Federal Estate and Gift Taxes -- Generation Skipping Taxes and How They Affect Trust Design

In the previous post, we took a quick overview of the generation-skipping transfers tax, "affectionately" known as the "GST."  This is the tax that's imposed, in addition to the federal estate or gift tax, on any "generation-skipping transfer."  A "generation-skipping transfer" (sometimes called a "skip") is any transfer, at death or by gift, to a "skip person."  To illustrate what a "skip person" is, let's use the family tree from the last post, with a slight modification:

Grandma

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Junior

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Skippy

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Skippy II

Grandma is the person who's going to be making the transfer.  Assuming all of these people are living on the date of the transfer, Skippy and Skippy II would be "skip persons" and Junior would be a "non-skip person"--yes, that's the official term from the tax code.  A gift to Skippy or Skippy II would be a "generation-skipping transfer," and will be subject to the GST unless the annual exclusion applies or Grandma has GST exemption she can allocate to the transfer.  A transfer to Junior is not a skip, and will not be subject to the GST.  (If Junior dies, and then Grandma makes a transfer to Skippy, that will not be a skip because there is no living person in the generation between them, and the GST won't apply--but transfers to Skippy II will still be skips subject to GST.)

So far, I've been talking about outright gifts.  If the gifts are made to a trust, the question of whether they're skips or not is determined by looking at the beneficiaries of the trust.  A gift to a trust for the benefit of Skippy will be a skip because Skippy is a skip person.  A trust for the benefit of Skippy and Skippy II--same result, because all of the beneficiaries are skip persons.  All of these transfers are called "direct skips," and if there's any GST to be paid, it's paid when the transfer is made.

Now for the tricky part: what about a trust for the benefit of Junior, Skippy, and Skippy II?  Let's assume for purposes of the example that the trustee can make distributions to any one or more of these three people in its discretion.  A trust like this might be seen where Junior is the "gray sheep" of the family.

In this case, when Grandma puts assets into the trust, we don't know if the transfer is a skip yet because we don't know if any particular property in the trust will be distributed out to a skip person (Skippy and Skippy II) or a non-skip person (Junior).  If the trust makes any distribution to Junior, those are not skips, and there's no GST.  Any distributions to Skippy or Skippy II are "taxable distributions" on which a GST will have to be paid at the time of distribution unless Grandma allocated GST exemption to the trust back when she created it.

What happens when Junior dies?  As of that moment, we know for a certainty that all future distributions will be to the skip persons.  Junior's death is therefore a "taxable termination"--it's called that because the interests of all non-skip persons in the trust have terminated--and is the occasion for assessing the GST against all of the remaining trust property--again, unless Grandma allocated GST exemption to the trust back when she created it.

In other words, a transfer to one of your children which is held in trust for life, with final distribution to your grandchildren, may subject the trust property to the GST.  Therefore, it's necessary to allocate GST exemption to the trust when the trust is created; this is done on the relevant estate tax or gift tax return.  If you don't have enough GST exemption to cover the entire transfer, the trust has to be designed so that the non-exempt part is included in your child's estate so that it's taxed there instead of being hammered by the GST.

Federal Estate and Gift Taxes -- the Generation Skipping Transfers Tax

The generation-skipping transfers tax, or "GST" for short, is perhaps the hardest-hitting element of the federal wealth transfer tax system. For purposes of illustration, let's use a very simple family tree:

Grandma

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Junior

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Skippy

To begin, imagine that it's before 1976, when the first version of the GST was enacted.  (It was replaced in 1986 with the arrangement we have today.)  By virtue of his place in the family business and/or earlier gifts from Grandma, Junior is independently wealthy.  Anything that Grandma leaves to him at death will simply get added to Junior's gross estate and taxed again at Junior's passing.  What people in Grandma's position often did was to create a trust for Skippy and the other grandkids, and perhaps also later generations, and thus "skip" taxation in Junior's generation.  The trust usually could reach no farther than the grandchildren's generation because of something called the Rule Against Perpetuities, which we'll discuss another time.

