5B: Generation-Skipping Transfer Tax Issues[Continued]

5B.10 TRANSFEROR DEFINED

Generally, a transferor (for GST tax purposes) means the decedent in the case of property includable in the decedent’s gross estate under Chapter 11 of the Internal Revenue Code, and the donor in the case of property subject to gift tax (without regard to exemptions, exclusions, deductions, and credits) under Chapter 12 of the Internal Revenue Code. IRC section 2652(a)(1); Treas. Reg. §26.2652-1(a)(2). Determining the identity of the transferor is important for determining a transferee’s generation assignment and whose GST tax exemption may be allocated to the transfer in question. Subject to the special exception concerning property that has been elected for reverse QTIP treatment under IRC 2652(a)(3), the most recent transfer subject to federal estate or gift tax determines the identity of the transferor and whether the transfer is subject to the GST tax. Once a new transferor is determined, any prior allocation of GST tax exemption by a prior transferor is lost. Identifying the transferor is important if the ILIT contains Crummey withdrawal rights. The identity of the transferor may change because of a release of a Crummey withdrawal right in excess of the five-by-five safe harbor of IRC 2514(e), the waiver of a Crummey withdrawal right, or the death of the holder of an unlapsed Crummey withdrawal right.

5B.10(a) Crummey Powers Can Change The Identity Of The Transferor

A Crummey withdrawal right is a general power of appointment. IRC sections 2514 and 2041. Although its lapse during the power- holder’s lifetime may not be a taxable release under the five-by-five safe harbor rules of IRC sections 2514(e) and 2041(b)(2), if the power- holder dies before the lapse of the withdrawal right (whether it’s a single right of withdrawal or a hanging right of withdrawal) the amount of the unlapsed right of withdrawal at the date of the powerholder’s death will be included in the powerholder’s estate under IRC section 2041. For GST tax purposes, the deceased powerholder will become the (new) transferor of the amount included in his or her estate. Thus, any GST tax exemption previously allocated by the grantor will be lost and ineffective as to the amount included in the powerholder’s estate, and the executor of the deceased powerholder’s estate may have to allocate the decedent’s GST tax exemption to that amount, to preserve the ILIT’s zero (0) inclusion ratio. Also, if the beneficiary’s Crummey withdrawal right lapses in an amount greater than five by five and the lapse amount in excess of five by five is a taxable release of a power of appointment under IRC section 2514, the beneficiary will become the new transferor of the lapsed amount in excess of five by five. Thus, any GST tax exemption previously allocated by the grantor will be lost and ineffective as to the amount in excess of five by five. Additionally, if the beneficiary has a retained interest in the ILIT, all or a portion of the value of the ILIT will be included in the beneficiary’s gross estate upon his or her death. IRC section 2036(a); Treas. Reg. §20.2041-3(d)(4). The effect of cumulative taxable releases with a retained interest by the beneficiary may result in all (or a significant portion) of the beneficiary’s separate trust share being included in his or her gross estate. Treas. Reg. §20.2041-3(d)(5). Furthermore, the beneficiary will become the (new) transferor for GST tax purposes of the trust share that is includable in his or her gross estate, thus wasting any GST tax exemption that was previously allocated to the trust share. IRC section 2652(a)(1); Treas. Reg. §26.2652-1(a)(2). See, section 3.11, above.

Practice Point: If an ILIT is designed from the onset to be a GST tax exempt dynasty trust, then it may be prudent to forgo the Crummey withdrawal rights—including those limited to five by five, and instead have the grantor make gifts that utilize the grantor’s gift tax applicable exclusion amount and GST tax exemption. As mentioned above, there is always a GST tax risk when a beneficiary who holds a Crummey withdrawal right dies before the lapse of the withdrawal right—even a withdrawal right that falls within the five-by-five safe harbor rules. This is particularly relevant where the ILIT’s beneficiaries are comparable in age to the grantor-insured, or older than the grantor- insured. However, if non-hanging Crummey withdrawal rights are to be used, consider limiting the withdrawal period to 30 or 60 days.

