The generation skipping transfer tax(“GSTT”) is a harsh tax (40%) imposed on certain transfers to grandchildren and certain individuals in that same generation. Fortunately, the Internal Revenue Code (the “Code”) provides a GSTT basic exclusion amount (the “Exemption”) which is the same amount as the basic exclusion amount for estate tax (currently $5.490 million in 2017). GSTT is in ADDITION to the federal estate tax and gift tax. Thus, if the Exexmption is not properly allocated, transfers to grandchildren could occur a gift or estate tax AND a GSTT.
Three types of generation skipping transfersare possible, a direct skip, a taxable distribution and a taxable termination. Generally, the most effective use of the Exemption is the allocation of the Exemption to a trust which benefits grandchildren and future generations. The assets can appreciate and not be subject to GSTT.
The Internal Revenue Service (the “Service”) permitted a taxpayer to extend time to properly elect OUT of an automatic allocation of the Exemption in Private letter ruling (“PLR”) 201653013. This relief prevented the wasting of valuable Exemption on transfers not subject to the GSTT.
Taxpayer transferred money to a trust that had a POTENTIAL of GSTT (“Trust 1”) in year 1. In year 2, the taxpayer established “direct skip” irrevocable trusts for her grandchildren (“Trusts 2”). The Code automatically allocates the Exemption, unless you affirmatively elect out of automatic allocation. Thus, advisors must understand the consequences of automatic allocation of the Exemption and the election out of automatic allocation.
The CPA, who prepared the gift tax return for Trust 1 and Trusts 2, did not opt OUT of the automatic allocation and thus, an automatic allocation of the Exemption to both Trust 1 and Trusts 2 were made. Why did that matter?
Taxpayer did NOT want to allocate the Exemption to Trust 1 because Trust 1 primarily benefited taxpayer’s child and it was unlikely that the Exemption was necessary. Further, taxpayer did NOT want Exemption allocated to Trusts 2 because the GST tax rate was ZERO in that year so there was no need to allocate the Exemption.
Automatic allocations are irrevocable after the due date of the gift tax return for the calendar year in which the transfer is made. As the due date for the gift tax returns had passed, the taxpayer requested relief from the Service to extend the time to automatically elect OUT of allocation of the Exemption to Trust 1 and Trusts 2.
The taxpayer is deemed to have acted in good faith if the taxpayer reasonably relies on a qualified tax professional and the tax professional fails to make or advise the taxpayer to make the election. The Service concluded that this taxpayer had satisfied these requirements and gave the taxpayer an extension of time of 120 days from the date of the PLR to make an election OUT of the automatic allocation of Exemption for the transfers to Trust 1 and Trusts 2.
ADVICE: GSTT is VERY complicated. Any time you are dealing with gifts or transfers at death directly to grandchildren or to trusts that have the potential to benefit grandchildren, then you need to plan to avoid this harsh tax. Fortunately, you can use your Exemption to the fullest potential and create a dynasty trust or implement other planning techniques to leverage the Exemption. Further, you and your advisor must be aware of the automatic allocation rules. The automatic allocation rules may save you, but they can also cut the other way, in that the automatic allocation of Exemption can waste precious Exemption.
WORD OF THE WEEK: Treasury Regulations are tax regulations issued by the Service, a bureau of the United States Department of the Treasury and are the official interpretation of a statute in the Code and are one source of U.S. federal income tax law. The regulations often provide examples of the statute’s meanings that can help advisors. You can usually tell a regulation instead of a code section because of the way it is labelled. For example, the Code section is 2632 and the related regulation is 26.2632-1. When researching an area, review the statute and the related regulations to clarify the Service’s interpretation of the statute.
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