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Since it became effective in 1985, the generation-skipping transfer (GST) tax has been a source of complexity, confusion and liability. Under current law, when the GST tax applies, it does so at a whopping 40% rate.
But despite the potentially dire consequences of incurring GST tax, it doesn’t get a lot of press. Perhaps this is because the estate and GST tax exemptions are now high enough—at $12.92 million per individual for 2023—that few individuals have to engage in estate tax planning for themselves, let alone for further generations.
But the exemptions weren’t always so high. In fact, when it was first enacted, the GST tax exemption was only $1 million. This means that many trusts established at that time weren’t exempt from GST tax.
And as we’ll see, GST tax is unlike estate and gift tax in one particularly relevant way. Estate and gift tax are due immediately on the transfer and are subject to a specific statute of limitations with respect to certain transactions disclosed to the Internal Revenue Service. But in the case of certain transfers to trusts, the GST tax lies in wait for certain future events to occur. And only then is GST tax due.
Perhaps the GST tax isn’t regularly imposed because the trusts that were established as part of this regime haven’t matured. As the years pass—and, as we’ll see below, as beneficiaries pass away—GST tax will apply to a non-exempt trust. This is the “ticking time bomb” of GST tax. The question, then, is when we might expect this timer to run out—and when this “bomb” might go off.
In the case of a trust, the time that GST tax is due depends on the age of the GST tax regime, the trusts and the beneficiaries. The GST tax applies to transfers to grandchildren and further descendants and to other “skip persons.” Skip persons include certain relatives who are two or more generations below the transferor. But for non-relatives, a skip person is someone who’s at least 37½ years younger than the transferor.
Interestingly, in 2023, the GST tax itself is turning 37½ years old. The GST tax itself is old enough that in terms of generation assignment, it could be treated like a grandparent.
As the GST tax is getting up there in years, GST trusts are slowly entering a new phase. We now expect the GST tax to apply to more and more trusts and events in a trust’s administration.
And in 2023, when the GST tax turns 37½, this symbolic anniversary is an opportunity to take stock of its status.
The GST Tax
Here’s a brief summary of the key elements of the GST tax.
Congress enacted the GST tax as part of the Tax Reform Act of 1986. The provisions are found in Chapter 13 of the Internal Revenue Code.1 The tax applies to lifetime transfers occurring after Sept. 25, 1985 and to testamentary transfers by individuals dying after Oct. 22, 1986.
Transfers that occurred before those dates are often said to be “grandfathered” from the GST tax, although the Treasury regulations themselves don’t use that term. This article will use the term
“pre-effective date” trusts, which is a more precise label for that category of trusts.
For those trusts established after the enactment of the current law, the GST tax applies when a transfer benefits individuals who are two or more generations below the transferor. We typically refer to the donor as “Generation 1” (Gen 1), the donor’s child as in “Generation 2” (Gen 2) and the donor’s grandchild as in “Generation 3” (Gen 3). Gen 3 and lower are skip persons for purposes of GST tax. Those in Gen 2 and higher are “non-skip persons.”
If Gen 1 makes a gift to Gen 3, then the gift might be subject to gift tax or estate tax, depending on whether the gift is made during life or on death. But independent of that analysis, the transfer might also be subject to GST tax.
If the transfer is made outright or to a trust in which the only beneficiaries are skip persons, then the transfer is a “direct skip,” and GST tax might be due at the time of the transfer.
But if the transfer is made to a trust that includes non-skip persons as beneficiaries, then the transfer is typically classified as an “indirect skip.” The transfer itself doesn’t trigger GST tax. Rather, to the extent the trust isn’t exempt from GST tax, then GST tax applies to certain distributions from the trust.
In the case of a trust that’s not fully exempt from GST tax, transfers to beneficiaries who are skip persons are “taxable distributions.” In the case of a taxable distribution, the transferee must pay the GST tax, typically by April 15 of the year after the transfer is made. The trustee files a Form 706-GS(D-1) to report that transfer and provides a copy to the beneficiary.
And perhaps more importantly, if the interests of all non-skip persons terminate, and only skip persons are left as beneficiaries, there’s a “taxable termination.” In that case, the entire trust is subject to GST tax, and the trustee files a Form 706-GS(T) and pays the GST tax.2 Then the transferor is deemed to “move down” one or more generations for purposes of generation assignment, such that a new generation is now considered non-skip persons.3 And then on the death of the last member of that generation, another level of GST tax will result.
