2001 Amendments to Generation-Skipping Transfer Tax Provisions Necessitates Trust Reviews

by Michael Kutzin Goldfarb Abrandt & Salzman LLP

While almost everyone is aware that there has been a purported “repeal” of the Federal Estate Tax effective in 2010 (but only for 2010 absent Congressional action), the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA” or the “2001 Act”) also made several significant changes to the generation-skipping transfer tax provisions. Like the Federal Estate Tax, the GST is also scheduled to be repealed for transfers to “skip persons” in the year 2010. Until that time, the GST rate will decline in tandem with the decline in the highest estate tax rate.

The exemption amount will also increase in tandem with the increase in the exemption for estate tax purposes, except that in 2002 and 2003, the GST exemption will be a $1 million exemption as adjusted for inflation, which for 2002 will be $1,100,000. (But note that the 2001 Act only expanded the gift tax exemption to $1,000,000 and the gift tax is not repealed in 2010).

GST exemption allocation.

For those who are unfamiliar with the arcane workings of the GST, the GST is imposed at the highest estate tax rate for transfers to “skip persons,” whether directly or from a trust, multiplied by an “inclusion ratio.” The “inclusion ratio,” in turn, is obtained by subtracting from one the “applicable fraction,” which is the amount of exemption allocated to to the trust, or for a “direct skip” to the property transferred, over the value of property transferred to the trust (less certain reductions for taxes paid or charitable deductions). Transfers with an inclusion ratio of zero are not taxed, so good GST planning involves making the optimal use of the GST exemption to create inclusion ratios of zero and one.

Under pre-EGTRRA, GST exemption was automatically allocated to direct skips to the extent necessary to make the “inclusion ratio” zero. If the transfer exceeded the amount of the taxpayer’s remaining GST exemption, the entire remaining exemption amount would be allocated to that transfer. The taxpayer could elect not to have the GST exemption allocated to the transfer. There was, however, no similar provision for a transfer for anything other than a direct skip.

EGTRRA attempts to remedy this problem by providing for a similar automatic allocation of GST exemption for “indirect skips” from a “GST Trust.”

As always, it is critical to understand the statutory definition of the terms provided in the Internal Revenue Code. “Indirect skip” means any transfer of property that is

  1. Not a direct skip;
  2. Subject to gift tax; and
  3. Made to a “GST Trust.”

IRC §2632(c)(3)(A).

A “GST Trust” is defined, in turn in IRC §2632(c)(3)(B) as any trust for which a taxable termination or taxable distribution can take place, except for the following exceptions:

  • The trust provides that more than 25% of principal must be distributed to or may be withdrawn by one or more non-skip persons
  • On or before the individual’s 46th birthday;
  • On or before one or more dates specified by the trust instrument that will occur before the individual’s 46th birthday; or
  • Upon the occurrence of an event that may be reasonably be expected to occur before the individual’s 46th birthday (in accordance with regulations to be promulgated)
  • The trust provides that more than 25% of the trust principal must be distributed to, or may be withdrawn by, one or more non-skip persons and who are living on the date of death of another person who is more than 10 years older than such individuals;
  • The trust provides that if one or more individuals who are non-skip persons die before the dates described in 1., above, or 2., above, then more than 25% of the trust principal will be distributed to such individual’s estate or be subject to a general power of appointment exercisable by such person.
  • Any portion of the trust that would be includible in the estate of a non-skip person (other than the transferor) if the non-skip person died immediately after the transfer.
  • A charitable lead annuity trust (“CLAT”), a charitable lead unitrust (“CLUT”), a charitable remainer annuity trust (“CRAT”) or a charitable remainder unitrust (“CRUT”).

Note that a Crummey power does not qualify to take a trust out of the “GST trust” definition. IRC §2632(c)(3)(B). Also, it is assumed that any powers of appointment exerciseable by a non-skip person will not be exercised.

In the event that a deemed allocation of GST exemption for an indirect skip is for property that would be includible in the person’s gross estate for Federal estate tax purposes (the so-called “estate tax inclusion period” or “ETIP”), the deemed allocation is treated as having occurred at the end of the ETIP rather than when the property is actually transferred to the trust. IRC §2632(c)(4). The value of property for determining the inclusion ratio is the value at the close of the ETIP. IRC §2642(b)(1)(B).

The automatic allocation of GST exemption for indirect skips applies to transfers subject to estate or gift tax that are made after December 31, 2000 and to ETIPs ending after December 31, 2000. Section 561(c)(1) of the 2001 Act.

In other words, transfers made in calendar year 2001 are subject to this automatic deemed election.

Election Out of Deemed Allocation. The allocation is automatic unless a timely filed election out of the deemed allocation is filed. IRC §2632(c)(5)(B)(i)(I) provides that election out is deemed timely if it is made

  1. On a timely filed gift tax return for the calendar year in which the transfer was made;
  2. On a timely filed gift tax return for calendar year in which there would be an automatic allocation for the close of an ETIP; or
  3. On any other dates prescribed by the IRS.