5B.10(b) Gift Splitting By Spouses Creates Two Transferors

If a married couple elects gift splitting under IRC section 2513, each spouse is treated as the transferor (for GST tax purposes only) of one-half of the entire value of the property transferred, regardless of the interest the donor-spouse is actually deemed to have transferred under IRC section 2513. IRC section 2652(a)(2). See, Pvt. Letter Rul. 200218001, where the gift-splitting wife was deemed to be the transferor (for GST tax purposes) of one-half of the entire value of the property transferred by her husband into a trust for the wife and their children, even though the wife had an ascertainable interest (for purposes of IRC section 2513) in part of the transferred property and thus was not able to gift split (for purposes of Chapter 12 of the Internal Revenue Code) the entire transferred amount.

5B.11 TAXATION OF MULTIPLE SKIPS AND TRANSFEROR MOVE DOWN RULE 

A non-GST-tax-exempt trust may be subject to successive taxable distributions, taxable terminations, or direct skips. However, a non-GST- tax-exempt trust will not be subject to double GST taxation when a double skip occurs simultaneously, such as a transfer to a non-GST- tax- exempt trust that is for the sole benefit of a great-grandchild (or more remote descendants), which results in two generations (child and grandchild) being skipped in the same transfer. IRC section 2653. This is because neither the transferor’s child nor the grandchild has any interest in the trust. See, Treas. Reg. §26.2612-1(a). However, a transfer to a non-GST-tax-exempt trust for the benefit of the transferor’s grandchild and great-grandchild is a direct skip (for which a GST tax must be paid) and any distributions to the great-grandchild will also be subject to GST tax. This is because there are two successive skips rather than one double simultaneous skip. As discussed below, any trust distributions to the transferor’s grandchild will not be subject to additional GST tax, due to the transferor move-down rule. However, trust distributions to the transferor’s great-grandchild will be subject to additional GST tax.

Property held in trust after a GST event has occurred continues to be subject to the GST tax. To determine whether future events constitute GST taxable events, the transferor is treated as occupying one generation above the trust beneficiary (in this instance the grandchild) who has the highest generation assignment vis-à-vis the other trust beneficiaries (in this instance the great-grandchild) in the non-GST tax-exempt trust. The trust beneficiary who is now just one generation below the transferor (in this instance the grandchild) is no longer a skip person vis-à-vis the transferor. This is known as the “transferor move- down rule.” IRC section 2653; Treas. Reg. §26.2653-1(a).

Consequently, any distributions to the grandchild are not taxable distributions (keeping in mind that the transferor has already paid a GST tax on the direct skip into the trust). However, because the great grandchild occupies a generation that is two generations below the deemed generation of the transferor (as a result of the transferor move down rule), the great-grandchild remains a skip person vis-à-vis the transferor and any trust distributions to the great-grandchild will be taxable distributions (for which a (second) GST tax must be paid). Treas. Reg. §26.2653-1(b), Example 1. When the grandchild dies, there will be a taxable termination (for which another GST tax has to be paid). A taxable termination will occur when the grandchild dies (because the only interest in the trust, after the death of the grandchild, is the interest of the great-grandchild, who is a skip person vis-à-vis the transferor). However, because of the taxable termination, the transferor will move down another generation and be deemed to be one generation above that of the great-grand- child. Consequently, any future trust distributions to the great-grand- child will not be taxable distributions (keeping in mind that a GST tax has been paid because of the taxable termination resulting from the grandchild’s death).

When the great-grandchild dies and the trust terminates in favor of the great-grandchild’s then living children (i.e., the transferor’s great-great grandchildren), there will be a taxable termination for which (another) GST tax has to be paid. The multiple skip rule underscores the need for a transferor to allocate his or her GST tax exemption to a GST trust to achieve a zero inclusion ratio and avoid successive GST taxation.

5B.12 INCLUSION RATIO DEFINED

Inclusion ratio is defined under IRC section 2642(a). When allocating GST tax exemption to a trust, the goal is to have a trust with either a zero inclusion ratio (i.e., be 100% GST tax exempt) or an inclusion ratio of one (i.e., be completely subject to GST tax). What is to be avoided is a trust with an inclusion ratio of greater than zero but less than one. The GST tax is imposed at the “applicable rate,” which is the current maximum federal estate tax rate multiplied by the inclusion ratio. IRC section 2641; Treas. Reg. §26.2641-1. Thus, the inclusion ratio is used to determine the rate of GST tax imposed on property that is subject to the GST tax. See, Treas. Reg. §26.2642-1. However, to determine the inclusion ratio, you must first determine the applicable fraction.

