GENERATION SKIPPING TRANSFER TAX PLANNING First Run Broadcast: September 5, 2013 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) The Generation Skipping Transfer Tax (GSTT) imposes a tax on property transfers among generations of a family and is intended to prevent tax reduction when a senior generation skips transfers to their children in favor of grandchildren. The tax is one of the most complex elements of estate planning, involving skip and “non-skip” persons, generation assignments, identifying which events are taxable and which are not. Planning has been further complicated with the recent revision of the federal estate and gift tax regime, including expiration of the GSTT safe harbor. Still, there are sophisticated planning techniques using dynasty and “HEET” trusts to reduce the incidence of the tax. This program will provide you with a framework for understanding and planning with the GSTT, including use of dynasty and HEET trusts, and compliance trips and traps.

• Framework of the GST – skip v. non-skip persons, taxable events, generation assignments, inclusion ratios

• Exemption planning for maximum tax and financial benefit • Sophisticated planning techniques using dynasty trusts and HEET trusts • Relationship of GST regime to new estate and gift tax law • Pitfalls of reporting on Form 709

Speakers: Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, where she works with clients and their advisors to help develop estate, gift, tax, and wealth transfer planning strategies. Earlier in her career she was a vice president in the estate planning department of U.S. Trust Company. She also practiced law with Weil, Gotshal & Manges in New York City. Ms. Christerson is the author of the monthly newsletter “Tax Topics." She received her B.A. from Sarah Lawrence College, her J.D. from New York Law School and her LL.M. in taxation from New York University School of Law.

Daniel L. Daniels is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP, where his practice focuses on representing business owners, corporate executives and other wealthy individuals and their families. A Fellow of the American College of Trust and Estate Counsel, he is listed in “The Best Lawyers in America,” and has been named by “Worth” magazine as one of the Top 100 Lawyers in the United States representing affluent individuals. Mr. Daniels is co-author of a monthly column in “Trusts and Estates” magazine. Mr. Daniels received his A.B., summa cum laude, from Dartmouth College and received his J.D., with honors, from Harvard Law School.

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Generation Skipping Transfer Tax Planning

Teleseminar September 5, 2013

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: September 5, 2013 Seminar Title: Generation Skipping Transfer Tax Planning Location: Teleseminar Credits: 1.0 General MCLE Credit Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

PROFESSIONAL EDUCATION BROADCAST NETWORK

Speaker Contact Information

GENERATION SKIPPING TRANSFER TAX PLANNING

Blanche Lark ChristersonDeutsche Asset & Wealth Management - New York City(o) (212) 454-1039blanche.christerson@db.com

Daniel L. DanielsWiggin & Dana, LLP - Greenwich, Connecticut(o) 203-363-7665ddaniels@wiggin.com

Generation Skipping Transfer Tax Planning

Blanche Lark ChristersonManaging Director, Deutsche Asset & Wealth Management

blanche.christerson@db.com(212) 454-1039

© 2013 Blanche Lark Christerson. All rights reserved.

Christerson

1

Generation Skipping Transfer Tax PlanningBlanche Lark Christerson

Deutsche Asset & Wealth Management

I. What is a transfer tax? A transfer tax is a tax on the privilege of transferring property to others.

There are three such taxes: the estate tax applies to transfers taking effect at death, the gift tax

applies to lifetime transfers, and the generation-skipping transfer tax (GST) applies to so-called

“generation-skipping transfers” (these typically involve transfers from grandparents to

grandchildren – either outright or in trust – when the grandparent is alive or at the grandparent’s

death). The federal estate tax was enacted in 1916. The gift tax was enacted in 1924, repealed

in 1926, and reinstated in 1932; it serves as a backstop to the estate tax and income tax. The

GST was first enacted in 1976, and was such a mess that it was retroactively repealed in 1986,

and replaced with a new regime. It is designed to ensure that transfer tax is collected every time

property passes from one generation to the next, so that wealthy donors cannot simply pay, say,

one estate tax, and leave property to a trust that benefits multiple generations for as long as the

“rule against perpetuities” permits (generally about 100 years – i.e., during the lives of the trust

beneficiaries who were “in being” when the trust was created, plus 21 years).

