in section 5.30, below.

In the case of an indirect skip made after December 31, 2000 that is not subject to an ETIP, the transferor’s unused portion of GST exemption is automatically allocated to the value of the property transferred in the indirect skip (but not in excess of the fair market value of the property on the date of the transfer, as finally determined for gift tax purposes) to the extent necessary to obtain a zero inclusion ratio. IRC section 2632(c); Treas. Reg. §26.2632-1(b)(2)(i). The automatic allocation of the transferor’s GST tax exemption is effective whether or not a U.S. Gift Tax Return is filed, and the automatic allocation is effective as of the date of the transfer to which it relates. The automatic allocation of the transferor’s GST tax exemption to the indirect skip is irrevocable after the due date of the U.S. Gift Tax Return for the calendar year in which the indirect skip is made.

In the case of an indirect skip subject to an ETIP, the indirect skip is deemed to be made at the close of the ETIP and the transferor’s GST tax exemption is deemed to be allocated at that time against the then fair market value of the trust’s property. Treas. Reg. §26.2632- 1(b)(2)(i). Special rules apply to electing out of the intervivos automatic GST exemption allocation rules concerning transfers that are subject to an ETIP under IRC section 2642(f ). Treas. Reg. §§26.2632- 1(b)(2)(i), (iii)(A)(1) and (5), (iii)(B), (iii)(C)(1), (iii)(D), and (iii)(E). The election out must be made on before the due date of the gift tax return for the calendar year in which the ETIP closes.

Practice Point: Allocation of GST tax exemption at the close of an ETIP can have disastrous results if the fair market value of the life insurance policy has increased significantly. See, section 3.1, above, concerning valuation of life insurance policies.

5C.29(b)(1) Opting In Or Out Of GST Trust Status

The new rule concerning allocation of a transferor’s GST tax exemption to indirect skips is overly broad. Trusts that were not initially designed to be GST Trusts may be deemed to be GST Trusts as a result of the uncertainty of the exceptions set forth in IRC section 2632(c)(3)(B)(i)-(vi). Such a result would cause an unintended allocation of the transferor’s GST tax exemption. Consequently, the transferor will have to decide whether to opt out of the intervivos automatic GST exemption allocation rules, as is permitted under IRC section 2632(c)(5). In this regard, a two-step analysis must be made. First, for those transferors who would like to rely on the new intervivos automatic GST exemption allocation rules, they must be certain that the trust at issue meets the definition of a “GST Trust.” Second, those transferors who have created “GST Trusts” must make certain that the automatic GST tax exemption allocation is appropriate for such trusts and, if not, elect out of the intervivos automatic GST exemption allocation rules. An election out of the rules is accomplished by filing an “Election Out of Indirect Skip GST Allocation Statement”⁵ on a timely filed U.S. Gift Tax Return (IRS Form 709). See also, Priv. Letter Rul. 200535025 where the IRS permitted the tax payer an extension of time to make a “late” election out of GST Trust status for a “GST Trust” that had been established four years before the enactment of IRC section 2632(c) under the 2001 Tax Act. The IRS held that the taxpayer had acted reasonable and in good faith under IRC Treas. Reg. §301.9100-3.

An election to opt out of the intervivos automatic GST exemption allocation rules does not affect the automatic allocation of GST exemption to any transfer not covered by the election out statement. An election out of the intervivos automatic GST exemption allocation rules does not apply to any prior-year transfer to a trust, including any transfer subject to an ETIP (even if the ETIP closes after the election is made). An election out of the intervivos automatic GST exemption allocation rules does not prevent the transferor from making a subsequent affirmative allocation of the transferor’s available GST exemption to any transfer covered by the prior election out, either on a timely filed Form 709 reporting the transfer, or at a later date in accordance with the provisions of Treas. Reg. §26.2632- 1(b)(4). This rule permits a transferor to make a late allocation of GST tax exemption to the previously opted-out trust. An election out of the intervivos automatic GST exemption allocation rules with respect to future transfers remains in effect unless and until terminated. Once an election out of the intervivos automatic GST exemption allocation rules with respect to future transfers is made, a transferor does not have to file an IRS Form 709 in future years solely to prevent the automatic allocation of the GST exemption to any future transfer covered by the election out. Treas. Reg. §26.2632-1(b)(2)(iii)(D).

GST Trust status is not permanent and could change from year to year depending on the facts and the six situations discussed below in section 5.29(c). Thus, transfers may or may not be subject to the intervivos automatic GST exemption allocation, depending on the trust’s status that year. Consequently, the transferor may want to con- sider either permanently opting in or opting out of the intervivos automatic GST exemption allocation rules by filing the appropriate notice of election on a timely filed U.S. Gift Tax Return for the first year with respect to which the opting in or opting out is intended to be effective. IRC section 2632(c)(5); Treas. Reg. §26.2632-1(b).

In determining the amount of a transferor’s unused GST tax exemption available to be automatically allocated to an indirect skip, allocations are deemed to occur in the following order:

(1) Allocations by the transferor.

(2) Automatic allocations to direct skips occurring during or before the calendar year in which the indirect skip is made; and

(3) Automatic allocations to indirect skips with respect to prior indirect skips.

As noted above, transferors can elect to not have the intervivos automatic GST exemption allocation rules apply by affirmatively opting out of the automatic allocation rules on a timely filed U.S. Gift Tax Return. IRC section 2632(c)(5)(A)(i); Treas. Reg. §26.2632-1(b)(2)(iii). Conversely, transferors can elect, on a timely filed U.S. Gift Tax Return, to have the intervivos automatic GST exemption allocation rules apply to a non-GST Trust by affirmatively electing to treat the non-GST Trust as if it were a GST Trust. This is accomplished by filing a “GST Trust Election Statement”⁶ with the U.S. Gift Tax Return. IRC section 2632(c)(5)(A)(ii); Treas. Reg. §26.2632-1(b)(3).

Caution: The election out of the intervivos automatic GST exemption allocation rules is not effective to prevent an automatic allocation of GST tax exemption upon the transferor’s death. Treas. Reg. §26.2632-1(b)(2)(ii) states that any election out of intervivos automatic GST exemption allocation rules has no effect on the application of the testamentary automatic GST exemption allocation rules applicable at the transferor’s death under IRC section 2632(e). Thus, to prevent the testamentary automatic allocation of GST tax exemption to a trust that the transferor elected to not have the intervivos automatic GST exemption allocation rules apply to (the “intervivos GST opt out trust”), the transferor’s executor will need to make an affirmative allocation of GST tax exemption on the transferor’s federal estate tax return (IRS Form 706) to other transfers (other than to the “intervivos GST opt out trust”). See, section 5.30, below.

5C.29(c) When The Indirect Skip Automatic Allocation Rules Do Not Apply

There are six situations in which the indirect skip automatic allocation rules do not apply, i.e., the trust will not be deemed a “GST Trust.” IRC section 2632(c)(3)(B)(i)-(vi).