As we've noted in earlier posts, one of the baseline policies of the gift and estate tax system is to tax accumulated wealth once per generation, and generation skipping transfers like these cut that down to once every other generation.  Because most people would only do this if Junior was well provided-for, these "generation-skipping trusts" were a strategy only a very very high net worth family could make use of--so that the estate and gift taxes actually fell harder on those who were wealthy enough to pay estate taxes, but not wealthy enough to play at generation skipping.

To redress this flaw and discourage generation skipping transfers, Congress enacted the GST.  The GST is imposed, in addition to the estate or gift tax, on any transfer to a "skip person."  There's a complex definition of a "skip person" in the tax code, but what it boils down to is that, in the example above, Skippy is a "skip person" if Junior is living on the date of the transfer.  If Junior dies, and then Grandma makes the transfer to Skippy, it's not a generation skipping transfer and the GST does not apply.

What makes the GST hit so hard is the rate of tax: it's equal to the highest estate tax rate then in effect.  In 1986, when the modern version of the GST entered the tax code, that top rate was 55%--so it was possible for a generation-skipping transfer to be taxed at a combined 110% (up to 55% estate/gift tax + 55% GST).  The purpose of this was not to collect a 110% tax so much as it was to make large generation-skipping transfers so uneconomical that no one would want to do them.

Well, maybe not all generation-skipping transfers.  Not wanting tax policy to interfere too much with the time-honored tradition of doting on grandchildren, Congress also provided that the GST does not apply to most annual exclusion gifts, and gave every person a $1 million GST exemption.  The exemption let each person transfer a total of $1 million to the grandkids (and other skip persons) before the GST kicked in.  (There was also a $2 million-per-grandchild temporary exemption which expired in 1989--named the "Gallo provision" in honor of the high net-worth family which "suggested" it to their Congressional representatives.)

Under the 2001 tax act ("the Bush tax cuts"), the GST exemption increased in parallel with the exemption equivalent provided by the estate and gift tax unified credit, so that it reached $3.5 million in 2009.  During the "estate tax holiday" in 2010, there was (so we thought) no GST at all.  The 2010 tax act reinstated the GST retroactive to January 1, 2010, but at a 0% rate--so if you made a generation-skipping transfer before the tax was retroactively re-imposed, you didn't get hit with a surprise tax assessment.  For 2011 and 2012, the GST exemption is $5 million.  Unless Congress acts before the end of next year, the GST exemption will "snap back" to $1 million on January 1, 2013, as part of what the media calls the "expiration" of the "Bush tax cuts."

You may think that the GST is a problem only for the super wealthy, but it can affect people of relatively modest means.  A trust for your "gray sheep" child which holds the assets for the child's life, then distributes to that child's offspring afterward, is a generation-skipping transfer that is subject to the tax unless there is sufficient GST exemption to cover it.  We'll talk about how the GST affects trust design, and some of the "work-arounds" that have been developed to counter it, in future postings.

E-Mail and Attorney-Client Confidentiality

I plan to do a future post on attorney-client privilege and confidentiality issues in estate planning.  While you're waiting for that, I'll refer you to an interesting article on confidentiality issues with the use of electronic mail published at lawyerist.com.

The Gray Sheep

What's a "gray sheep?"

You all know what a "black sheep" is, in the metaphorical sense: the black sheep is the child or grandchild who has turned out wrong, done something stupid or illegal or immoral (or some combination thereof) that has brought shame and disgrace to the family.  When it comes time to do the estate planning, the black sheep is the one who doesn't get anything--or, at best, gets some token distribution on the condition that they don't contest the will or the trust.

A gray sheep is a beneficiary who isn't quite bad enough to be a black sheep. He may have done something stupid or illegal or immoral (or some combination thereof), but whatever it was it wasn't quite bad enough to justify cutting him out completely.  There's a second breed of gray sheep, the one who has a chemical dependency problem, massive debts, a spouse that can't be trusted, or a simple lack of good sense.  The client I'm drafting the documents for still wants to give something to the gray sheep, but not directly, not in a way that puts them in control of the wealth.