II. Background on the now “permanent” transfer tax landscape.

A. “The fiscal cliff.” The “fiscal cliff” is the dramatic term the media coined to describe the

convergence of circumstances set to occur at the end of 2012 unless Congress took action:

the 2001 and 2003 tax cuts would expire, and mandatory spending cuts known as

“sequestration” would commence. Congress did act, and forestalled the tax portion of the

cliff with the American Taxpayer Relief Act of 2012 (ATRA) (Pub. L. 112-240), enacted on

January 2, 2013. Thus, there was no across-the-board tax increase and transfer taxes did

not revert to what could be called confiscatory levels ($1 million exclusions and a top rate of

55%). Sequestration was deferred for several months, but has now taken effect.

B. The 2010 Act. But for the Tax Relief, Unemployment Insurance Reauthorization, and Job

Creation Act of 2010 (the “2010 Act”) (Pub. L. 111-312), enacted on December 17, 2010, the

fiscal cliff would have occurred at the end of 2010. Yet the 2010 Act postponed that event for

two years, and reinstated the estate tax and GST, retroactive to January 1, 2010. (The two

taxes had been repealed in 2010 (but only for that year).) For 2010, the estate tax exclusion

and the GST exemption were both increased to $5 million, the top estate tax rate was

reduced to 35%, and the GST rate – for 2010 only – was reduced to 0%; executors of 2010

decedents could opt out of the estate tax in favor of a “modified carryover basis” regime,

whereby heirs effectively inherited a decedent’s built-in capital gains. As of 2011, the

exclusion amount was $5 million, indexed for inflation, and “portable” spousal exclusions (see

below) were now permitted. Nevertheless, these provisions were set to expire at the end of

2012, along with the rest of the 2001 and 2003 tax cuts that the 2010 Act had temporarily

extended.

C. ATRA, briefly. ATRA came to the rescue at the beginning of 2013, and made the 2001 and

2003 tax cuts permanent for most taxpayers, while raising taxes on the top 1% to 2% of

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taxpayers. As to transfer taxes, ATRA increased the top rate from 35% to 40%, and made

permanent the $5 million exclusion amount and portability.

1. The $5 million exclusion amount. The “applicable exclusion amount” (AEA) consists of

the $5 million “basic exclusion amount” (BEA), indexed for inflation as of 2012, plus, in

the case of surviving spouses, the “deceased spousal unused exclusion amount”

(DSUE). IRC Sec. 2010(c). (For individuals who have no DSUE, their basic exclusion

amount is the same as their applicable exclusion amount.) The applicable exclusion

amount protects taxable transfers from gift and estate tax, and the GST exemption, which

equals the basic exclusion amount, protects transfers to people such as grandchildren

(either outright or in trust) from GST. In 2012, inflation-indexing increased the BEA to

$5.12 million, and in 2013, has increased the BEA to $5.25 million.

2. “Portability.” “Portability” refers to the surviving spouse’s ability to effectively “inherit”

the deceased spouse's unused exclusion amount – the DSUE mentioned above –

provided that the deceased spouse’s executor files an estate tax return, as filing the

return is deemed to elect portability (if the executor does not wish to claim portability, the

executor must check a box to opt out). If the deceased spouse’s estate is under the filing

threshold – $5.25 million in 2013 – a return still must be filed to claim portability. The

surviving spouse can use that extra exclusion amount for gift or estate tax purposes.

To illustrate, assume that Husband and Wife have only ever been married to each other

and have made no lifetime gifts. Husband dies on January 1, 2013, and leaves

everything to Wife, who also receives his unused $5.25 million exclusion amount

because of portability. In 2013, her applicable exclusion amount is thus $10.5 million,

which she can use against gift or estate tax. In subsequent years, Wife’s applicable

exclusion amount will grow: because of inflation-indexing, her own basic exclusion

amount will increase, even though her inherited DSUE is frozen. Note that there can only

be one unused spousal exclusion – namely, that of the “last” predeceased spouse. In

addition, the IRS will have an unlimited amount of time to examine the deceased

spouse’s return with respect to the portable exclusion: in other words, even if it is too late

to assess gift or estate tax against that spouse’s estate, the IRS can still challenge the

size of the DSUE. Note that neither the GST exemption nor any state estate tax

exclusion is portable. See below for more on portability.