5C.29(c)(1) More Than 25% Withdrawable By Non-Skip Persons Of A Certain Age

than 25% of the trust corpus must be distributed to or may be with drawn by one or more individuals who are non-skip persons: (1) before that individual reaches 46 years of age; or (2) on or before one or more dates specified in the trust instrument that will occur before that individual attains 46 years of age; or (3) before an event that (in accordance with Treasury Regulations, that as of the writing of this book have not yet been issued) may reasonably be expected to occur before the date that individual attains age 46.⁷ The rationale for this situation appears to be that a transferor would not want the GST tax exemption allocated to a trust for which more than 25% of the trust corpus (i.e., a substantial portion of the trust corpus) is directed to be distributed to a non-skip person at an age the individual is statistically and most likely expected to attain (in this instance, age 46). IRC section 2632(c)(3)(B)(i).

Caution: This exception will not apply to ILITs when the trust property is (typically) distributed on the later of (i) the insured’s (or the surviving spouse’s) death, or (ii) when the insured’s child reaches a specified age. Specifically, this exception does not apply (in most instances) to ILITs because it may not be reasonably expected for the insured (or the surviving spouse) to die before the children (the trust beneficiaries) reach age 46. To avoid the transferor’s GST tax exemption being automatically allocated, the transferor will have to timely file a U.S. Gift Tax Return and opt out of the intervivos automatic GST exemption allocation rules.⁸

Example 1: Transferor creates a trust for his son that pro- vides that the son will receive discretionary distributions of income and principal until he is 40, at which time the entire balance of the trust corpus will be distributed to him. If the son dies before age 40, the trust corpus will be distributed to the son’s then-living descendants, by right of representation. This is not a GST Trust because the trust instrument requires that more than 25% of the trust corpus must be distributed to the son before he attains age 46, to wit, age 40.

Example 2: Transferor creates a trust for his son that pro- vides that the son will receive discretionary distributions of income and principal until he is 60, with mandatory principal distributions as follows: one-third at age 40, one-half at 50, and the balance at age 60. If the son dies before reaching age 60, the balance of the trust corpus will be distributed to the son’s then-living descendants, by right of representation. This is not a GST Trust even though the trust will not terminate before the son attains age 46 because more than 25% of the trust corpus must be distributed to the son before he attains age 46, to wit, one- third of the corpus will be distributed by age 40.

 Example 3: Transferor creates a trust for his son that pro- vides that the son will receive discretionary distributions of income and principal until he is 60, with mandatory principal distributions as follows: 20% at age 45, 25% at age 50, 33% at age 55, and the balance at age 65. If the son dies before reaching age 65, the trust corpus will be distributed to the son’s then-living descendants, by right of representation. This is a GST Trust because the trust instrument does not require that more than 25% of the trust corpus be distributed to the son before he attains age 46.

Example 4: Transferor creates a trust for his son that terminates and distributes the corpus to son in 15 years. If the son dies before the trust terminates, the trust corpus will be distributed to the son’s then-living descendants, by right of representation. Son is 25 years old at the creation of the trust. This is not a GST Trust because the date of required distribution for the corpus will occur before the son reach- es age 46, to wit, age 40.

Example 5: Transferor creates an incentive trust for his son (who is age six at the time) which pays 100% of the trust corpus to the son when he graduates from college. If the son dies before the trust terminates, the trust corpus will be distributed to the son’s then-living descendants, by right of representation, or if none, to the transferor’s then-living descendants, by right of representation. Until Treasury Regulations are issued, it cannot be determined whether this is a GST Trust because it cannot be determined whether it may reasonably be expected that a child will graduate from college before the child attains age 46.

5C.29(c)(2) More Than 25% Withdrawable By Non-Skip Persons Alive At A Certain Time

The second situation in which an intervivos trust will not be deemed a “GST Trust” is when the trust instrument provides that more than 25% of the trust corpus must be distributed to or may be with- drawn by one or more individuals who are non-skip persons and who are living on the date of death of another person identified in the instrument (by name or by class) who is more than 10 years older than such individuals. The rationale for this situation appears to be that a transferor would not want the GST tax exemption allocated to a trust that is likely to terminate and be distributed outright to a non-skip person at the death of an individual whom the non-skip person is generally expected to survive. IRC section 2632(c)(3)(B)(ii).

Caution: This exception will not apply to ILITs when the trust property is (typically) distributed on the later of (i) the insured’s (or the surviving spouse’s) death, or (ii) when the insured’s child reaches a specified age. Specifically, this exception does not apply (in most instances) because no portion of the ILIT corpus would be distributed outright to the child at the death of the grantor-insured (or the surviving spouse) unless the child had already reached a specified age; and in many instances, distributions would be staggered over time. To avoid the transferor’s GST tax exemption being automatically allocated, the transferor will have to file IRS Form 709 and opt out of the intervivos automatic GST exemption allocation rules.⁹ However, once the child (or all the children) reaches the specified age (even though the insured is still alive), if more than 25% of the trust corpus would be distributable to the child/children (because he or she has attained the specified age and the surviving spouse does not have an intervening life estate (e.g., the surviving spouse is deceased), then at the time the child (or all the children) attains the specified age, the ILIT would no longer be a GST Trust, would come within the second situation described above, and the GST automatic allocation rules would no longer apply.

Example 6: Transferor creates a trust for his mother for her lifetime with discretionary distributions of income and principal to her as determined by the trustee, remainder to transferor’s child or, if the transferor’s child is not living at the death of the transferor’s mother, remainder to the transferor’s then-living descendants, by right of representation. At the time of the creation of the trust, the transferor’s mother is 70 years old and the transferor’s child is 25 years old. This is not a GST Trust because the trust instrument provides that more than 25% of the trust corpus will be distributed to the transferor’s child (a non-skip person vis-à-vis the transferor) at the death of the transferor’s mother who is (obviously) more than 10 years older than the transferor’s child.

Example 7: Transferor creates a trust for the benefit of his spouse and their three children, with discretionary distributions of income and principal to any of them during the spouse’s life, and remainder to the transferor’s then-living descendants who survive the spouse, by right of representation. This is not a GST Trust because the transferor’s children (who are non-skip persons) are eligible to receive more than 25% of the trust corpus at the death of their mother who is more than 10 years older than any of her three children.

Example 8: Transferor creates a trust for the sole benefit of the transferor’s second wife for her lifetime. The second wife is the same age as the transferor’s youngest child (30). Upon the death of the second wife, the remainder of the trust is to be distributed to the transferor’s then-living descendants who survive their stepmother, by right of representation. This is a GST Trust because, although the trust instrument requires that the trust corpus must be distributed to the transferor’s children if they are living at the death of their stepmother, the stepmother is not more than 10 years older than the transferor’s children. In fact, it is possible the second wife may outlive all of the transferor’s children and the trust corpus may pass entirely to the transferor’s grandchildren or more-remote descendants.