As you might have guessed, gifts to gray sheep are going to be held in trust. The exact terms will vary based on the circumstances, including the amount of money or property at stake, and how gray (metaphorically) the gray sheep is and how she got that way.  Some of the terms used in gray sheep trusts include:

• Holding the principal in trust until some advanced age (50, 55, 60, 65 even) or for the gray sheep's life.  (A lifetime trust with remainder to grandchildren presents some issues with the generation-skipping transfers tax that we will go into in a future installment).
• Making distributions out of the trust discretionary subject to an "ascertainable standard" such as "health, maintenance, education, and support."
• Making distributions "wholly discretionary."  Under the Ohio Trust Code, a "wholly discretionary" trust is not subject to the claims of the gray sheep's creditors-making wholly discretionary trusts extremely useful for gray sheep with creditor problems.
• The discretionary distributions may be further subject to the approval of a trust advisor.
• The distributions, even though they may be discretionary or even wholly discretionary, may be capped off at a certain amount per year, or limited to expenditures for certain purposes only.
• If the gray sheep's problem is one of motivation, the trustee could be directed to make distributions in an amount determined with reference to the gray sheep's earned income.  The harder you work, the more the trust gives you.
• Distributions could be made contingent on certain accomplishments, or on refraining from certain specified bad behavior.  I have drafted at least two trusts where the beneficiary's right to further distributions was contingent upon passing random drug tests.  If the beneficiary failed, the trustee was restricted to making distributions only to pay for rehab treatment.

Federal Estate and Gift Taxes -- the Annual Exclusion

The purpose of the gift tax is to prevent people from "sneaking" around the estate tax by giving away assets before death.  There's no official definition of a gift, but the general understanding is that a gift is any transfer of property that makes your estate smaller.  The gift tax part of the Internal Revenue Code expressly says that it is not a "gift" to pay someone's medical or educational expenses.  There's no exemption for everyday living expenses, but as far as I know the IRS has never tried to characterize basic consumption, such as the cost of feeding and housing your kids, as a taxable gift.

Even with those exceptions, every Christmas present and birthday card would still be a taxable gift, and only the most miserly among us would not be required to file Form 709 every year.  To avoid the resulting absurdity, Congress wrote in something called the "annual exclusion."  It's presently $13,000 per recipient per year, and that number adjusts for inflation every so often.  Put simply, the first $13,000 in gifts you make to a person in any one year are "freebies," ignored for gift tax purposes.  If you have two children, you can give each of then $13,000 and not owe any gift taxes.  A married couple can combine their exclusions (something called "gift splitting") and give $26,000 per year to each recipient tax free--it's considered to come equally from both, no matter who wrote the check or made the transfer.

Now here's the tricky part: the annual exclusion only applies to a "present interest" gift; that is, something that the recipient can enjoy immediately.  A gift of a right to receive something in the future, or a gift in trust that won't be distributed immediately, is not a present interest, and doesn't get the benefit of the annual exclusion.

It's often not a good idea to make a substantial gift outright to a young person, or an adult with maturity or creditor problems.  You'd want to hold the property in trust so the beneficiary can't mishandle it--and, in the case of a minor, so you don't have to establish a guardianship to hold the property.  Section 2503(c) of the IRC sets out a specific exception for gifts in trust to a minor, but section 2503 trusts have to terminate when the beneficiary reaches age 21.  21 is the traditional age of majority, but not always a comfortable age to be distributing substantial wealth to someone.

So does that mean that if you want to make a gift in trust to, say, age 30 you can't use the annual exclusion?  No; there's a work-around called a "Crummey power," named after the United States Tax Court case which validated the tactic.  The trust will give the beneficiary a legal right to withdraw property as soon as it's added to the trust, but that right expires one month after the date the beneficiary (or, if a minor, her parent or guardian) is advised that a contribution has been made.  That's a present enough present interest to qualify the gift for the annual exclusion.  As you might expect, this is something we use a lot in my business.

Estate Planning for Guardians

The title of this post is also the topic of a CLE presentation I'm giving next Tuesday in Cleveland.  Adult guardianships are something I deal with pretty regularly, and the intersection between estate planning and guardianship law is an interesting subject (at least to me).