The applicable fraction is determined as follows: the numerator of the applicable fraction is the amount of GST tax exemption allocated to the trust (or to the property transferred in a direct skip), and the denominator is generally the value of the transferred property (less certain adjustments described in IRC section 2642(a)(2)(B)(ii) for federal estate tax and state death taxes actually recovered (or paid) from the trust (or transferred property) and any charitable deduction allowed under IRC sections 2055 or 2522 with respect to the property). GST tax exemption allocated for the full amount of the transferred property results in an applicable fraction of 1, an inclusion ratio of zero (1-1 = 0), and an “applicable rate” (i.e., GST tax rate) of zero (48% estate tax rate (for 2004) ¥ 0 inclusion ratio = 0 GST tax rate).

Applicable rate = GST tax rate (i.e., maximum federal estate tax rate) X inclusion ratio.

Inclusion ratio = 1- applicable fraction.

Applicable fraction = GST tax exemption allocated to transfer

Value of GST transfer (less certain adjustments)

Thus, the formula for determining the GST tax liability is: GST tax liability = value of transferred property subject to GST tax X applicable rate.

5B.12(a) Simple Definition Of Inclusion Ratio

In simpler terms, the inclusion ratio is the percent age of the trust that is subject to GST tax, with an inclusion ratio of zero resulting in zero% of the trust being subject to GST tax,1 and an inclusion ratio of one resulting in 100% of the trust being subject to GST tax. Thus, an inclusion ratio of .50 would effectively result in 50% of the trust being subject to GST tax. The reason that a trust with an inclusion ratio of greater than zero but less than one should be avoided, is that every distribution, whether to skip persons or non-skip persons, will be only partially exempt from GST tax—an ineffective and wasteful use of the transferor’s GST tax exemption.

5B.12(b) Changes To The Inclusion Ratio

A trust maintains its inclusion ratio until (1) a transferor makes an additional transfer of property to the trust; (2) additional GST tax exemption is allocated; (3) there is a new transferor; (4) there is a consolidation or merger of separate trusts; (5) a recapture tax is imposed under IRC section 2032A; or (6) pursuant to IRC section 2653(b), a GST tax is borne by the trust with respect to a transfer of property, if immediately after the transfer, the property remains in the trust (presumably where the inclusion ratio before the payment of the GST tax was greater than zero but less than one). IRC section 2642(d)(1); Treas. Reg. §26.2642-4. In such instances, the applicable fraction (i.e., inclusion ratio) must be re-determined.2 As discussed below, a trust may be divided, pursuant to a qualified severance, into two separate trusts one with an inclusion ratio of zero and another with an inclusion ratio of one.

Practice Point: If a trust has an inclusion ratio greater than zero, GST tax will always have to paid when the trust makes a taxable distribution or has a taxable termination.

5B.13 RIGHT TO RECOVER GST TAX PAID

Because GST taxes are chargeable to the property generating the tax, a transferor’s executor is entitled to recover any GST taxes paid by the transferor’s estate, unless that right of recovery is waived in the transferor’s governing instrument by specific reference to the GST tax. IRC section 2603(b).

5B.14 THE GST TAX EXEMPTION

Each person is allotted a lifetime exemption from the GST tax. IRC section 2631(a). The exemption was initially $1 million dollars. It was first increased by cost of living adjustments in the Taxpayer Relief Act of 1997 (“TRA 1997”), and subsequently increased, in the 2001 Tax Act, to match the estate tax applicable exclusion amount. The 2001 Tax Act’s increase in the GST tax exemption expires on January 1, 2010 (as does the GST tax itself), and on January 1, 2011, the pre- 2001 Tax Act GST tax exemption amount is reinstated, as is the GST tax. See, section 6.1, below, and Chapter 7, below.

The GST tax exemption amount can be used by the transferor during his or her lifetime; and upon death, any unused exemption can be used by the deceased transferor’s executor, and/or it can be automatically allocated pursuant to IRC section 2632(e). The automatic allocation rules are discussed in sections 5.29 and 5.30, below.