3. “Clawback.” Because the BEA is now permanently $5 million (indexed for inflation),

“clawback” is no longer an issue. In other words, because the exclusion amount is not

declining, taxpayers who took advantage of the generous $5 million exclusion amount in

2011 and 2012 to make significant lifetime gifts will not be subject to additional gift or

estate tax on those gifts.

III. President Obama’s Fiscal Year 2014 transfer tax proposals. President Obama’s Fiscal Year

2014 Budget, released on April 10, 2013, proposes transfer tax changes (along with other tax

changes). The Treasury Department’s “Green Book,” or General Explanations of the

Administration’s Fiscal Year 2014 Revenue Proposals, fleshes out those proposals. Although

most of them are familiar, some have been refined. There is also a new proposal designed to

“clarify” the GST treatment of a type of trust called a “HEET” (Health and Education Exclusion

Trust). Here are some details of the transfer tax proposals:

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A. Restore the 2009 transfer tax parameters starting in 2018. As of 2018, transfer taxes

would revert to a $3.5 million estate tax exclusion and GST exemption, a $1 million gift tax

exclusion, and a top rate of 45% (with NO inflation-indexing of these amounts). Portability

would remain, and donors who took advantage of the higher applicable exclusion amount to

make lifetime gifts, would not face additional gift or estate tax because of that.

B. Consistent value for transfer tax and income tax. The basis of inherited property would

have to equal the property’s estate tax value, and the basis of property received by lifetime

gift generally would have to equal the donor’s basis. Executors of estates and donors of

lifetime gifts would be required to report the property’s value and basis to both the recipient

and the IRS.

Comment. Although this proposal reflects the current basis rules for property acquired from

a decedent or by lifetime gift, the real purpose of it seems to be ensuring compliance, by way

of the reporting requirements.

C. Require a minimum term for Grantor Retained Annuity Trusts (GRATs). To limit the

effectiveness of GRATs, which are designed to pass potential appreciation at little or no gift-

tax “cost,” GRATs would be required to have: 1) a minimum term of 10 years and a maximum

term of the annuitant’s life expectancy plus 10 years; 2) at least some gift at the trust’s

creation (i.e., no more “zeroed-out” GRATs); and 3) no declining annuity during the trust term.

D. Limit the duration of the GST Exemption. A trust that is protected from generation-

skipping transfer tax would lose that protection after 90 years, when the GST would again

apply to the trust.

E. Coordinate income and transfer tax rules applicable to Grantor Trusts. The grantor of a

“grantor trust” is responsible for paying the trust’s income taxes. Such trusts are often

includible in the grantor’s estate (as in a “revocable trust” or a GRAT). A trust that is not

includible in the grantor’s estate but for which the grantor is still responsible for the trust’s

income taxes is known as a “defective” grantor trust. Transactions between the grantor and

his grantor trust are not recognized, so that if, for example, the grantor sells appreciated

property to the grantor trust in exchange for an interest-bearing note – known as a “sale to a

defective grantor trust” – the sale does not trigger capital gains taxes, and the grantor is not

taxable on the trust’s interest payments to him (see V.A.2. below).

To eliminate this planning technique, the proposal provides that if the deemed income tax

owner of the trust (this could be the grantor or a beneficiary) “engages in a transaction with

that trust that constitutes a sale, exchange, or comparable transaction,” then the portion of

the trust attributable to this transaction (along with income or appreciation on the property): 1)

would be includible in the deemed owner’s estate; 2) would be subject to gift tax if the

deemed owner ceased to own the trust during life; and 3) would be treated as a gift from the

deemed owner if, during the owner’s life, distributions were made from the trust to another

person. Any gift or estate tax triggered by the proposal would be payable from the trust. The

proposal would not apply to trusts that are already includible in the grantor’s estate, “rabbi

trusts” (non-qualified deferred compensation plans that are subject to claims of the grantor’s

creditors) or trusts that are grantor trusts solely because the trust’s income can be used to

pay insurance premiums on the life of the grantor or the grantor’s spouse (i.e., insurance

trusts that are designed to remove insurance proceeds from an insured’s estate).