5C.29(c)(3) Mandatory Distributions Of More Than 25% To Estates Of Certain Non-Skip Persons

The third situation in which an intervivos trust will not be deemed a GST Trust is when the trust instrument provides for mandatory distribution of more than 25% of the trust corpus to the estate or estates of, or subjects such corpus to a general power of appointment held by, one or more individuals who are non-skip persons if one or more such non-skip persons die on or before a date or event described in IRC section 2632(c)(3)(B)(i) or (ii), which are described in sections 5.29(c)(1) and (2) immediately above.¹⁰ This situation covers trusts that do not meet the literal requirements of the situations described in sections 5.29(c)(1) and (2) above, provided more than 25% of the trust corpus is includable in the non-skip person’s estate if he or she were to die prematurely (i.e., before age 46), even if the non-skip person does not otherwise have a right to receive trust distributions or a right to make withdrawals from the trust before the specified events. The rationale assumes that a transferor does not generally intend to allocate the GST tax exemption to a trust that is structured to be includable in a non-skip person’s estate (and that will result in the non- skip person becoming the [new] transferor for GST tax purposes). IRC section 2632(c)(3)(B)(iii).

Caution: This exception will not apply to an ILIT where the child does not hold a testamentary or intervivos general power of appointment (other than a Crummey withdrawal right) over his or her separate trust share, which share is established at the inception of the ILIT. Nor will this exception apply if the surviving spouse has an intervening life estate in the ILIT, which is typical in single life ILIT for a married couple.

Example 9: Transferor creates a discretionary common (pot) trust for his descendants. The pot trust provides that his two children will receive distributions of income and principal for their lives, at the sole discretion of the trustee. At the death of each child, the child has a testamentary general power of appointment over the child’s then-existing pro rata share of the trust and if the power of appointment is not exercised, the child’s share passes to the child’s then-living descendants, by right of representation. This is not a GST Trust because it provides that if a child dies before attaining age 46 (an event described in section 5.29(c)(1) above), more than 25% of the trust corpus is includable in each child’s estate as a result of the child’s testamentary general power of appointment. In this example, 50% of the trust (or 100% of the child’s trust share) would be includable in each child’s estate. Presumably the same result would obtain even if the transferor had five children, because the trust provides that the shares of each of them would be includable in their respective estates if they died before attaining age 46.

Example 10: Transferor creates a trust for the sole benefit of the transferor’s second wife, income only for her lifetime. The second wife and the transferor’s only child are both age 30. Upon the death of the second wife, the remainder of the trust is to be distributed to the transferor’s then-living descendants who survive their stepmother, by right of representation. If the child predeceases the stepmother, the child has a testamentary general power of appointment over the child’s share of the remainder at the death of the stepmother. This is not a GST Trust because the child’s share is includable in the child’s estate if the child dies before age 46. Consequently, a trust that was otherwise a GST Trust under section 5.29(c)(2) above is not a GST Trust if it meets the requirements of section 5.29(c)(3) above or section 5.29- (c)(4) immediately below.

5C.29(c)(4) Any Portion Of Trust Included In Certain Non-Skip Decedents’ Estates

The fourth situation in which an intervivos trust will not be deemed a GST Trust is when any portion of the trust would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer. However, there is an exception to this exception, concerning Crummey withdrawal rights limited to IRC section 2503(b) amounts. IRC section 2632(c)(3)(B)- (iv). It is possible for a trust described in this situation to periodically switch back and forth between being a GST Trust and not being a GST Trust. This could occur if there were hanging Crummey powers held by non-skip beneficiaries at the close of the year. However, once all the non-skip persons’ hanging powers lapse, the trust would no longer be a GST Trust. The switching back and forth issue can be dealt with by either affirmatively electing in to GST Trust status,¹¹ or by affirmatively opting out of GST Trust status.

Example 11: Transferor creates an intervivos QTIP trust for his spouse, remainder to their then-living descendants who survive their mother, by right of representation. This is not a GST Trust because it would be includable in the spouse’s estate under IRC section 2044 if the spouse died immediately after the transfer. (Note that this fact situation may also qualify under the second situation above.)

Example 12: Transferor creates an intervivos ILIT for his spouse and descendants (children and grandchildren) that runs for the rule against perpetuities. Immediately after a contribution to the ILIT, each beneficiary has a 30-day Crummey withdrawal right over the contribution amount, limited (on a cumulative basis) to the amount specified in IRC section 2503(b) (as adjusted for inflation) as concerns each transferor/contributor to the ILIT. The Crummey withdrawal right lapses within the five-by-five safe harbor rules. The Crummey withdrawal right is a general power of appointment; and if the transferor’s spouse or a child were to die before the exercise or lapse of the withdrawal right, the value of the withdrawal right would be includable in the decedent’s gross estate. This is a GST Trust because of the exception for Crummey withdrawal rights limited to IRC section 2503(b) amount. IRC section 2632(c)(3)(B). As discussed later, hanging Crummey powers of withdrawal apparently do not fall within the exception to the exception (concerning Crummey withdrawal rights limited to IRC section 2503(b) amounts). In other words, if (for the year in question), the cumulative amount of the hanging Crummey withdrawal right is greater than the annual gift tax exclusion amount, the trust will not be a GST Trust, and the trust will not be subject to the automatic allocation rules for that tax year. However, in future tax years, the trust may (or may not) be a GST Trust, depending on the amount of the cumulative hanging Crummey withdrawal amount. Consequently, the intervivos automatic GST exemption allocation rules should not be relied upon, and the transferor should consider filing a one time notice with the IRS to either elect in 40 or elect out 41 of GST Trust status.

Example 13: Transferor creates an ILIT for the benefit of his children. The ILIT contains separate trust shares for each child. Each child has a Crummey withdrawal right with regard to intervivos contributions made to his or her trust share. Each child also has a testamentary general power of appointment over his or her trust share. Upon the death of the child, any trust property not otherwise appointed by the child is held in further trust for the deceased child’s then living children (i.e., the transferor’s grandchildren). This is not a GST Trust since the child’s trust share would be includable in his or her estate if the child were to die immediately after the transfer.

5C.29(c)(5) CLATs, CRATs, Or CRUTs

The fifth situation in which an intervivos trust will not be deemed a GST Trust is when the trust is a charitable lead annuity trust (“CLAT”), charitable remainder annuity trust (“CRAT”), or a charitable remainder unitrust (“CRUT”). Apparently, the rationale for this situation is that these forms of trusts have characteristics that would generally not lead a transferor to allocate the GST tax exemption to them. IRC section 2632(c)(3)(B)(v).

5C.29(c)(6) CLUT With A Non-Skip Non-Charitable Remainder Beneficiary

The sixth situation in which an intervivos trust will not be deemed a GST Trust is when the trust is a charitable lead unitrust (“CLUT”) that is required to pay the principal to a non-skip person if such person is alive when the unitrust interest ends. Given the complexity of this type of planning, apparently Congress felt that if a non- skip person is named as a remainder person, no automatic allocation of GST tax exemption should be made and that inadvertent failures to allocate the GST tax exemption under these circumstances are less likely since the use of a charitable split-interest trust typically involves the transferor’s legal and tax counsel. In other words, this type of transfer- or is deemed to be “sophisticated” and does not need a statutory GST- tax-exemption allocation “safety net”. IRC section 2632(c)(3)(B)(vi).