Allocation of GST tax exemption can be of a specific amount, or by a formula (that self adjusts in the event of a change in value on audit by the IRS). Treas. Reg. §§26.2632-1(b)(4) and 26.2632-1(d)(1). Some of the most technical and complicated provisions of the GST tax regulations relate to the allocation of GST tax exemption regarding property transferred from a trust or held in trust. This is because if property is held in trust, allocation of GST tax exemption must be made to the entire trust rather than to specific trust assets. Treas. Reg. §26.2632-1(a). Hence, there are special GST tax regulations concerning the treatment of property transferred from a trust or held in trust. These special regulations are discussed in the GST tax separate share rule (section 5.16, below) and in the GST tax qualified severance rule (section 6.3, below). These two rules are designed to treat portions of a trust as separate trusts for GST tax purposes.

Allocation of GST tax exemption is effective as of the date of transfer if made on a timely filed U.S. Gift Tax Return (IRS form 709). Generally, an allocation of GST tax exemption on a late-filed gift tax return is effective on the date the gift tax return is filed. However, special rules exist with regard to certain late allocations, and also with regard to life insurance policies. See, section 5.23, below concerning late allocations of GST tax exemption.

Practice Point: Each time a gift is made to an ILIT, a decision has to be made whether or not to allocate GST tax exemption to the trust (or to opt in or opt out of “GST Trust” status, a defined term in IRC section 2632(c)(3)(B)). Reliance on the automatic GST tax exemption allocation rules (discussed in section 5.29, below), may not be sufficient since there is uncertainty as to what constitutes an exception to a “GST Trust.”

5B.15 VALUATION OF PROPERTY FOR GST TAX PURPOSES

Generally, the value of property for GST tax purposes is the property’s value at the time of the GST, such as the property’s date of transfer value (in the case of an intervivos gift) or date of distribution value (in the case of a taxable distribution). IRC section 2624(a); Treas. Reg. §26.2642-2. Different rules apply to different types of GST events. In the case of a direct skip of property that is included in the transferor’s gross estate, the value of the property is generally its federal estate tax value, as determined under IRC sections 2031 (date of death valuation), 2032 (alternate valuation date value), and 2032A (special use valuation). IRC section 2624(b). However, under certain circumstances, the GST tax regulations require additional conditions to be satisfied if property includable in the transferor’s gross estate is to be valued at its federal estate tax value. Treas. Reg. §26.2642-2(b)(2) and (3).3 If a GST tax is incurred on a taxable termination due to the death of an individual, the property subject to the taxable termination may be valued under IRC section 2032 (alternate valuation date value). IRC section 2624(c).

5B.16 SEPARATE SHARE RULE

The separate share rule is set forth in IRC section 2654(b) and Treas. Reg. §26.2654-1(a). This rule determines when a single trust with multiple beneficiaries will be treated as having substantially separate and independent shares, thus enabling the allocation of GST tax exemption to any of the shares. The separate share rule also determines when certain pecuniary bequests payable from a trust included in the transferor’s gross estate will be treated as separate shares for allocating GST tax exemption. And, if there are portions of a single trust that are attributable to transfers from different transferors (such as when gift splitting occurs under IRC section 2513), the separate share rule treats those portions as separate trusts. IRC section 2654(b)(1); Treas. Reg. §2654-1(a)(2).

5B.16(a) Two Requirements For A Single Trust With Multiple Beneficiaries To Be Treated As Having Separate Shares For GST Tax Purposes 

The separate share rule provided in Treas. Reg. §26.2654-1(a)(1) states that is a single trust4 has more than one beneficiary and the beneficiaries have substantially separate and independent shares vis-à-vis one another (such as a common (pot) trust with distinctly separate interests for the transferor’s descendants, with each descendant being entitled to receive income and principal from his or her share), the share attributable to each beneficiary (or group of beneficiaries) will be treated as a separate share for GST tax purposes only.5 Treas. Reg. §26.2654-1(a)(1)(i). Two requirements must be met for the rule to apply. If these two requirements are met, GST tax exemption can be allocated to any of the separate shares, and it does not have to be allocated to the whole single trust (which may result in an overuse and waste of the transferor’s GST tax exemption). Treas. Reg. §26.2654- 1(a)(4). A single trust will be deemed to consist solely of substantially separate and independent shares6 for different beneficiaries for the purpose of allocating GST tax exemption to some or all of the shares, if both of the following two requirements are met:

5B.16(a)(1) Existence Of Shares Requirement

 The separate shares must exist from and at all times after the creation of the ILIT (unless the trust is for some reason included in its entirety in the transferor’s gross estate for federal estate tax purposes, in which case the separate shares are deemed created at the transferor’s date of death). When the ILIT is not included in the transferor’s gross estate (which should be the situation for most ILITs, particularly if there is no IRC section 2035 issue), the separate shares must exist at the time of the creation of the ILIT and all times thereafter; otherwise they will not be recognized as separate shares for GST tax purposes. Treas. Reg. §26.2654-1(a)(1)(i). If separate shares do not exist at the onset, a qualified severance of the trust may be required. See, section 6.3, below.