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Comments. Last year’s 2013 Fiscal Year Budget marked the first appearance of this

proposal to unify income and transfer tax rules for grantor trusts. It was so broadly worded

that it would have caught existing trusts, such as insurance trusts. This new iteration aims to

simply target sales to defective grantor trusts.

F. Extend the lien on estate tax deferrals. Although the tax law normally requires that the

estate tax be paid within nine months of the decedent’s death, a special provision allows the

estate tax on certain closely held business interests to be paid over 15 years. Another

provision of the tax law imposes what is generally a 10-year lien on the estate’s assets to

ensure payment of the estate tax. Because that lien can expire before the estate tax is paid,

it may be difficult for the IRS to collect all of the deferred tax dollars. The proposal would

extend the lien so that it lasts for the permitted deferral period.

G. Clarify the GST treatment of “HEETs.” Donors can make direct payments of tuition and

medical expenses free of gift tax. If that donor is a grandparent, for example, such payments

are also free of generation-skipping transfer tax. Specifically, the tax law provides that the

GST will not apply to “any transfer which, if made inter vivos by an individual [i.e., during the

donor’s life], would not be treated as a taxable gift” because it is a direct payment for tuition

or medical expenses. This language has been read to mean the following: GST will not apply

to a trust’s direct payments for, say, a grandchild-beneficiary’s tuition or medical expenses,

even though the trust is otherwise subject to GST. (See VIII.B.2.a. below.)

Some planners have taken this understanding a step further with “HEETs,” or Health and

Education Exclusion Trusts. These trusts purportedly are fully protected from GST, despite

not having any GST exemption allocated to them. That is, because charity has an ongoing

“substantial” income interest in the HEET (say, 10%), gifts into the trust are not subject to

GST, and GST won’t apply when one generational level of beneficiaries dies off. In addition,

because trust distributions on behalf of beneficiaries such as grandchildren can only be made

for tuition or medical expenses, they are GST-exempt. The proposal says that it would

“clarify” that this GST exclusion for direct payments of tuition or medical expenses only

applies to payments made by a living donor, and not from a trust. The proposal would apply

to trusts created after the bill proposing this change is introduced in Congress, and to

transfers after that date made to pre-existing trusts.

Comments. The desire to "clarify" this special exclusion reflects the perception that HEETs

are abusive, given the proposal’s recommended effective date (introduction, rather than

enactment, of legislation). Despite this perception, however, it is worth noting that trusts that

typically take advantage of direct payments for tuition and medical expenses are subject to

GST but for this special exclusion. Also, although HEETs have been written about in

planning publications, it is unclear how often they are actually implemented: donors who use

their GST exemption for multi-generational trusts often feel that they’ve done “enough” for

those lower generations (particularly in light of the ever-increasing GST exemption), and may

lack the charitable intent necessary for the HEET to work. In addition, given life’s

uncertainties, trust creators may be reluctant to limit trust distributions to tuition and medical

expenses only.

H. Note regarding modifying rules on valuation discounts. Prior budget proposals

suggested trying to limit valuation discounts by expanding the category of “disregarded

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restrictions” for purposes of valuing an interest in a family-controlled entity that is transferred

to a family member if, after the transfer, the restriction lapses or could be removed by the

transferor or the transferor’s family. Although this proposal is not part of the Fiscal Year 2014

Budget, it seems possible that Treasury will now take a regulatory approach in addressing

the issue of valuation discounts.