Example 14: Transferor creates a charitable lead unitrust and provides that at the end of the lead interest, the remainder is to be paid to his then-living descendants, by right of representation. At the time of creation of the trust, the transferor has three children. This is not a GST Trust.

Example 15: Transferor creates a charitable lead unitrust and provides that at the end of the lead interest, the remainder is to be paid to grandchildren. This, of course, is a GST Trust.

5C.29(d) Crummey Withdrawal Right Gifts

For purposes of the six situations described in sections 5.29(c)(1)—(6), above, the value of transferred property is not considered to be includable in the gross estate of a non-skip person or considered to be subject to a right of withdrawal by a non-skip person if the right of withdrawal does not exceed the amount referred to in IRC section 2503(b) with respect to any transferor, i.e., the non-skip per- son holds a Crummey withdrawal right. IRC section 2632(c)(3)(B). It is assumed that powers of appointment held by non-skip persons will not be exercised. IRC section 2632(c)(3)(B).

5C.29(e) Indirect Skips And ETIP

An indirect skip subject to the ETIP rules of IRC section 2642(f ) is deemed to have been made at the close of the ETIP, and the automatic allocation of GST exemption occurs at the close of the ETIP based on the fair market value of the trust property at that time. IRC section 2632(c)(4). See, section 3.1, above, concerning the valuation of life insurance policies. (It is hoped that the policy has not increased in value and the insured is still insurable at the close of the ETIP.) See, Treas. Reg. §26.2632-1(c).

Practice Point: Trusts subject to an ETIP ending after December 31, 2000 may be subject to the new automatic allocation of GST exemption rules unless the transferor elects out. See, section 5.29(g) below for how to elect out.

5C.29(f) Filing A Gift Tax Return

IRC section 2503(b) refers to the $10,000 annual gift tax exclusion amount, as adjusted for inflation. Because the above-mentioned exception does not refer to the IRC section 2503(b) amount at the time of the transfer, but rather, “with respect to any transferor”—with- out reference to time—the right of a non-skip beneficiary to withdraw more than the annual gift tax exclusion amount by reason of a cumulative hanging Crummey withdrawal right may cause the trust to not be treated as a GST Trust under sections 5.29(c)(1), (3) and (4) above and therefore prevent the intervivos automatic GST exemption allocation rules from applying to the trust.

The IRC section 2503(b) exception seems to say that if the withdrawal right is limited to the annual exclusion amount at the time of the transfer, the trust may be a GST Trust (unless it comes within one of the six situations described in IRC section 2632(c)(3)(B)(i)-(vi)). However, if the withdrawal right is a “hanging” power of withdrawal that can accumulate over time, the trust may not be a GST Trust with respect to subsequent gifts, and no intervivos automatic GST exemption allocation will occur. This, of course, suggests that it may be desirable to file a timely U.S. Gift Tax Return with a notice of election to either opt in or opt out of the automatic GST-tax-exemption allocation rules. See, section 5.29(b)(1), above. By filing a U.S. Gift Tax Return, the transferor can be assured that the desired GST inclusion ratio is achieved and is not dependent on the amount of the beneficiary’s right of withdrawal, which could change from year to year and thus affect the trust’s classification as a GST Trust or non-GST Trust from year to year.

Regardless of whether the ILIT qualifies as a GST Trust, because all of the provisions of the 2001 Tax Act, including the new automatic intervivos automatic GST exemption allocation rules, sunset (expire) on January 1, 2011, it is probably best for the transferor to file a U.S. Gift Tax Return and attach: (1) a “Notice of Allocation of GST Tax Exemption to Trust” (and allocate GST tax exemption)¹²; or (2) an IRC section 2632(c)(5) “Election Out of Indirect Skip GST Allocation Statement”¹³ to opt out of the intervivos automatic GST exemption allocation rules of IRC section 2632(c), in which case the transferor will have to either make a one time current and future election to opt out, or make an annual determination whether or not to allocate GST tax exemption to the ILIT contributions; or (3) a “GST Trust Election Statement”¹⁴ to treat the ILIT as a GST Trust under IRC section 2632- (c)(5) for current transfers and/or some or all future transfers to the ILIT.

5C.29(g) Final Automatic GST Exemption Allocation Regulations, And Electing In And Out Of “GST Trust” Status

On June 29, 2005, the IRS issued final regulations concerning the electing in and electing out of the intervivos automatic GST exemption allocation rules concerning indirect skips and GST Trusts. Treas. Reg. §26.2632-1. (Treasury Decision 9208 [6/29/2005]). The final regulations provide guidance on how to: (1) elect out of the intervivos automatic GST exemption allocation rules for current and/or future transfers to a GST Trust, and how to terminate that election (Treas. Reg. §26.2632-1(b)(2)(ii)), and (2) elect to treat a non-GST Trust as a GST Trust and have the intervivos automatic GST exemption allocation rules apply to current and/or future transfers to that trust, and how to terminate that election (Treas. Reg. §26.2632- 1(b)(3)). The final regulations specifically confirm that an election out of the intervivos GST automatic allocation rules for future years is not an election out of the testamentary automatic GST exemption allocation rules under IRC section 2632(e), which are discussed in section 5.30, below. Treas. Reg. §26.2632-1(b)(2)(ii).

Special rules apply to electing out of the intervivos automatic GST exemption allocation rules concerning transfers that are subject to an ETIP under IRC section 2642(f). Treas. Reg. §§26.2632-1(b)- (2)(i), (iii)(A)(1) and (5), (iii)(B), (iii)(C)(1), (iii)(D), and (iii)(E); and Treas. Reg. §26.2632-1(c). A blanket election out of the intervivos automatic GST exemption allocation rules concerning all future indirect skips made by the transferor does not apply to any prior-year transfer to a trust, including any transfer subject to an ETIP (even if the ETIP closes after the election out is made). This is because the timelines of the election out is based on the date of the transfer to the trust, and not on the (future) date of the close of the ETIP. Treas. Reg. §26.2632-1(b)(2)(iii)(D). However, a transferor can affirmatively elect out of the intervivos automatic GST exemption allocation rules concerning a prior transfer that is subject to an ETIP if the election out is made on before the due date of the gift tax return for the calendar year in which the ETIP closes and the election out statement specifically describes the ETIP or otherwise identifies the transfer that is subject to the ETIP. Treas. Reg. §26.2632-1(b)(2)(iii)(C).

Caution: An affirmative allocation of GST tax exemption to a transfer that is subject to an ETIP becomes irrevocable after the due date for a timely filed IRS Form 709 reporting the transfer, and the allocation becomes effective at the close of the ETIP. Treas. Reg. §26.2632-1(c)(1)(ii). Consequently, a transferor may want to abstain from making an affirmative election of GST tax exemption to a transfer subject to an ETIP until the ETIP closes. And if the trust is a GST Trust, the transferor should also make a timely election out of the intervivos automatic GST exemption allocation rules concerning the ETIP. A transferor can elect to treat a non-GST Trust as a GST Trust, where the non-GST Trust is subject to an ETIP. Treas. Reg. §§26.2632- 1(b)(3)(i).