An election out of the deemed election can also be made to any or all transfers made by a particular individual to a particular trust. IRC §2632(c)(5)(A)(i)(II). The election is made on a timely filed gift tax return for the calendar year in which the election is to become effective. IRC §2632(c)(5)(B)(ii).

Similarly, an individual can also elect, on a timely filed gift tax return, to have a deemed allocation to any or all transfers made by an individual to a trust that is not a GST Trust by having such trust be deemed as a GST Trust. IRC §2632(c)(5)(A)(ii).

Relief from Mistakes and Errors Available. The 2001 Act gives the IRS power to extend the time to allocate GST exemption, elect out of automatic allocations, and to grant exceptions to time requirements. IRC §2642(g)(1). If the relief is granted, then the value of the transfer for purposes of GST exemption allocation and computing the inclusion ratio is determined on the date of the transfer to the trust.

In the absence of such relief being granted by the IRS, IRC §2642(b)(3) permits late allocations of inter vivos transfers based on valuation at the time the allocation is made with IRS. This is sometimes useful from a planning standpoint (such as for contributions to a trust holding only term insurance), but is generally not the preferred course of action for property that, the donor would hope, will rise in value.

The standard that the IRS must use in order to determine whether to grant an extension and or to make an exception to the deadlines is the same as for a “regulatory election” for purposes of IRC §9100 and the underlying regulations. IRC §2642(g)(1)(B). The IRS is required to promulgate regulations detailing circumstances and procedures, including procedures for requesting comparable relief for transfers made before the enactment of the 2001 Act.

Aside from relief for failure to make allocations and elections, the 2001 Act also requires the IRS to overlook mistakes made in the mechanics of allocating GST exemption. A GST exemption allocation that demonstrates an intention to have lowest proper inclusion ratio is deemed to be, under the new substantial compliance rules, an allocation of so much of unused GST exemption as to produce lowest possible inclusion ratio. IRC §2642(g)(2). The IRS is required to take into account all relevant circumstances, including evidence of intention contained in trust instrument or transfer document. Thus, an inartfully drafted allocation cannot be used against the transferor if the evidence suggests that he or she intended to create the lowest possible inclusion ratio (and therefore the lowest ultimate tax) – the IRS must, by statute, read the allocation and the surrounding facts in the manner that would produce the lowest inclusion ratio.

Severance of trusts at any time.

The 2001 Act provides that a trust can be severed at any time to permit split-up into two trusts – one with a zero inclusion ratio and one with an inclusion ratio of one. In order to do this, the split-up must be be a “qualified severance” under IRC §2642(a)(3).

A split-up is a “qualified severance” if

  1. A single trust is divided, under provisions of the governing instrument or under state law) on a fractional basis; and
  2. The terms in both new trusts provide for same succession of interests of beneficiaries that were provided in original trust.

IRC §2642(a)(3)(B)(i).

If the trust’s inclusion ratio is greater than zero and less than one (i.e., the trust has been funded and the property transferred exceeds GST exemption), the trust must be divided into two trusts in the following manner:

  1. One trust must receive a fractional share of trust assets that equals the applicable fraction immediately before the severance (i.e., trust property to which exemption allocated over total property transferred to trust); and
  2. The trust receiving the fractional share based on the applicable fraction is assigned an inclusion ratio of zero (i.e., no GST paid from the trust) and the other has an inclusion ratio of one.

The procedure in New York for dividing trusts to obtain trust with inclusion ratio of zero is found in EPTL 7-1.13.

Retroactive allocation of GST exemption.

The Code was also amended to give a taxpayer the opportunity to rectify the lack of GST exemption allocation where an unexpected death of a non-skip person (i.e., the death of a child) occurred.

This opportunity to make retroactive GST exemption allocations should not be confused with a so-called “generational step-up” that had previously existed (and still exists) where the non-skip person had died before the transfer was made (IRC §2651(e)(1)) – in such a case, there is no need to allocate GST exemption because the grandchild, for example, would not be a skip person. This new provision (IRC §2632(d)(1)) allows a transferor to allocate GST exemption to one or more transfers to which no allocation was made previously – ostensibly because the transferor thought that the other person would receive the property and thus no GST would be incurred.

In order to take advantage of a retroactive allocation, the person who died who had an interest or future interest in trust must have been a lineal descendant of the grandparent of the transferor, transferor’s spouse or the transferor’s former spouse, and must be assigned to a generation below the transferor’s assigned generation.

If a retroactive allocation is made, exemption is deemed allocated to previous transfers to the trust on chronological basis.

If the retroactive allocation is made by a gift tax return filed on or before the date for filing a gift tax return for the calendar year in which the non-skip person died, the value of the transfer for the purpose of the GST exemption allocation is as of the date of the original transfer. IRC §2632(d)(2).


The GST is complex, arcane, and can result in the substantial diminution of an estate. Trusts that provide for grandchildren or other persons who may be considered to be two generations below that of the donor should be reviewed by an estate planning attorney to determine whether GST exemption will, or should be, allocated to transfers to the trust. The 2001 Act made a number of substantial changes to the GST provisions of the Internal Revenue Code, and proper planning can avert inadvertent, and sometimes disasterous, tax consequences.

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