IV. Drafting issues in light of the $5 million exclusion amount.

A. Formula provisions. Many wills and trusts have formula provisions that are designed to

take advantage of certain tax benefits, such as the “maximum amount that can be protected

from federal estate tax,” or the “maximum amount that can be protected from GST.” When

many of these formulas were first drafted, the maximum estate tax exclusion was going to be

$1 million, and the GST exemption was $1 million, indexed for inflation. Accordingly,

individuals who have not updated their planning documents in many years may find that

these documents have unintended results – and tax consequences. For example, suppose

that Dad intended to give his “credit shelter amount” (i.e., the amount he could protect from

estate tax) to the adult children of his first marriage, with the balance of his property passing

to his new spouse and minor children. If Dad’s document was written with a $1 million

exclusion in mind, the steadily increasing $5 million exclusion amount could result in far more

property passing to those adult children than Dad intends – particularly if Dad’s prior spouse

died and he received any of her DSUE. In addition, if Dad lives in a state that has

“decoupled” from the federal system and has its own estate tax, full use of the exclusion

could trigger state estate tax (see below).

1. Formulas and “decoupled” states. The Economic Growth and Tax Relief

Reconciliation Act of 2001 (Pub. L. 107-16) (the “2001 Act”) phased out and eliminated

the “state death tax credit,” a revenue-sharing arrangement between the states and

Uncle Sam. Although the credit didn’t reduce a decedent’s estate taxes, it did reduce

Uncle Sam’s share of them. “Pick-up” or “sop” tax states (such as Florida) simply

charged whatever amount of state estate tax Uncle Sam was willing to recognize as a

credit. When that credit disappeared in 2005 (it was replaced by a deduction for state

death taxes paid), states lost these revenues unless they “decoupled” from the federal

system. Some 20 or so states currently have done so, including New York, Connecticut,

New Jersey, Massachusetts and Vermont. Decoupled states vary as to their respective

estate tax exclusions and whether they recognize the state death tax deduction (more on

this below). (State estate tax exclusions typically range from $675,000 to about $2

million, although they can reach as high as the basic exclusion itself.) The upshot is that

if the decedent lives in a decoupled state, or has property in a decoupled state, full use of

the federal exclusion amount will likely trigger state death tax. (Note that if widowed Dad

lives in a decoupled state and dies in 2013, leaving his entire $5.25 million estate to his

children, his estate will be subject to state estate tax, although any DSUE Dad received

from Mom will help mitigate federal estate tax.)

2. Deaths in 2005 and after – effect of state death tax deduction. When there was still a

state death tax credit, state death taxes were treated as being paid by the credit shelter

trust, and therefore did not reduce the marital share. When the state death tax credit

disappeared in 2005, and these taxes instead became deductible, they no longer

depleted the credit shelter trust and, on the federal level, did not reduce the marital share.

In decoupled states that don’t recognize this deduction, however, the marital share IS

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treated as being reduced, which therefore results in an interrelated computation (and

higher state estate taxes). Here’s how it works: because the marital share is reduced by

those non-deductible state estate taxes, the taxable estate becomes larger, and triggers

more federal (and state) estate tax. These additional taxes further reduce the marital

share, and thereby further increase the taxable estate. The larger taxable estate means

higher taxes, and a smaller marital share…and so forth. This circular computation

continues until it finally bottoms out.

Here’s what this means for New York: its estate tax laws 1) reference the Internal

Revenue Code that was in effect on or before July 22, 1998, 2) only permit a $1 million

state estate tax exclusion, and 3) don’t recognize the state death tax deduction. Thus, in

2011, when the federal basic exclusion amount was $5 million, a married New Yorker’s

credit shelter/marital deduction formula provision that took full advantage of that amount

would trigger an interrelated computation and incur New York estate tax of $444,091

(without the interrelated computation, the tax would have been $391,600; in 2009, when

the federal exclusion was $3.5 million, the interrelated computation would incur $254,911

of tax, and $229,200 without it). Does it make sense for Dad, say, to pay this New York

tax? That depends on his prognosis for New York’s estate tax, his wealth and whether

it’s likely that Mom, as the surviving spouse, will be a New York resident at her death.

