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THE BASIC TAX STRUCTURE: (3)
THE GENERATION-SKIPPING TRANSFER TAX

by Christopher G. Stoneman

Strong men and women have been known to become weak at the knees at the mere mention of the federal GSTT, the newest transfer-tax kid on the block - dreaded as much for its complexity as for its costliness. In this article we will examine some of the more basic provisions of this enfant terrible.

The basic purpose of the GSTT is to ensure that transfers that "skip" over (or bypass) a generation along the north-south axis receive transfer-tax treatment which is approximately equal to that given to transfers which are made first to a member of the intermediate generation and then, by that person, on down to the next. As a Congressional committee put it, the object of the GSTT was to ensure that "transfers having a similar substantial effect will be subject to tax in a similar manner." It was in short a loophole-closing measure.

Formerly, a grandfather who established a trust for his son, say, for life and directed that at the son's death the trustee should distribute the trust to the son's son, would pay a gift tax when he set up the trust, but there would be no additional transfer tax upon the son's death. Similarly, if the grandfather had "skipped" over his son and had made the gift directly to his grandson, there would have been but the one tax, a gift tax, at least until the grandson's death, at which point there might be an estate tax. But if the grandfather had made an outright gift to his son, who in turn had left the property to his son, there would have been two taxes: a gift tax upon the grandfather's gift to the son, and a second gift tax or an estate tax when the son passed the gift on down the line.

Under the GSTT (adopted in its present form in 1986 - there was an earlier, 1976, version which the 1986 statute repealed), the son's death in the trust scenario is treated as a taxable generation-skipping transfer, as is the grandfather's direct gift to the grandson. Accordingly, a generation-skipping transfer tax is payable at the son's death, in the case of the trust example, and upon the grandfather's completion of the gift, in the case of the direct gift to the grandson. And this tax, it should be emphasized, is in addition to the gift tax imposed upon the grandfather (whichever scenario applies).


And now, alas, it is necessary to get technical in order to describe some of the key definitions around which the GSTT is structured.

To begin at the beginning, there can be no GST tax unless there is a "generation-skipping transfer". A generation-skipping transfer may be any one of three kinds:

  • a "taxable distribution"

  • a "taxable termination"

  • a "direct skip"

To take each of these in turn—

A taxable distribution occurs whenever there is a trust distribution, whether of income or of principal, from a trust to a "skip person" (most commonly, someone who is assigned to a generation which is two or more below the generation of the transferor - i.e., below the donor in the case of a living gift or the decedent in the case of a will).

Example - In his will Henry creates a trust for his daughter, Henrietta, who receives all of the income from the trust for life. After her death the trust continues until all of her children have died and then terminates and goes to her grandchildren outright. Since Henrietta's children are two generations removed from Henry, each pre-termination distribution from the trust to a child of Henrietta will be a taxable distribution, and the recipient will be subject to the GST tax on that distribution in addition to whatever income tax may also be applicable.

Example - Same facts as above except that if Henrietta has no children (which turns out to be the case), the trust continues instead for the benefit of Henry's other two children until they have both reached the age of 50, or died, at which time it is distributed to them or to the survivor of them. If neither of them lives to age 50 the trust goes to a charity at the survivor's death. There is no taxable distribution since none of Henrietta's siblings and the charity is a skip person.

A taxable termination occurs, under the general rule, whenever there is a termination of an interest in property held in a trust (caused typically by the death of the holder of a life interest) unless immediately after the termination a person who is not a "skip person" has an interest in that property or at no time after the termination may a distribution (including a distribution upon termination) be made from the trust to a skip person.

Example - Take the first taxable distribution example. Upon the death of the last to die of Henrietta's children, the trust by its terms terminates and all of the trust property is passed out to Henrietta's grandchildren. This is a taxable termination and there will be a GST tax on the property distributed, payable in this instance by the trustee of the trust.

Example - Suppose the same facts as in the immediately preceding case, except that at the death of the last of Henrietta's grandchildren to die the trust is to be distributed to one or more charities. While there will have been taxable distributions during the lives of Henrietta's grandchildren, because they are skip persons, there will be no taxable termination because the charities, which have remainder interests, are not skip persons (nor is there any possibility that a post-termination distribution might be made to a skip person

Example - Norman sets up a trust for the benefit of Susan, his wife, and their children for Susan's life and then at Susan's death to their descendants "per stirpes" (see Article VI). When Susan dies there are two surviving children of Norman and Susan and one grandchild, the child of a deceased child who died during Susan's lifetime. The two surviving children each receive one third of the trust, and this is not a taxable termination, since they are not skip persons vis a vis Norman, the transferor; the one-third interest which goes to the grandchild, however, is a taxable termination, since the grandchild is a skip person. See discussion below.

A direct skip occurs whenever there is a transfer to a skip person of an interest in property which is subject to a gift tax or an estate tax.

Example - Matthew makes a gift of $1,000 to each of his twin sister's grandchildren. Each of Matthew's gifts is "subject to" the gift tax (even if, as here, such tax may not actually result). Accordingly, it is a direct skip by Mathew. In the case of a direct skip, the GST tax is payable by the transferor, not the transferee.