5.16(a)(2) Allocation Requirement

 Unless the governing instrument expressly provides otherwise, additions to and distributions from the single trust are allocated pro rata among the separate shares.

5B.16(b) Severance Of A Separate Share From A Single Trust

 Separate shares that are part of a single separate trust for GST tax purposes may be severed from the single trust at any time (rather than remaining as separate shares). Treas. Reg. §26.2654-1(a)(3). The severance of a separate share from the single trust and the funding of a severed share must comply with the rules of Treas. Reg. §26.2654- 1(b)(1)(ii)(C). Thus, the severance of a separate share from a single trust must be either on a fractional basis, or on a pecuniary basis. However, a pecuniary severance can be made only if it is mandated by the governing instrument. Treas. Reg. §26.2654-1(b)(1)(ii)(C)(2). The requirements for severing a separate share from a single trust are given in the next two sections, immediately below.

5B.16(b)(1) Requirements For A Fractional Severance Of A Separate Share From A Single Trust

 If the severance of a separate share from the single trust is made on a fractional basis, the funding of the severed share may be pro-rata or non-pro-rata as to specific assets of the single trust. If non-pro-rata funding is used, the funding of the severed share must be either based on the fair market value of the single trust’s assets on the date of funding or provided in a manner that fairly reflects the net appreciation or depreciation in the value of the single trust’s assets measured from the valuation date to the date of funding.

5B.16(b)(2) Requirements For A Mandatory Pecuniary Severance Of A Separate Share From A Single Trust

If the severance of a separate share from the single trust is required by the terms of the governing instrument to be made on the basis of a pecuniary amount, the trustee must be required to pay “appropriate interest” on the pecuniary amount; and the pecuniary amount must be funded either (1) entirely with cash; or (2) partly with cash and partly (or solely) with non-cash property (e.g., stocks and bonds) either by using the non-cash assets’ date-of-distribution value, or by allocating the trust property in a manner that fairly reflects net appreciation or depreciation in the value of the assets in the fund avail- able to pay the pecuniary amount measured from date of death to date of payment. Treas. Reg. §26.2654-1(a)(1)(ii).

5B.17 ESTATE TAX INCLUSION PERIOD (“ETIP”) DEFINED

Allocation of GST tax exemption is not effective until the close of the Estate Tax Inclusion Period(“ETIP”).IRC section 2642(f).An ETIP is the period during which the trust property would be included in the gross estate of the transferor or the transferor’s spouse if either were to die.7 Examples would be transfers to revocable trusts, grantor-retained annuity trusts (“GRATs”), and qualified personal residence trusts (“QPRTs”). Treasury Regulations provide that if any part of a trust is subject to an ETIP, the entire trust is subject to the ETIP. At the close of the ETIP, the previously allocated GST tax exemption is allocated against the fair market value of the ILIT property. If the amount of GST tax exemption that was initially allocated is less than the fair market value of the ILIT property at the close of the ETIP, the ILIT will not be GST tax exempt. See, section 3.1, above, for valuation of a life insurance policy. Accordingly it is generally best to wait until the close of the ETIP to allocate GST tax exemption to a trust.8 An alternative to this approach is to make a formula allocation of GST tax exemption at the beginning of the ETIP; how ever, the amount of the GST tax exemption being allocated under the formula will not be known until the close of the ETIP. An allocation of GST tax exemption made to a trust during the ETIP cannot be revoked, even though the allocation is not effective until the close of the ETIP. Treas. Regs. §26.2632-1(c)(1).