The same considerations apply to any decoupled state.

3. GST formula provisions. As mentioned above, the GST exemption reached $3.5

million in 2009, prior to its temporary repeal in 2010 and reinstatement with a $5 million

exemption, indexed for inflation. Just as full use of the applicable exclusion amount can

pass “too much” property, so can a GST formula designed to protect the “maximum

amount” from GST.

B. Portability. As mentioned above, ATRA made “portable” spousal estate tax exclusions

permanent. In other words, Dad, for example, won’t be required to use a credit

shelter/marital deduction formula provision to ensure full use of his applicable exclusion

amount. He can leave everything to Mom, and as long as his executor elects portability,

Mom will be able to use what remains of Dad’s AEA for gift OR estate tax purposes. This

could greatly simplify Mom and Dad’s planning. Yet despite this appealing prospect,

portability does not necessarily mean the death knell for credit shelter trusts, for several

reasons. First, state death taxes can be an issue if Mom and Dad live in a decoupled state.

That is, although the federal exclusion is portable, the state exclusion is not. Thus, if Mom,

say, doesn’t take advantage of her state estate tax exclusion amount, extra state tax could be

payable at Dad’s death. Second (and here’s the unvarnished truth about many spousal

trusts), by putting Dad’s inheritance in trust, Mom can ensure what happens to the property at

Dad’s death. In other words, if Dad remarries and starts a new family after Mom is gone, she

can at least ensure that her children will take what is left at Dad’s death. Similarly, if Dad dies

first, a trust can help ensure that Mom is not quite such a “soft touch” for her ne’er-do-well

brother. Finally, a credit shelter trust will “freeze” the value of the property passing into the

trust – in other words, as generous as the current basic exclusion amount is ($5.25 million in

2013, or $10.5 million per married couple), it is still possible that the property could

appreciate beyond Mom and Dad’s applicable exclusion amounts. Accordingly, a credit

shelter trust could still shelter that appreciation from future federal OR state estate tax.

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Note. On June 18, 2012, the IRS issued temporary regulations on portability (T.D. 9593).

These regs clarify a number of points regarding portability, including the following: to take

advantage of portability, Dad’s executor must timely file his estate tax return (Form 706). For

estates that otherwise would not have to file a Form 706 because they are under the filing

threshold ($5.25 million in 2013), the executor still must file the return to claim portability

(although there is no “Form 706-EZ” for such estates, simplified reporting for property passing

to the surviving spouse or charity is permitted, assuming certain requirements are met). In

addition, if Mom, for example, receives Dad’s unused exclusion amount, and then makes a

lifetime gift, she is first treated as using Dad’s DSUE (in other words, Mom’s basic exclusion

amount is “stacked” on top of Dad’s DSUE).

V. Gifting opportunities with the $5 million exclusion amount.

A. Lifetime gifts. As previously noted, the basic exclusion amount is $5.25 million for 2013,

and can be used against gift or estate tax (remember if there’s a surviving spouse and she

has received Dad’s unused exclusion – DSUE – her applicable exclusion amount consists of

her basic exclusion plus the DSUE). Although this generous exclusion amount is now

“permanent,” and the “basic” part of it will permanently increase thanks to inflation-indexing,

Congress is not precluded from re-examining this structure at a later date. Nevertheless, the

magnitude of the exclusion gives donors some breathing room, particularly if they are giving

away hard-to-value property. In other words, they don’t necessarily have to give away every

last dollar, and can have a cushion in case the IRS challenges a valuation on audit. Still,

discounted gifts have appeal, such as GRATs (grantor retained annuity trusts) and even

QPRTs (qualified personal residence trusts). Sales to Defective Grantor Trusts are also

popular.

