The generation-skipping transfer (GST) tax regime is complex and intricate, and entire books have been written to explain the workings of the tax itself and recommended planning strategies to take advantage of the GST exemption ($12.06 million under current law, the same amount as the estate/gift tax exemption). The modest aim of this short article is to cover the basic principles of reporting (and when not to report) a few common types of lifetime gifts that are or may be subject to the GST tax on Form 709, and to briefly describe the estate/gift tax and GST tax consequences of those gifts. It is intended for practitioners who are generally familiar with the estate and gift tax rules but are unfamiliar with the GST tax and the relationship between the exemptions and exclusions available against the estate/gift tax and those available against the GST tax.
Section One of this article covers direct skip gifts; Section Two covers indirect skips and other transfers in trust. In all of the examples discussed in both sections, it is assumed that the donor has made no gifts in the same calendar year apart from the gift described, has sufficient exemption available to shelter the reported transfer from both gift and GST tax, and is not splitting gifts with a spouse.
Section One – Direct Skips
Direct skip gifts are reported on Part 2 of Schedule A of Form 709. A direct skip is a transfer of property that is: (1) subject to the gift tax; and (2) made to a skip person. A skip person is an individual deemed to be two or more generations younger than the donor, or a trust in which all of the interests are held by skip persons. (Correspondingly, a non-skip person is any done that is not a skip person.)
If the donee is a descendant of a grandparent of the donor, the donee’s generation is determined by comparing the number of generations between the grandparent and the donor and the number of generations between the grandparent and the donee. Thus, a donor’s sibling is in the same generation as the donor, a donor’s child, niece, or nephew is one generation younger than the donor, and a donor’s grandchild, grandniece, or grandnephew is two generations younger than the donor.
An important exception to the generation assignment rules for relatives is the “predeceased parent” exception. If a lineal descendant of the donor is deceased at the time of the transfer, the deceased descendant’s children (and more remote descendants) move up one generation closer to the donor. For example, if the donor’s child is deceased, that child’s children (the donor’s grandchildren) move up to the level of the donor’s child and thus are not skip persons.
One common direct skip is an outright gift to a grandchild. Outright gifts to skip persons qualify for the GST tax annual exclusion under Internal Revenue Code Section 2642(c) as well as for the gift tax annual exclusion. (The amount of both exclusions under current law is $16,000.) So if a donor gives $100,000 to her grandchild, the first $16,000 qualifies for the GST tax (and gift tax) annual exclusion; the remaining $84,000 is a direct skip which uses that amount of the donor’s available GST exemption (and the same amount of estate/gift tax exemption).
Gifts to trusts benefiting one or more grandchildren (but no other beneficiaries) are also common direct skips. Such gifts qualify for the GST annual exclusion only if:
They otherwise qualify for the gift tax annual exclusion as present interest gifts (e.g., because the grandchild has a withdrawal right, or because the trust is an Internal Revenue Code Section 2503(c) trust for the benefit of a minor which either passes to the minor when he attains age 21 or over which the minor has a withdrawal right at age 21);
The trust has only one beneficiary; and
The trust is includible in the beneficiary’s estate if he dies before receiving all of the trust outright.
Section Two – Indirect Skips and Other Transfers in Trust
Part 3 of Schedule A is used to report gifts to trusts that are not direct skips (because some of the trust beneficiaries are non-skip persons) but from which a GST transfer may occur in the future (for example, when a distribution from that trust is subsequently made to a skip person). While direct skip gifts are relatively straightforward in terms of their reporting requirements and tax consequences, “indirect skips and other transfers in trust” reportable on Part 3 are less so.
An indirect skip is defined in Internal Revenue Code Section 2632(c) as a transfer (other than a direct skip) to a GST trust. A GST trust is defined in the same Code section as a trust from which a generation-skipping transfer could occur in the future (for example, a pot trust allowing current distributions to the donor’s children and grandchildren), subject to six exemptions.
A donor’s GST exemption is automatically allocated to indirect skips unless the donor opts out of automatic allocation on a timely filed Form 709. Automatic allocation does not apply to gifts in trust that are not indirect skips, but a donor may choose to allocate exemption to such gifts by filing Form 709, even if such gifts are not otherwise required to be reported because they are covered by the annual exclusion.
The examples below illustrate the tax consequences of a few types of gifts reportable on Part 3 of Schedule A.
Example 1. A donor gives $10,000 to a trust benefiting his daughter. Distributions may be made to or for the benefit of the daughter until she attains age 35, at which point the remaining trust assets pass outright to her. If the daughter dies before reaching age 35, the remaining assets are distributed to her then-living descendants, per stirpes. The daughter has a withdrawal right that qualifies contributions to the trust for the gift tax annual exclusion.
This gift is not required to be reported on Form 709 since it is less than the annual exclusion amount. Although a generation-skipping transfer from this trust could occur if the daughter dies before reaching age 35 and trust assets pass to her descendants, this is not a GST trust because it meets one of the exceptions listed in Code Section 2632(c). Accordingly, the donor’s GST exemption is not automatically allocated to this gift. If the donor does not affirmatively allocate exemption on a timely filed Form 709, GST tax will be imposed on any future transfers from the trust to the daughter’s descendants. Given the actuarial unlikelihood of an individual dying before age 35 (assuming the individual is not in poor health), this may be a risk worth taking. However, if the donor is unlikely to make other use of his GST exemption, it may be prudent to file Form 709 to allocate GST exemption to the transfer.
This gift uses none of the donor’s estate/gift tax exemption since it is less than the annual exclusion amount. If the donor wishes to ensure that future distributions from the trust are not subject to GST tax, he will need to file Form 709 and allocate $10,000 of GST exemption to the gift.
Example 2. The facts are the same as in Example 1, except that the amount of the gift is $100,000.
Form 709 is required in this case since the gift amount exceeds the annual exclusion. The donor may choose to allocate GST exemption to the gift, considering the same factors noted above.
This gift uses $84,000 of the donor’s estate/gift tax exemption. If the donor wishes to ensure that future distributions from the trust are not subject to GST tax, he will need to file Form 709 and allocate $100,000 of GST exemption to the gift.
Example 3. The facts are the same as in Example 1, except that the trust does not provide for distribution of all trust assets to the daughter when she reaches age 35. Instead, the trust lasts for her lifetime, with the remaining trust assets passing to her descendants at her death.
No Form 709 is required in this case since the amount of the gift is less than the annual exclusion. However, this trust is a GST trust under Code Section 2632(c), making this gift an indirect skip to which the donor’s GST exemption is automatically allocated. The donor may choose to file Form 709 to opt out of automatic allocation (perhaps because he believes that all trust assets will likely be distributed to or for the benefit of the daughter during her lifetime, leaving nothing to pass to her descendants at her death) or simply to document the amount of GST exemption used.
This gift uses none of the donor’s estate/gift tax exemption since it is less than the annual exclusion amount. Unless the donor opts out of automatic allocation on a timely filed Form 709, $10,000 of his GST exemption will be automatically allocated to the gift.
Example 4. The facts are the same as in Example 3, except that the amount of the gift is $100,000.
Form 709 is required in this case, and GST exemption is automatically allocated unless the donor chooses to opt out of automatic allocation.
This gift uses $84,000 of the donor’s estate/gift tax exemption. Unless the donor opts out of automatic allocation on a timely filed Form 709, $100,000 of his GST exemption will be automatically allocated to the gift.