5.17(a) Exceptions To ETIP

 Treas. Reg. §26.2632-1(c)(2)(ii) provides several exceptions to ETIP, including (1) a reverse QTIP election (typically concerning an intervivos QTIP trust established by the donor-spouse for the benefit of the donee-spouse9); and (2) a Crummey withdrawal right held by the grantor’s spouse that is limited to no more than five-by-five and the withdrawal right terminates no later than sixty (60) days after the transfer to the ILIT—not sixty (60) days after notice of the transfer to the ILIT. This exception concerning spousal Crummey withdrawal rights, with its abbreviated period for the Crummey withdrawal right to lapse, automatically precludes the use of a hanging right of withdrawal (See, section 3.13, above), as concerns the lapse of the spouse’s Crummey withdrawal right. See, Paragraphs 3.1(A)(1) and 3.2(D) of Sample ILIT.

Caution: The most common forms of triggering an ETIP in an ILIT is where these two exceptions are violated. Practice Point: If the ILIT provides the grantor’s spouse with a Crummey withdrawal right that does lapse within 60 days of the transfer, and the grantor desires to allocate GST tax exemption to the ILIT, consider, modifying the spouse’s right of withdrawal. This may be accomplished by judicial modification or reformation, through the exercise of a power to limit (modify) future Crummey withdrawal rights reserved by the grantor, or through the power of amendment held by a non-interested trustee. See, Paragraphs 3.2(H) and 3.2 (J) of the Sample ILIT.

5B.17(b) Possible Inclusion Of Property Under IRC Section 2035 Is Not An ETIP

 Treas. Reg. §26.2632-1(c)(2)(i) provides that possible inclusion of transferred property in the estate of the transferor-grantor because of the three-year inclusion rule of IRC section 2035 is not an ETIP, and GST tax exemption can be effectively allocated to the ILIT during the transferor-grantor’s lifetime, even if the transferor-grantor dies within three years of transferring an existing life insurance policy to an ILIT.

 5B.17(c) Termination Of ETIP

An ETIP terminates on the first to occur of (i) the death of the transferor; (ii) the time at which no portion of the property is includible in the transferor’s gross estate (other than by reason of IRC section 2035) or, in the case of a spouse who has merely consented to gift splitting under IRC section 2513, the time at which no portion would be includible in the gross estate of the consenting spouse (other than by reason of IRC section 2035); (iii) the time of a GST event (such as a taxable distribution or taxable termination) but only with respect to the property involved in the GST event; or (iv) in the case of an ETIP arising by reason of an interest or power held by the transferor’s spouse on the first to occur of (a) the death of the spouse or (b) the time at which no portion of the property would be includable in the spouse’s gross estate (other than by reason of IRC section 2035). Treas. Regs. §26.2632-1(c)(3). Thus, if the ETIP is created by the spouse holding a Crummey withdrawal right that is in excess of five by five and/or lapses more than 60 days after the date of the contribution that gives rise to the Crummey withdrawal right, the ETIP will terminate upon the earlier of the spouse’s death or the complete lapse of the Crummey withdrawal right (which will lapse annually at the rate of $5,000, or 5% of the value of the trust assets).

5B.18 GIFT SUBJECT TO A CRUMMEY WITHDRAWAL RIGHT IS GIFT TO TRUST FOR GST PURPOSES

 There is a disconnect between the gift tax annual exclusion rules under IRC section 2503(b) and the GST tax exemption rules concerning transfers to a trust. This disconnect means that although the Crummey withdrawal right qualifies for the gift tax annual exclusion, the gift does not automatically qualify for the GST tax exclusion; and if no GST tax exemption is allocated by the insured to the ILIT, the ILIT will not be GST tax exempt. The disconnect exists because, under the GST tax rules, a gift to a trust that has Crummey withdraw- al rights is not considered a gift to the individual donees; rather, the gift is considered a transfer to the trust itself. Treas. Reg. §26.2642- 1(c)(3). See also, Treas. Reg. §26.2612-1(d)(2) concerning trusts that are skip persons.

5B.18(a) Special Rule Concerning Skip Person Trusts

An exception to the above-mentioned rule concerns trusts that are ski persons, such as:(i)an IRC section 2642(c)(2) trust for a skip person, and (ii) possibly, an IRC section 2503(c) trust for a minor skip person.10 However, neither of these two forms of trust is generally suitable for use as an ILIT because they permit only a sole beneficiary, require inclusion of the trust proceeds in the beneficiary’s gross estate if the beneficiary dies before the trust terminates, and, in the case of an IRC section 2503(c) trust, the trust is required to terminate when the beneficiary attains age 21.