But a transferor can apply GST tax exemption to a trust and make the trust exempt from GST tax altogether. The transferor has the same starting amount of GST tax exemption as the transferor does for estate and gift tax purposes—$12.92 million in 2023.
GST tax exemption can be a valuable tool to avoid transfer tax for a trust for future generations. A trust that waives the rule against perpetuities (RAP) under applicable law and that’s made fully exempt from GST tax can exist in perpetuity, making distributions to beneficiaries without any gift, estate or GST tax.
Meanwhile, for those multi-generational trusts that aren’t exempt from GST tax, unless certain steps are made to essentially avoid skipping a generation, there comes a time when GST tax will be due.
The question that we pose here is this: When do we expect to see more events triggering GST tax with respect to those trusts?
We have to admit that the title of this article— that the GST tax might be old enough to have grandchildren—is a bit contrived. The GST tax implications of a trust are determined on a case-by-case basis. And the age of the trust also doesn’t directly trigger GST tax. As younger generations of beneficiaries are born into a trust, that, too, doesn’t trigger GST tax. So the fact that the GST tax is turning 37½, by itself, doesn’t trigger GST tax.
As these trusts age, any trust that’s subject to the RAP comes closer to termination. But the running of that perpetuities period is still a long way off. Consider a trust established in 1985, when the GST tax was first effective. If a perpetuities period applies to that trust, then that period is based on the lifetimes of individuals alive when the trust was established. A newborn in 1985 would now be at least 37. They’re hopefully decades from passing away, and even then, the perpetuities period would typically last another 21 years after that individual’s death. And even on termination of the trust, GST tax would only be due if distributions are made to skip persons as part of the termination.
But something else is happening to existing GST non-exempt trusts. The members of Gen 2 of those trusts—the last non-skip persons of the trusts—are also aging. Consider a trust set up in 1985, when a member of Gen 2 was 30. That individual is now at least 67. As the last member of Gen 2 passes away, a taxable termination will result. And consider Gen 3.
If those individuals were newborns in 1985, then they’re now at least 37, well into their adult years, when they might receive distributions from the trust.
As distributions are made to Gen 3, then this results in a taxable distribution, and GST tax is due to be paid by those recipients.
But perhaps more importantly, the death of the last non-skip person who’s a beneficiary—such as the death of the last member of Gen 2—causes a taxable termination, triggering GST tax.
This result would come as a surprise if the parties didn’t realize that the trust wasn’t exempt from GST tax. And this result might seem particularly unfair if the members of Gen 2 had sufficient estate tax exemption to shelter the trust assets. That is, if the trust assets were instead included in the estate of Gen 2 for GST tax purposes, no GST tax would be due. Gen 2 could shelter some or all of those assets from estate tax with their estate tax exemption, and the assets would receive a step-up in basis for income tax purposes.
Therefore, the aging of those generations is precisely the time that we should be concerned about GST tax—and when we should be taking steps to temper, minimize or avoid it. It’s critical for the trustee of an irrevocable trust to take this time to identify the GST tax characteristics of the trust, to properly report this information to the beneficiaries and to identify and take appropriate steps to avoid, minimize or temper the GST tax implications.
Reporting
Methods of allocating GST tax exemption. Information about the GST status of a trust should be available on two particular forms: the allocation of GST tax exemption to transfers during life is reflected on a gift tax return, Form 709, and the allocation of GST tax exemption to transfers on death is shown on an estate tax return, Form 706, Schedule R. This symbolic anniversary of the GST tax is a good time for trustees to gather that information, especially because it might take a long time to get copies from prior advisors, the IRS or the client’s files.
But those returns don’t tell the whole story. GST tax exemption can also be automatically allocated, based on default rules applicable to the kind of transfer. And these rules apply whether or not that automatic allocation is reflected on the return and the return was filed.