Caution: The intervivos GST automatic allocation rules concerning indirect skips and GST Trusts do not apply to pre-2001 intervivos transfers. Advisors may want to consider informing clients who have a pre-2001 ILIT that is not a GST Trust with regard to post 2000 transfers, that the client may need to make a late allocation of GST tax exemption¹⁵ (or a Rev. Proc 2004-46 election (which is discussed in section 6.5, below) in lieu of a late allocation) and an election to treat the non-GST Trust as a GST Trust, if the client wants to be assured that the ILIT is GST tax exempt. Similarly, if a pre-2001 ILIT is a GST Trust with regard to post 2000 transfers, but no GST tax exemption was allocated to the pre-2001 transfers, the client should consider: (1) making a late allocation of his or her GST tax exemption (or a Rev. Proc 2004-46 election (which is discussed in section 6.5, below) in lieu of a late allocation) and an election to treat the ILIT as a GST Trust with regard to all future transfers, or (2) elect out of GST Trust status and the intervivos GST automatic allocation rules (and consider a qualified severance of the trust since the ILIT will have an inclusion ratio of greater than zero but less than one as a result of the automatic allocation of GST tax exemption to post December 31, 2000 transfers). Option (1) will result in the ILIT having a zero inclusion ratio and being GST tax exempt. Option (2) will result in the ILIT having an inclusion ratio between one and zero (because of the post 2000 intervivos GST automatic allocations), and the ILIT will not be completely exempt from GST tax if a GST event subsequently occurs. See, sections 5.23, above and 6.5, below (concerning late allocations of GST tax exemption).

5C.30 ALLOCATION OF GST TAX EXEMPTION TO ILIT UPON DEATH OF TRANSFEROR

If a transferor dies and has not exhausted his or her GST tax exemption through intervivos transfers or through allocation by the transferor’s executor on the federal estate tax return,¹⁶ the transferor’s unused GST tax exemption is automatically allocated at death.¹⁷ IRC Section 2632(e). This type of automatic allocation is referred to as a “testamentary automatic GST exemption allocation,” which is in contrast to the “intervivos automatic GST exemption allocation” discussed in section 5.29 above and in section 5.32 below. The testamentary automatic GST allocation occurs, first, to direct skips occurring at the transferor’s death. Second, to trusts established by the transferor that result in (or may subsequently result in) a taxable distribution or a tax- able termination as a result of the transferor’s death. IRC section 2632(e). Treas. Reg. §26.2632-1(d)(2) contains provisions that pre- vent the testamentary automatic GST allocation rule from inadvertently wasting the deceased transferor’s unused GST tax exemption. The regulation provides that no testamentary automatic GST allocation will be made to a trust that will have a new transferor with respect to the entire trust before the occurrence of any generation-skipping transfer with respect to the trust (such as a QTIP marital deduction trust for which no reverse QTIP election has been made under IRC section 2652(a)(3)), and no testamentary automatic GST allocation will be made to a trust established by the transferor if, during the nine month period ending immediately after the transferor’s death (i) no generation-skipping transfer has occurred with respect to the trust, and (ii) at the end of the nine month period no future generation-skipping transfer can occur with respect to the trust (e.g., a trust beneficiary dies within nine months of the transferor’s death which causes the trust to terminate and distribute all of its assets to a person who is not a skip person). If the testamentary automatic GST allocation rules are applicable, then the allocation of GST tax exemption will occur on the due date of the filing of the deceased transferor’s federal estate tax return, whether or not the return is actually filed. Once GST tax exemption has been allocated under the testamentary automatic GST allocation rules, the allocation is irrevocable and cannot be changed by the deceased transferor’s executor.

Caution: The election out of the intervivos automatic GST exemption allocation rules (see, section 5.29(b)(1), above) is not effective to prevent an automatic allocation of GST tax exemption upon the transferor’s death. Treas. Reg. §26.2632-1(b)(2)(ii) states that any election out of intervivos automatic GST exemption allocation rules has no effect on the application of the testamentary automatic GST exemption allocation rules applicable at the transferor’s death under IRC section 2632(e). Thus, to prevent the testamentary automatic allocation of GST tax exemption to a trust that the transferor elected to not have the intervivos automatic GST exemption allocation rules apply to (the “intervivos GST opt out trust”), the transferor’s executor will need to make an affirmative allocation of GST tax exemption on the transferor’s federal estate tax return (IRS Form 706) to other transfers (other to the “intervivos GST opt out trust”).

5C.31 CERTAIN GST TAX EXEMPTION ALLOCATIONS ARE VOID

Except as provided in Treas. Reg. §26.2642-3 (relating to charitable lead annuity trusts), an allocation of GST tax exemption to a trust is void to the extent the amount allocated exceeds the amount necessary to obtain an inclusion ratio of zero. Allocation of GST tax exemption is also void if the allocation is made to a trust that has no GST potential with respect to the transferor at the time of the allocation, provided, however, a trust is deemed to have GST potential even if the possibility of a GST is so remote as to be negligible. Treas. Reg. §26.2632-1(b)(4)(i).

Example: If GST tax exemption is allocated to a trust in which the transferor’s child has an intervivos general power of appointment, the allocation is void. Thus, the regulations protect the transferor and the executor from unnecessary waste of the GST tax exemption.

5C.32 U.S. GIFT AND GST TAX RETURN (IRS FORM 709)

In 2004, the IRS revised IRS Form 709 (United States Gift [and Generation-Skipping Transfer] Tax Return) because of the revisions in the GST tax rules promulgated by the 2001 Tax Act, and in particular, the GST automatic allocation rules (discussed in section 5.29, above).