Practice Point: When funding an ILIT, the insured needs to determine if GST tax exemption should be allocated to the ILIT. Generally, this will require the insured to either “opt in” or “opt out” of the GST tax exemption automatic allocation rules when property is initially transferred to the ILIT. See, section 5.29, below.

5B.19 GST TAX CONSEQUENCES OF EXERCISE OF A CRUMMEY WITHDRAWAL RIGHT

 The exercise of the Crummey withdrawal right by a skip person (assuming the trust is not a skip person under IRC section 2642(c)(2) and no GST tax exemption has been previously allocated by the grant- or) is a taxable distribution for GST purposes. Treas. Reg. §26.2612- 1(f), Example 13.

5.20 GST TAX CONSEQUENCES OF LAPSE OF A CRUMMEY WITHDRAWAL RIGHT

 Transfer of property to an ILIT where a skip person has a Crummey withdrawal right is not a direct skip, and does not immediately attract any GST tax provided the ILIT itself is not a “skip person.” Treas. Reg. §26.2612-1(f), Example 3. Furthermore (assuming the ILIT itself is not a skip person under IRC section 2642(c)(2)) a skip person’s unexercised Crummey withdrawal right is not itself a direct skip or a GST tax event if the withdrawal right lapses within the five-by-five safe harbor amount. This means that the grantor remains the original and continuing transferor for GST purposes and any GST tax exemption previously allocated by the transferor will remain intact, assuming the beneficiary does not die while the Crummey withdrawal right remains outstanding and/or there is no taxable release of the Crummey withdrawal right. IRC sections 2041(a)(2) and 2652(a); Treas. Reg. §§26.2652-1(a)(2) and 26.2601-1(b)(1)(v)(A).

5B.21 GST TAX CONSEQUENCES OF WAIVER OR RELEASE OF A CRUMMEY WITHDRAWAL RIGHT

 A beneficiary’s waiver of a Crummey withdrawal right or the lapse of a Crummey withdrawal right greater than five by five constitutes a tax- able release under IRC section 2514(b). Treas. Reg. §26.2652-1(a)(5), Example 5. A taxable release results in a taxable transfer under Chapter 11 or 12 of the Internal Revenue Code and changes the identity of the transferor for GST tax purposes (with regard to the property subject to Chapter 11or12).Treas.Reg.§26.2652-1(a)(2).Any previously allocated GST tax exemption by the original transferor is lost and ineffective when the identity of the transferor changes, thus necessitating allocation of GST tax exemption by the new transferor, if such an allocation is possible, necessary or appropriate. For a typical three-generation ILIT, an allocation of GST tax exemption by a second-generation Crummey withdrawal right holder would not be needed, because the third-generation beneficiary would not be a skip person vis-à-vis the second generation beneficiary (who is now the “new” transferor).

A way to avoid a taxable release (and to avoid a change in the identity of the transferor) is to not let a beneficiary waive his or her Crummey withdrawal right (in the case of a waiver) or, in the case of a release, to limit a beneficiary’s Crummey withdrawal right to the lesser of the contribution or five by five. If hanging rights of withdrawal are used (see, section 3.13, above), the hanging rights should lapse at the rate of five by five each calendar year. If a skip person waives his or her Crummey withdrawal right or allows a lapse of his or her withdrawal right greater than five by five, a taxable distribution for GST tax purposes is deemed to have occurred to such skip person with respect to the value of the property subject to the taxable release. Treas. Reg. §2612-1(c)(1). Furthermore, the skip person becomes the (new) transferor for GST tax purposes with regard to the amount of the taxable release. Treas. Reg. §§26.2652-1(a)(2) and 26.2652-1(a)(5), Example 5.

5B.22 GST TAX CONSEQUENCES OF GIFT SPLITTING

 If a married couple elects gift splitting under IRC section 2513, each spouse is treated as the transferor (for GST tax purposes only) of one- half of the entire value of the property transferred, regardless of the interest the donor-spouse is actually deemed to have transferred under IRC section 2513. IRC section 2652(a)(2). See, Pvt. Letter Rul. 200218001, where the gift-splitting wife was deemed to be the transferor (for GST tax purposes) of one-half of the entire value of the property transferred by her husband into a trust for the wife and their children, even though the wife had an ascertainable interest (for purposes of IRC section 2513) in part of the transferred property and thus was not able to gift split (for purposes of Chapter 12 of the Internal Revenue Code) the entire transferred amount.