For transfers on death, unless the decedent opts out of those automatic rules on the timely filed estate tax return, a decedent’s unused GST tax exemption will be automatically allocated based on an order of priority.4
For transfers during life, unless the donor opts out of those rules on a timely filed gift tax return, GST tax exemption is automatically allocated to a transfer to a trust defined as a “GST trust” that occurs on or after Jan. 1, 2001.5
These automatic allocation rules make sense; if a trust has certain potential to skip generations, then the law would presume that the transferor intended to allocate GST tax exemption to the transfer. The challenge is that this definition of “GST trust” is very rule-based, and it can be overbroad in application. In many cases, the donor wouldn’t intend for the trust to benefit further generations—such as if the transfer was to a trust for the primary benefit of a surviving spouse or children, with only secondary intent of benefiting further generations. But unless the transferor opts out of those default rules, then GST tax exemption is applied.
Methods to confirm allocation. Once the trustee reviews the available documentation, the trustee might find that in some cases, the donor’s intent was to make the trust exempt from GST tax, but the Form 709 or Form 706 doesn’t reflect the allocation of GST tax exemption. In that case, there’s an opportunity to clean up the reporting to reduce or avoid doubt in the future.
One option is to revise the gift tax return or estate tax return. But if the limitations period has run, or if the taxpayer worries about re-starting the limitations period for other items disclosed on the return, this might not be a practical option.
If the transferor is alive, a second option is to attach a “Notice of Automatic Allocation” to a future gift tax return. This at least brings the reporting of the lifetime gifts to the attention of the IRS.
As a third option, if the parties are taking the position that the trust is exempt from GST tax, some practitioners advocate deliberately making a distribution to a skip person and filing a
Form 706-GS(D-1), which reflects that no tax is due. This puts the IRS on a kind of notice of the trustee’s view of the GST tax-exempt status of the trust. There doesn’t appear to be any statutory basis that would start a limitations period against the IRS in that case. But the regular filing of these forms might strengthen the taxpayer’s position that the trust is GST tax exempt—or at the very least, might weaken the IRS’ position if it challenges the tax exemption later.
A fourth option is to seek a private letter ruling to confirm the automatic allocation of GST tax exemption. This might seem like a drastic step, but it might be warranted if there are significant assets in the trust.
Methods to adjust allocation. A more complex issue arises when the GST tax exemption was automatically applied, or not applied at all, and the taxpayer wishes to go back and modify that allocation based on the transferor’s intent.
In such case, there’s no easy or simple solution. Once the period for the estate tax return or gift tax return has passed, the taxpayer isn’t able to reallocate the GST tax exemption on the return.
If the trust isn’t fully exempt from GST tax, then if the taxpayer is still alive, or if the issue is identified at death, the taxpayer could allocate additional GST tax exemption based on complicated rules and valuations.6 One challenge with this approach is that the late allocation is based on the value in the trust at the time the allocation is made.
A second option, which is more complicated, would apply if the trust is partially exempt from GST tax. In that case, the trustee might pursue a qualified severance on death7 or during life.8
The most complicated option is to seek a PLR from the IRS, which is authorized under Treasury Regulations Section 301.9100-3.
Over the past few years, the IRS has regularly issued PLRs allowing a transferor to go back in time to allocate GST tax exemption, such as when a return didn’t affirmatively allocate GST tax exemption9 or when the return wasn’t filed on time.10 This can arise in various scenarios. Two recent interesting PLRs addressed the allocation of GST tax exemption to charitable trusts, which aren’t considered “GST trusts.”11 PLRs have also addressed automatic allocation of GST tax exemption to a grantor retained annuity trust at the termination of the estate tax inclusion period.12
Steps to Mitigate GST Tax
The above discussion emphasizes the importance of understanding the GST tax status of a trust. And if the trust isn’t fully exempt from GST tax, and there aren’t options to re-allocate the GST tax exemption, then there could be options to reduce the impending tax liability before the taxable distribution or taxable termination.
One case highlights the potential cost of the GST tax—and potential liability for fiduciaries. In Hobbs v. Legg Mason, various trusts—some exempt from GST tax and others not—were established on the death of a settlor and his spouse.13 Distributions were subsequently made to the plaintiffs, who were skip persons. After a few years of those distributions, the trustee informed the beneficiaries that the prior distributions had triggered GST tax and that the beneficiaries were liable for that GST tax and interest. The plaintiffs brought a claim against the trustee. The trial court found that the trustee had no duty to modify the trust to avoid the GST tax liability, and so the trial court dismissed that claim. But the trial court found that the trustee might have breached its duty by failing to notify the beneficiaries of the GST tax liability, and the trial court allowed that claim to proceed.