• Transfers to a trust that is a both a non-skip person and is not a “GST Trust” (as defined in IRC section 2632(c)(3)(B)) are reported on Part 1 of Schedule A, and a “Notice of Allocation of GST Tax Exemption to Trust”¹⁸ must be attached to the 709.
• Direct skips (including transfers to a trust that is a skip person) are reported on Part 2 of Schedule A. (Direct skips are gifts that are subject to both gift tax and GST tax. See, section 5.7, above.) Allocation of GST tax exemption for direct skips reported on Part 2 of Schedule A are made on line 4 of Part 2 of Schedule C.
• A new Part 3 (“Indirect Skips”) has been added to Schedule A of Form 709, which is to be used to report gifts to trusts that are currently subject to only the gift tax, but may later be subject to the GST tax, i.e., a GST Trust (as defined in IRC section 2632(c)(3)(B)). Only those gifts defined as Indirect Skips in IRC section 2632(c)(3)(A) (or those gifts that the donor wants to be treated as Indirect Skips) are to be listed in Part 3 of Schedule A. Additionally, if a donor wants to treat gifts to a non-GST Trust as Indirect Skips to a GST Trust (defined in section 5.29(b), above) and elect into the GST automatic allocation rules of IRC section 2632(c), the donor must check Column C and attach a “GST Trust Election Statement”¹⁹ to the Form 709.
• A new line 5 has been added to Part 2 of Schedule C of Form 709 for use in reporting the allocation of GST tax exemption to “Indirect Skip” transfers reported on Part 3 of Schedule A.
• Column C in Part 2 of Schedule A of Form 709 is now used to elect out of the GST automatic allocation rules of IRC sections 2632(b) concerning direct skips, and a “Direct Skip GST Allocation Election Out Statement”²⁰ must be attached to the Form 709. See, section 5.29, above.
• Column C in Part 3 of Schedule A of Form 709 is now used to elect out of the GST automatic allocation rules of IRC sections 2632(c) concerning Indirect Skips to a GST Trust, and an “Election Out of Indirect Skip GST Allocation Statement”²¹ must be attached to the Form 709. See, section 5.29(g), above.
• As previously stated, if a donor does not want the intervivos GST automatic allocation rules to apply to a current transfer and/or to one or more future transfers, the donor must attach an “Election Out of Indirect Skip GST Allocation Statement” to a timely filed Form 709, whether or not a Form 709 otherwise would be required to be filed for that year by the donor. Treas. Reg. §26.2632-1(b)(2)(iii).²² If, however, the donor wants to treat a non-GST Trust as a GST Trust (defined in section 5.29(b), above) and have current transfers and/or some or all future transfers be subject to the intervivos GST automatic allocations rules, the donor must attach a “GST Trust Election Statement” to a timely filed Form 709, whether or not a Form 709 otherwise would be required to be filed for that year by the donor. Treas. Reg. §26.2632-1(b)(3).
• Split gifts are now reported on Parts 1, 2, and 3 on page 2 of Form 709, rather than being split out in the Taxable Gift Reconciliation section.
• The instructions for IRS Form 709 also state that IRS Form 709-A, U.S. Short Form Gift Tax Return, is obsolete. All gift tax returns must now be filed on IRS Form 709.

The IRS has issued Form 8892, “Payment of Gift/GST Tax and/or Application for Extension of Time to File Form 709” for a tax- payer to request an extension of time to file IRS Form 709 (and paying any applicable gift or GST taxes). Form 8892 should be used when (i) the taxpayer owes gift or GST tax and has requested an initial extension to file his or her individual income tax return pursuant to IRS Form 4868, (ii) the taxpayer has already obtained an initial four month extension to file Form 709 pursuant to IRS Form 4868 and the tax- payer needs an additional extension of time only for his or her Form 709 (and not for his or her individual income tax return), or (iii) the taxpayer needs an initial extension of time only for his or her Form 709 (and not for his or her individual income tax return).

Practice Point: Consider filing a U.S. Gift Tax Return for the year that the ILIT is created (even if all of the gifts to the ILIT qualify for the gift tax annual exclusion) and make an election to either: (i) treat the ILIT as a GST Trust and have GST tax exemption be automatically allocated to the ILIT, or (ii) elect out of GST Trust status (even if the trust meets one of the exceptions described in IRC section 2632(c)(3)(B)(i)-(vi) (see, section 5.29(c), above). This way the grantor (and the practitioner) will be assured of the obtaining the desired GST tax exemption allocation result with regard to the grantor’s transfers to the ILIT.

5C.33 CHECKLIST OF 25 RULES FOR GST TAX PLANNING WITH ILITS

The following rules are helpful reminders for dealing with the GST tax and ILITs.

Rule 1: If the ILIT is included in the grantor’s gross estate for federal estate tax purposes, be aware of the requirements of the GST tax separate share rule contained in Treas. Reg. §26.2654-1(a)(1)(ii) concerning the payment of a pecuniary bequest from a trust included in the transferor’s gross estate. The separate share rule is important if the grantor’s executor wants to allocate GST tax exemption to the pecuniary bequest (e.g., a reverse QTIP trust established under a pecuniary marital deduction funding formula) or to the residue of the grantor’s estate (e.g., the credit shelter trust), rather than to the entire trust (e.g., the decedent’s revocable [now irrevocable] living trust). See, footnote accompanying section 5.15, above.

Rule 2: If the ILIT is included in the grantor’s gross estate for federal estate tax purposes, be aware of the requirements of the GST tax separate trust rule contained in Treas. Reg. §26.2654-1(b)(1) concerning the division of a trust (whether by a formula clause, or otherwise) that is included in the transferor’s gross estate, and the requirements of the GST tax qualified severance rule under IRC section 2642(a)(3). The separate trust rule pertains to making a mandatory or discretionary severance of a single trust²² included in the transferor’s gross estate into multiple separate trusts for the purpose of allocating the transferor’s GST tax exemption to any of the separate trusts (rather than to the whole [undivided] single trust, which could result in an overutilization and waste of the transferor’s GST tax exemption). (Note however, that the GST tax qualified severance rule is meant to replace and supersede the separate trust rule. Preamble to Prop. Treas. Reg. §26.2642-6.) See also, footnote accompanying section 5.15, above.

Rule 3: If the ILIT is included in the grantor’s gross estate for federal estate tax purposes, be aware of the requirements of the GST tax valuation rules contained in IRC section 2642(b)(2)(A) and Treas. Reg. §26.2642-2(b)(2) and (3). These rules apply to transfers made from a trust included in the transferor’s gross estate (and from a transferor’s probate estate). If ILIT assets are included in the transferor’s gross estate, the goal of the transferor is to have his or her GST tax exemption allocated to those assets based on their federal estate tax value, rather than their value at a later date (such as their date of distribution value). If the GST tax valuation rules measure the assets’ value other than at their estate tax value, then it may require more GST tax exemption to be allocated, particularly if the assets have appreciated in value during the administration of the transferor’s estate. If there is not enough GST tax exemption available to exempt the assets, the trust may not have a zero inclusion ratio. See, footnote accompanying section 5.15, above.

Rule 4: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, consider using a QTIP marital deduction trust to maintain maximum flexibility for GST tax planning purposes. This will allow for a reverse QTIP election. See, sections 5.27 and 5.28, above, and section 11.3, below.

Rule 5: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, a reverse QTIP election should not be made to the entire QTIP marital deduction trust if the election and subsequent allocation of GST tax exemption would result in an inclusion ratio greater than zero. Instead, before making the reverse QTIP election and allocation of the grantor’s GST tax exemption, the QTIP marital deduction trust should be severed into two trusts, and the governing instrument should provide for the creation of a reverse QTIP trust equal to the amount of the grantor’s unused GST tax exemption and a non-GST-tax- exempt QTIP trust to which no GST tax exemption will be allocated. See, section 5.28(C), above. See, Paragraph 5.1(A)(8) of Sample ILIT.

Rule 6: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, and the grantor has not previously allocated GST tax exemption to the ILIT, allocation of GST tax exemption to a reverse QTIP trust may not be the most efficient use of the grantor’s GST tax exemption vis-à-vis other GST events because of the QTIP trust’s all income to spouse requirement. Therefore, in determining the amount of the grantor’s GST tax exemption available for allocation to the reverse QTIP trust by the executor of the grantor’s estate, the following allocations should be reviewed: (1) GST tax allocations made on lifetime transfers; (2) automatic GST tax allocations made on lifetime transfers; (3) late GST tax allocations to be made by the grantor’s executor concerning lifetime transfers made by the grantor; (4) any GST tax allocations that the executor of the grantor’s estate will make concerning direct skips occurring at the grantor’s death, transfers in trust to skip persons, or other potential GST transfers, such as taxable distributions or taxable terminations that may occur in the future. After reviewing these allocations, it may be deter- mined that a reverse QTIP election is not desirable. See, section 5.3(A), above.