Practice Point: If gift splitting is elected with respect to a life insurance policy that has been transferred to an ILIT and the insured dies within three years of the transfer, the consenting spouse’s previously allocated GST tax exemption will be wasted and ineffective. This is because the inclusion of the life insurance proceeds in the gross estate of the insured under IRC section 2035 changes the identity of the transferor for GST purposes to that of the decedent. For this reason, it may be desirable to not elect to gift split for transfers of life insurance policies subject to the three-year inclusion rule of IRC section 2035.

5B.23 LATE ALLOCATION OF GST TAX EXEMPTION TO ILIT

 Late allocation of GST tax exemption at the gift tax value of the transferred property is not effective with respect to a life insurance policy or an ILIT if the individual insured has died. Treas. Reg. §26.2642- 2(a)(2). However, if the insured has not died, late allocation of GST tax exemption can be made utilizing the value of the life insurance pol- icy or ILIT as of the first day of the calendar month in which the late allocation is filed with the IRS. Treas. Reg. §26.2642-2(a). A late allocation of GST tax exemption is effective on the date the gift tax return is filed with the IRS, and once made is irrevocable. The gift tax return’s postmark date will be the deemed filing date for the late allocation of GST tax exemption. Treas. Reg. §26.2632-1(b)(4)(ii). Query whether the addition of IRC section 2642(g)(1) under the 2001 Tax Act, concerning relief from late allocations (See, section 6.5, below), will change this result. See, Pvt. Letter. Rul. 200227017 concerning late allocation of the deceased-insured’s GST tax exemption under second-to-die life insurance policy, where only one of the insureds had died and the pol- icy had not yet matured. If a GST event occurs on the same date as the filing of the gift tax return, the late allocation of GST tax exemption is deemed to precede the GST event. Treas. Reg. §26.2632-1(b)(4)(ii).

Late allocation of GST exemption is made on IRS Form 709 by attaching a notice of late allocation.11 Treas. Reg. §26.2642-2(a)(2). The notice of late allocation must state (i) that a late allocation of GST tax exemption is being made to a trust (with the trust being sufficiently identified), (ii) the applicable valuation date for allocating the GST tax exemption to the trust, and (iii) the fair market value of the trust assets on the applicable valuation date. Id. A late allocation of GST tax exemption may be made at any time before the due date of the transferor’s federal estate tax return, including extensions actually granted. Treas. Reg. §26.2632-1(a). See also, section 6.5, below, concerning special procedures for making a late allocation pursuant to IRC section 2642(g).

Practice Point: Late allocation of GST exemption may be desirable where the trust assets have depreciated in value between the time of the gift and the due date for the gift tax return concerning the gift.

Practice Point: Late allocation of GST exemption may be desirable where a pre-2001 trust is now a GST Trust (because of the 2001 Tax Act’s enactment of IRC section 2632(c)(3)(B)) and has been subject to the GST automatic allocation rules. Absent a late allocation, the trust may not have a zero inclusion ratio for GST tax purposes. See, section 5.29, below.

Caution: If the insured is seriously or terminally ill at the time of the late allocation, the value of the life insurance policy for GST tax exemption purposes may not be its interpolated terminal reserve value. Instead, the value of the policy may be closer its death benefit amount. See, section 3.1(a), above.

5B.24 GST GRANDFATHERED TRUSTS

Three types of trusts are grandfathered for GST tax purposes (and are automatically GST tax exempt): (i) a trust that was irrevocable on 9/25/1985 but only to the extent that a GST transfer is not made out of corpus that was added to the trust after 9/25/1985 or out of income attributable to such corpus (Treas. Reg. §26.2601-1(b)(1)),12(ii) any trust (or testamentary trust to be established under a will) executed before 10/22/1986 and not amended thereafter if the decedent died before 1/1/1987 (Treas. Reg. §26.2601-1(b)(2)), and (iii) any trust made by a person who on 10/22/1986, and at all times thereafter, was mentally incompetent and the trust was included in the incompetent person’s gross estate. (Treas. Reg. §26.2601-1(b)(3)).

Practice Point: The purchase of an existing life insurance policy for full and adequate consideration by a GST grand- fathered trust will not cause the grandfathered trust to lose its GST tax exempt status. Priv. Letter Rul. 200120007

 

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