The law presumes that adults are competent. In a sense, "competency" is a synonym for "autonomy." A competent adult is free to use or dispose of his or her property in whatever manner he or she sees fit—subject to certain constraints which we won't go into right now.

A person is "incompetent" if, as the statute says, he or she is

...so mentally impaired as a result of a mental or physical illness or disability, or mental retardation, or as a result of chronic substance abuse, that the person is incapable of taking proper care of the person's self or property or fails to provide for the person's family or other persons for whom the person is charged by law to provide....

An incompetent person is legally unable to act for themselves.  Unless he or she has appointed an agent under a durable power of attorney or placed property in trust, it will be necessary to appoint a guardian to manage the individual's property.  Guardians have most of the same powers over property as their ward would have if competent, but everything the guardian does is subject to court approval in advance.

The guardianship statutes explicitly state that the guardian cannot make or change a will, and the courts interpret that to prohibit the guardian from making any kind of change to a trust or other estate planning arrangements. A guardian can obtain authority to make lifetime gifts, but only if the court finds that the ward would have wanted to make the gift if competent.

The Classic A-B Trust Estate Plan

In previous articles, I've discussed the basics of the federal estate tax, including the unified credit and the unlimited marital deduction. In this installment, I'm going to explain how a married couple can use the marital deduction and the unified credit in the most efficient manner.  Under the estate tax as it presently stands, a couple can transmit up to $10 million to the next generation without paying any federal estate tax, and deferring any estate tax at all to the second death.  This is accomplished by the use of an estate planning tactic known as an "A-B Trust."

The A-B Trust works like this: the couple divides their assets equally, and each of them creates a revocable trust to hold their share of the assets.  When one of them dies, the deceased person's trust splits into two components:

The first is traditionally called the "B Trust."  In my office, we call it the "Family Trust," and other draftsmen may call it the "Credit Shelter" or "Bypass" trust. A "formula clause" in the trust instrument allocates assets to the B/Family/Credit Shelter/Bypass Trust equal to the maximum amount that can be protected from the federal estate tax by the deceased spouse's unified credit.  This trust is taxable, but the tax is "paid" by the unified credit, so there's no tax due on this part.

Anything left over usually goes to what is traditionally called the "A Trust."  We call it the "Marital Trust" in my office; I've also seen it called the "Marital Deduction Trust."  The "A Trust" is designed to qualify for the marital deduction, so there is also no tax due on this part.  The "price" of the marital deduction is that any property left in the "A" trust will be part of the spouse's gross estate at the second death.

There are a couple of variations on this arrangement that you should be aware of:

• If, instead of a trust, we simply distribute the assets in the "A" component directly to the surviving spouse, the tax result is exactly the same: deduction and no tax at the first death, remaining property in the gross estate on the second death.

• If the surviving spouse is not a U.S. citizen, the "A" component will be a "qualified domestic trust."

Why do we do this?  There are two tax-planning reasons.

First, it ensures that we make use of the first spouse's unified credit on the first death.  Up until last December, the unified credit was not transferable between individuals, so if you didn't use up the first spouse's credit when he died, it was lost forever.  The 2010 tax act made unused credits "portable" between spouses, which would eliminate much of the tax reason for A-B trust arrangements--except that the 2010 tax act "sunsets" at the end of 2012, and, unless Congress amends the tax code and the President signs the amending bill into law, there will be no portability on January 1, 2013.  Until we know for sure that we'll still have portability after the ball drops on New Year's Eve 2012, I am not relying on it in the estate plans I am drafting for my clients.

The second tax effect is that whatever estate taxes are paid on the couple's assets, they aren't paid until the second death.  This gives the family the benefit of the time value of the money that would otherwise be paid in taxes on the first death.

Because the "A" trust has to qualify for the marital deduction, the surviving spouse is the only beneficiary while he or she is living, and the trust must pay out all of its income at least annually.  The "B" trust can be anything you want.  In most instances, the surviving spouse is a beneficiary, but the children or others can also be beneficiaries.  The spouse's interest in the "B" trust can be more restricted than that in the "A" trust, since it need not be qualified for the marital deduction.   In some situations ("blended" families in particular) the "B" component goes directly to the children or later generations on the first death, either outright or in trust.