Rule 7: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, and the grantor has not previously allocated GST tax exemption to the ILIT, do not make a reverse QTIP election if the unused amount of the deceased transferor’s GST tax exemption can instead be allocated to direct skips occurring at the grantor’s death and transfers in trust for skip persons that will result in tax- able distributions or taxable terminations. Because the QTIP trust property will be included in the gross estate of the surviving spouse when he or she dies (IRC section 2044), the surviving spouse will become the transferor of the QTIP trust property. Treas. Reg. §26.2652-1(a)(2). Consequently the executor of the surviving spouse’s estate can allocate the surviving spouse’s GST tax exemption to the QTIP trust property, if necessary.

Rule 8: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, consider giving the surviving spouse a testamentary limited power of appointment over the QTIP trust. The class of appointees can be limited to the grantor’s descendants. This will permit the surviving spouse to maximize the utility of the reverse QTIP trust election and the predeceased parent rule, because of unforeseen or changed circumstances occurring after the grantor’s death. For example, the surviving spouse could appoint the reverse QTIP trust property to a trust for the grantor’s grandchildren and more remote descendants who are skip persons, and the surviving spouse could appoint the non-GST-tax-exempt marital trust property to the grantor’s children and grandchildren who are non skip persons (because of the predeceased parent rule). See, section 11.8, below. See, Paragraph 5.1(A)(3)(a) of Sample ILIT.

Rule 9: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, upon the death of the surviving spouse consider having the non-GST-tax-exempt QTIP marital deduction trust property be divided into separate shares for the ultimate benefit of children and for the issue of a deceased child.

This common form of disposition will preserve the pre- deceased parent rule as to any children who die after the grantor but before the surviving spouse, because the surviving spouse is treated as the transferor of the non-GST- tax-exempt QTIP trust (and any children who die before the surviving spouse’s death come under the predeceased parent rule). See, section 5.9, above.

Rule 10: If ILIT property that qualifies for the marital deduction ILIT (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, whenever you are going to allocate GST tax exemption to a pecuniary bequest or to a residual transfer or residual trust that follows a pecuniary bequest (e.g., a pecuniary marital deduction funding formula bequest, a reverse pecuniary funding formula bequest, or a specific bequest of a dollar amount to a devisee), make sure either that the pecuniary bequest is funded within 15 months, or that the pecuniary bequest receives “appropriate interest” under the GST tax valuation rules of IRC section 2642(b)(2)(A) and Treas. Reg. §26.2642-2(b)(2) and (3).²³ Also, if non-cash property (e.g., stock and bonds) is use to satisfy the pecuniary bequest, make sure that the non-cash assets are distributed using either their date of distribution value or in a manner that is fairly representative of the assets’ net appreciation and depreciation, as is required under the GST tax valuation rules. A requirement in the governing instrument to pay interest or allocate income to all bequests (including pecuniary bequests from trusts) is recommended to protect the trust in case the funding is not completed within 15 months. See, footnote accompanying section 5.15, above. See, Paragraph 7.1(B)(3)(a) of Sample ILIT.

Rule 11: If ILIT property that qualifies for the marital deduction (other than an ILIT containing a second to die policy on the life of the grantor and the grantor’s spouse) is included in a married grantor’s gross estate for federal estate tax purposes, and the remainder beneficiaries of both the husband’s estate plan and the wife’s estate plan are the same, make sure both spouses’ wills waive the right to reimbursement under IRC section 2207A so as to relieve the reverse QTIP trust from having to reimburse the surviving spouse’s estate for the federal estate taxes attributble to that trust, thereby preserving 100% of the GST-tax- exempt property.

However, in a second-marriage situation or when there are different remainder beneficiaries, who should be responsible for the death taxes attributable to the reverse QTIP trust? See, sections 4.17 and 5.28, above.

Rule 12: Enable the trustee to distribute the GST tax exempt trust property to skip persons, and the non-GST tax exempt trust property to non-skip persons.

A non-GST tax exempt trust’s direct payment of medical expenses and tuition expenses of a skip person does not constitute a GST event. IRC sections 2503(e) and 2611(b)(1). Distributions to skip persons from a trust with a zero inclusion ratio do not generate any GST tax. IRC sections 2602 and 2641; Treas. Reg. §25.2503-6. Similarly, distributions to non-skip persons from a trust with an inclusion ratio greater than zero do not generate any GST tax. See, section 5.2, above. See, Paragraph 7.1(B)(7) of Sample ILIT.

Rule 13: When creating a GST-tax-exempt ILIT, be careful that the beneficiaries do not possess powers (either as a beneficiary or as a trustee) that constitute general powers of appointment under IRC section 2041. Otherwise, the GST tax-exempt property will be included in the beneficiary’s gross estate under IRC section 2041, and that beneficiary will become the “new” transferor for GST tax purposes, thus wasting the grantor’s allocation of GST tax exemption. See, section 5.10, above. See also, Chapter 8 below, and section 1.7, above.

Rule 14: In an ILIT that does not hold a second to die pol- icy on the life of the grantor and the grantor’s spouse, con- sider giving the surviving spouse and children broad testamentary limited powers of appointment over their respective trust shares. These powers can be exercised to reduce or avoid the GST tax. Because the GST tax is scheduled to be repealed in 2010 (for a one-year period), any way to post- pone a GST event until then should be considered. See, section 11.8, below. See, Paragraphs 5.1(A)(3)(a), 5.4(C) (alternate 2) and 5.5(C) of Sample ILIT.

Rule 15: Consider having the GST-tax-exempt ILIT be a discretionary common (pot) trust for the grantor’s descendants that runs for the longest period permitted under the rule against perpetuities (if that is consistent with the grantor’s desires).