Example - Arthur's son, Chester, dies, survived by two children. Thereafter, Arthur, a widower, gives them generous outright gifts during his lifetime and again in his will. He also leaves the residue of his estate in trust for them for life, and then to their offspring. Arthur's lifetime gifts as well as his outright gifts in his will are not generation-skipping transfers because his grandchildren are moved up one generation on account of their father's death.


Let us conclude with a look at three other features of the GSTT: the assignment of generations; the exemptions and various exclusions from the tax; and last but most assuredly not least, the computation of the tax.

Generation assignments. Where lineal descendants are concerned, the number of generations is determined by comparing the number of generations between the transferor's grandparent and the individual in question with the number of generations between the grandparent and the transferor.

Example - Marcia married at a very young age and has a child, a grandchild, a great-grandchild and a great great grandchild. Her grandchild makes a gift to her, Marcia's, great great grandchild. The number of generations involved is two (four [the number between the transferor's grandparent, Marcia, and her great great grandchild] minus two [the number between Marcia and the transferor]).

Adoptive relationships are treated as being blood relationships; and relationships by the half-blood are treated as being of the whole blood.

Individuals married or formerly married to the transferor are given the same generation as the transferor, regardless of how much of an age difference there may be. A similar rule applies to individuals married or formerly married to a lineal descendant of a transferor.

In the case of other individuals, a "generation" equals 12 1/2 years.

Example - John (53) has an ex-wife Jane (39) who has remarried. Jane's second husband, Michael, also previously married, has two children by his first marriage. Michael dies in a plane crash and for reasons best known to himself, John decides to make significant gifts to Jane as well as to Michael's two children, ages 27 and 20. Jane is treated as being of John's generation regardless of their ages and regardless of the fact that they are no longer married. However, the applicability of the GSTT to John's gifts to Michael's children is determined solely on the basis of age. The GSTT would therefore apply to Michael's children, who are John's juniors by 26 and 33 years respectively

There are important exceptions to the usual generation assignment rules. These involve situations where the individual who is one generation below the transferor has died, leaving a descendant who is two or more generations down the line. In the direct skip scenario, for example, this predeceased ancestor exception arises where a direct skip transfer is made to a grandchild of the transferor (or of the transferor's spouse or ex-spouse) and at the time of the transfer the parent of the grandchild who is a lineal descendant of the transferor (or of the transferor's spouse or ex-spouse) is dead. In that situation the grandchild moves up one generation (as though he or she was a child and not a grandchild of the transferor) and there is no generation-skipping transfer, because only one generation is involved, not two.

Exemption

Affording complete relief for most of us, there is a $1,000,000 exemption from the GSTT, which is available to offset both lifetime and so-called "deathtime" transfers. As in the case of the gift and estate tax unified credit (Article VIII), now $625,000, any part of the GSTT exemption which is not utilized during a donor's lifetime is available to his estate. In addition, in most instances the term "generation-skipping transfer" does not cover those transfers which the gift-tax statute excludes from the gift tax (amounts paid to a tax-exempt educational organization for a designated individual's education or to a provider of medical care for an individual's medical care) or which qualify for the annual $10,000 exclusion.

Computation of the tax

Computation of the generation-skipping transfer tax actually payable involves yet another safari into the definitional hinterland.

The tax is the product of (i) the "taxable amount" and (ii) the "applicable rate".

The taxable amount is different for each of the three types of generation-skipping transfer (see above).

  • in general, the taxable amount in the case of the taxable distribution is the value of whatever is distributed to the distributee plus any GSTT paid out of the distributing trust (rather than by the distributee, upon whom the statute places legal liability for the tax);

  • in general, the taxable amount in the case of the taxable termination is the value of the property with respect to which the taxable termination has occurred (the GSTT being imposed upon the trustee, not the distributee, there is no on tax on the GSTT paid by the trustee); and

  • in the case of the direct skip, the taxable amount is the amount paid to the skip person (who is liable for the tax)

The applicable rate is the product of the maximum federal estate tax rate (currently 55%) and the "inclusion ratio".

In general, the inclusion ratio is the excess, if any, of 1 over the "applicable fraction".

The applicable fraction in turn is defined as a fraction whose numerator is the amount, if any, of the transferor's $1,000,000 GSTT exemption allocated to the transfer and whose denominator is the value of the property transferred (with certain reductions which can sometimes apply).

Example - Acting without legal advice, David, a grandfather, gives his only grandson, Saul, stock valued at $1,300,000, on which a gift tax is payable by David out of other funds. $300,000 of David's exemption is allocated to the gift. Saul's father is alive at the time of the gift. Saul's GSTT bill is a whopping $537,000, determined as follows:

Applicable fraction = 300,000/1,300,000 =3/13
Inclusion ratio =(1-3)/13 =10/13
GST tax rate =10/13 x 55% =41.31%
GST tax =41.31% x $1,300,000 =$537,000

Christopher Stoneman

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