There are various options available to try to manage or mitigate any impending GST tax liability. If there are some trusts that are exempt and some that aren’t, the parties could try to use assets from the non-exempt trust to benefit non-skip persons, while they also move assets that might appreciate significantly into the exempt trust. And if need be, the trusts could be modified to re-allocate distributions to skip persons to be only from the GST tax-exempt trusts.
The trust could simply be terminated and distributed to non-skip persons. As an alternative, the trust could be modified to grant a beneficiary a general power of appointment (GPOA), which keeps the trust in place but brings the assets into the beneficiary’s estate for estate tax purposes.
The pitfall of these approaches to terminate or modify the trust is that these steps, even if authorized by the trust instrument and applicable law, can’t easily be undone. This might have a negative effect if circumstances change and if the termination or modification doesn’t result in the estate tax savings and other benefits that were anticipated.
As an alternative, a beneficiary could be granted a GPOA over only a fraction of the trust assets, to the extent of the beneficiary’s remaining estate tax exemption. This was the approach the parties took in PLR 202206008 (Feb. 11, 2022). Another option to preserve flexibility is to modify the trust to give a third party, such as a trust protector, the power to grant beneficiaries a GPOA for GST tax purposes.
GST Tax Trap
As this discussion demonstrates, it’s critical that the parties keep the GST tax status of a trust in mind. This doesn’t just apply to potential terminations in the future, but also to other steps in the administration of the trust. In fact, there’s an irony in the current law. There are now numerous options available to modify a trust—through a judicial modification, nonjudicial settlement agreement and decanting. But this flexibility might come at a price—or might set a GST tax trap. Parties might be tempted to make use of the various methods to modify a trust—and might inadvertently cause a trust to lose its GST tax-exempt status.
In administering a trust that was established pre-effective date or which has been made exempt from GST tax, parties should always be mindful of the GST tax regulations, which provide various actions that would cause a trust to lose its GST tax-exempt status and provide “safe harbors” that allow modification while preserving the GST tax-exempt status of a trust.14
As this discussion has shown, the fact that the GST tax will soon reach age 37½ is a kind of contrived benchmark—even more so than any other half-birthday. But like any birthday or anniversary, this is a great time to take stock. And as this discussion has also shown, the GST tax will increasingly apply to trusts as they enter this new era, with non-skip persons passing away and with skip persons becoming eligible for distributions. But with the right planning, practitioners and donors can ensure that the trusts are administered in an efficient manner—for generations to come.
Endnotes
1. Internal Revenue Code Sections 2601 to 2664.
2. IRC Section 2612(a).
3. IRC Section 2653.
4. IRC Section 2632(e).
5. See Section 2632(c)(3)(A).
6. Treasury Regulations Section 26.2632-1(b)(4).
7. IRC Section 2654, Treas. Regs. Section 26.2654-1(b).
8. IRC Section 2642(a)(3), Treas. Regs. Section 26.2642-6.
9. Private Letter Ruling 202116006 (April 23, 2021).
10. PLR 202117001 (April 30, 2021).
11. Section 2632(c)(3)(B)(v); PLR 202233002 (Aug. 19, 2022); PLR 202133006 (Aug. 20, 2021).
12. Section 2642(f); PLR 202117002 (April 30, 2021); PLR 202117003 (April 30, 2021); PLR 202133008 (Aug. 20, 2021); PLR 202133007 (Aug. 20, 2021).
13. Hobbs v. Legg Mason Inv. Counsel & Trust Co., No. 3:09-CV-9-SA-DAS, 2011 WL 39044 (N.D. Miss. Jan. 5, 2011), order clarified on reconsideration, No. 3:09-CV-9-SA-DAS, 2011 WL 304421 (N.D. Miss. Jan. 25, 2011).
14. See generally Treas. Regs. Section 26.2601-1, Treas. Regs. Section 26.2601-1(b)(4). Although those regulations expressly apply to generation-skipping transfer (GST) pre-effective date trusts, many parties rely on these same rules for purposes of post-1985 trusts that are exempt from GST tax.