The GST-tax-exempt trust could be established in a jurisdiction that has curtailed or abolished the rule against perpetuities,²⁴ such as (i) South Dakota (which does not impose a state income tax on trusts, permits trust protectors, domestic asset protection trusts, and is not a creditor- friendly trust jurisdiction); (ii) Delaware—except for real estate (does not impose a state income tax on non-residents, and permits trust protectors and domestic asset protection trusts); (iii) Alaska (which limits powers of appointment to 1,000 years, does not impose a state income tax on trusts, and permits trust protectors and domestic asset protection trusts); (iv) New Hampshire (which imposes a special “income” tax on residents with regard to dividends and interest, and permits trust protectors); (v) Idaho (which imposes a state income tax on all trusts, and permits trust protectors); (vi) Missouri (which imposes a state income tax on all trusts, and permits domestic asset protection trusts); (vii) Wisconsin (which imposes a state income tax on residents only); and (viii) New Jersey (which imposes a state income tax on all trusts). Even if the grantor is not a resident of a state that has abolished the rule against perpetuities, the grantor can choose the governing law of that state, provided there is a sufficient connection between the GST-tax-exempt trust and that state, such as having a co-trustee who is a resident of that state. Caveat—Professor Ira Mark Bloom of Albany Law School argues that the states, in a blind race to facilitate the exploitation of the GST tax exemption by perpetual dynasty trusts, have overlooked important non- tax societal reasons for the rule against perpetuities, which serves to limit “dead hand control.” He asserts that, over time, the administration of such trusts is likely to become unwieldy and very costly, noting that the average grantor will have more than 100 descendants in 150 years, 2,500 beneficiaries in 250 years, and 45,000 beneficiaries in 350 years. See, Paragraph 5.3 of Sample Second to Die ILIT contained in Appendix 2. Even if the trust runs for the longest period permitted under the rule against perpetuities, the grantor can further prolong the insulation of the trust assets from transfer tax by directing or permitting younger generations to share to some degree in the final distribution, rather than following a pure “per stirpes” distribution regime, which inevitably will put the assets in the hands of the oldest descendants, who are closest to the imposition of the estate tax. There- fore, consider giving the Independent Trustee (i.e., a trustee who is not related or subordinate [within the meaning of IRC section 672(c) to the grantor or the ILIT beneficiaries and also meets the requirements of IRC section 674(c)] the ability to appoint the trust assets to any of the transferor’s then living descendants upon the termination of the trust’s term. This will permit trust assets to be dis- tributed to beneficiaries in younger generations. Appointing trust property to younger beneficiaries will permit the trust property to escape estate taxation for another generation, and possibly insulate the trust assets from estate taxes for up to 200 years. Casting the Independent Trustee’s power as a limited power of appointment will protect the trustee from a potential abuse of discretion claim.

Rule 16: Minimize distributions to grandchildren from a non-GST-tax-exempt ILIT by having the grantor’s children make gifts to the grandchildren from trust distributions. This will avoid a taxable distribution to the grand children. If the grantor’s intent is to benefit his or her grandchildren, a distribution from a non-GST tax exempt trust can be made to a child followed by a gift from the child to the grandchild. The gift avoids the GST tax and permits the child to use his or her gift tax annual exclusion amount. Even if the gift is larger than the annual gift tax exclusion amount, the gift tax paid by the child is less costly than a taxable distribution, since the gift tax is calculated on a tax exclusive basis, whereas a taxable distribution is calculated on tax inclusive basis. See, section 5.5, above. In this regard make sure the trustee’s authority for making discretionary distributions includes “distributions for the purpose of assisting a beneficiary in making gifts to reduce the trusts and my family’s overall potential transfer tax liability.” See, Paragraph 7.11 of Sample ILIT (which will have to be modified to accomplish this purpose).

Rule 17: When adding to, combining or merging trusts (which is likely to happen when the surviving spouse’s credit shelters trust is merged into the first spouse’s credit shelter trust), preserve each trust’s GST inclusion ratio. Therefore, do not add or combine trust property that has an inclusion ratio of greater than zero with trust property that has an inclusion ratio of zero. A trust’s inclusion ratio will change if there is a consolidation or merger of separate trusts with different inclusion ratios. Treas. Reg. §26.2642-4(a)(2). See, section 5.12(B), above. See, Paragraphs 7.1(A)(7) and 7.1(B)(5) of Sample ILIT.

Rule 18: Before merging or combining GST-tax-exempt trusts (for example combining the grantor’s credit shelter trust and the ILIT), consider the perpetuities period that applies to each trust.

The rule against perpetuities for a credit shelter trust generally starts at the grantor’s date of death, whereas the rule against perpetuities for an ILIT generally starts at the inception of the trust. If one grantor survives the creation of the ILIT by 10 to 20 years, an extra generation of descendants may exist, which will extend the perpetuities period of the grantor’s credit shelter trust estate for an extra generation. See, Paragraphs 7.1(A)(7) and 7.1(B)(5) of Sample ILIT.

Rule 19: When creating a GST tax exempt ILIT for the benefit of skip persons, and the grantor does not want to allocate his or her GST tax exemption to the ILIT (or has exhausted his or her GST tax exemption), make sure that each skip-person-beneficiary’s interest in the ILIT is a separate trust share that complies with the requirements of IRC section 2642(c)(2). See, section 5.7(C), above.

Rule 20: Do not have a beneficiary waive his or her Crummey withdrawal right. A waiver (rather than a lapse) may constitute a taxable release under IRC section 2514(b) and change the identity of the transferor (from the grantor to the beneficiary). Any previously allocated GST exemption by the grantor will be lost and ineffective. See. sections 5.10 and 5.21, above.

Rule 21: When establishing an ILIT that is to be GST tax exempt, make sure the grantor’s spouse’s withdrawal rights are limited to five by five, are non-cumulative (i.e., no hanging Crummey withdrawal right for the spouse), and lapse within 60 days of the grantor’s contribution to the ILIT (and not 60 days after the notice of the grantor’s contribution). Otherwise, there will be an estate tax inclusion period (“ETIP”) under IRC section 2642(f), which will prevent the grantor from allocating his or her GST tax exemption until the close of the ETIP. See, section 5.17, above.

Rule 22: If possible, do not gift split (IRC section 2513) the transfer of an existing life insurance policy to a GST tax exempt ILIT. If the grantor dies within 3 years of the policy’s transfer to the ILIT, the insurance proceeds will be included in the grantor’s gross estate under IRC section 2035 and the gift splitting-consenting spouse’s previously allocated GST tax exemption will be wasted and ineffective. See, section 5.22, above.

Rule 23: If possible, avoid late allocations of GST tax exemption to an ILIT. If the grantor dies before the actual filing date²⁵ of the late allocation, the GST tax exemption will have to be allocated to the full value of the life insurance proceeds. Treas. Reg. §26.2642-2(a)(2). See, section 5.23, above.

Rule 24: Do not rely on the GST tax exemption automatic allocation rules (IRC section 2632(c)) for indirect skips to GST Trusts. Many ILITs that were initially designed to not be GST Trusts (including those where the surviving spouse has a life estate if he or she survives the insured spouse) may, as a result of the GST automatic allocation rules for intervivos trusts, be classified as GST Trusts (and have GST tax exemption be automatically allocated to transfers made to such trusts). Consequently, taxpayers should consider making a one time election to permanently opt in or opt out of GST Trust status and the GST automatic allocation rules. IRC section 2632(c)(5). See, section 5.29(b)(1), above.

Caution: The filing of an election to opt out of GST Trust status and the GST automatic allocation rules concerning indirect skips to GST Trusts is not effective to prevent an automatic allocation of GST tax exemption to the opted out trust upon the transferor’s death. See, section 5.30, above.

Rule 25: Annual exclusion gifts to an ILIT are not automatically GST tax exempt, and GST tax exemption may need to be allocated by filing a U.S. Gift Tax Return. Treas. Reg. §26.2642-1(c)(3). See, sections 5.18 and 5.32, above.

5C.34 SAMPLE TRUSTEE POWERS FOR GST TAX ISSUES

A sample comprehensive trustee power clause concerning GST tax issues is contained in Paragraph 7.1(B) of Sample ILIT.

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