1. GRATs (grantor retained annuity trusts). GRATs can transfer potential appreciation at

little or no gift tax cost. With a GRAT, Mom, say, transfers property into the trust that she

feels is likely to appreciate or is a “cash cow.” For, say, two or three years, she receives

an annuity from the trust, in cash or in kind; assuming that property remains in the trust at

the end of the trust term, it passes gift-tax free to the trust’s remaindermen (typically, her

children). The trust is structured so that the present value of Mom’s annuity equals (or

nearly so) the fair market value of the property she transferred to the trust. Because of

that, the remainder gift to her children is zero (a “zeroed-out” GRAT). The “7520 rate,” an

interest rate published monthly by the IRS, is used to determine the present value of

Mom’s interest. To the extent that the property outperforms that rate, that “excess”

passes gift-tax free to her children.

Note: Because GRATs have been so successful in the 20+ years of their existence, they

are now on Congress’s hit list. And as mentioned above, President Obama’s Fiscal Year

2014 Budget continues to propose restrictions on GRATs, which would make them less

attractive, in part, by requiring a minimum 10-year term, thereby increasing the mortality

risk (if Mom dies while she’s still receiving the annuity, most (or all) of the trust would be

includible in her estate), and by requiring at least “some” gift at the trust’s creation

(thereby eliminating “zeroed-out” GRATs). Although these restrictions may be used as a

“revenue raiser” in future tax legislation, GRATs remain viable for the moment, and work

extremely well in our current low interest-rate environment.

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Example. Mom plans to take her company public within the next six months to a year.

Based on the latest venture capital financing, her company stock is currently worth $10

per share. In April 2013, when the 7520 rate is 1.4%, she creates a two-year GRAT and

transfers 200,000 shares of stock worth $2 million ($10/share) to it. By the end of the

second year, Mom has received a total of 153,155 shares to satisfy her $1,021,033

annual annuity, the present value of which is nearly $2 million (the remainder gift to her

children is $0.17). At the end of two years, the stock has doubled in value, and her

children (the GRAT’s remaindermen) now receive 46,845 shares of stock, worth

$936,900, gift-tax free.

2. Sales to Defective Grantor Trusts. The Sale is a variation on the GRAT, and is another

way to pass potential appreciation gift-tax efficiently. Unlike the GRAT, however, which

can be “zeroed-out” so that there is little or no use of Mom’s applicable exclusion amount,

the typical structure of a Sale requires a gift with a value of at least 10% of the property

Mom intends to sell to the trust, with Mom taking back an interest-only balloon note to

memorialize the sale. Assuming the note is for nine years or less, its interest rate will be

lower than the 7520 rate used to calculate the present value of the annuity interest in a

GRAT. Thus, the Sale has a lower “performance hurdle” than the GRAT, and more

potential appreciation can accrue for the trust’s beneficiaries; in addition, unlike the

GRAT, the trust can benefit multiple generations, rather than just children. And if Mom

dies while the note is outstanding, only the balance due on the note is includible in her

estate – not the entire value of the trust, as with the GRAT; note, however, that the

income tax consequences of Mom’s death are uncertain (some commentators believe

that any gain on the sale might then be realized, while others disagree). Finally, if the

IRS successfully increases the valuation of the asset sold, Mom can be treated as

making a “bargain sale,” meaning that she didn’t charge enough for the property, and

made an additional gift to the extent the property was undervalued (this is not an issue

with a GRAT, since the formula used to express the annuity payment automatically

adjusts to account for any valuation increase).

Example. Mom creates an “intentionally defective” grantor trust for her descendants

(i.e., she is responsible for the trust’s income taxes, but the trust won’t be includible in her

estate when she dies). Mom gives $200,000 to the trust, which uses up part of her $5.25

million exclusion amount. In April 2013, she sells $2 million of stock (200,000 shares at

$10/share) to the trust in exchange for a 1.09%, interest-only, five-year note. Over the

five-year period, Mom receives a total of $109,000 in interest, which the trust pays using

seed money and distributions from the corporation; by the end of the period, the stock

has doubled in value, and she receives 100,000 shares to satisfy the $2 million note.

The trust retains 100,000 shares, worth $2,000,000 for the benefit of her descendants.

Note. As mentioned at III.E. above, President Obama’s Fiscal Year 2014 Budget

proposes unifying the income and transfer tax rules applicable to the deemed income tax

owner of the trust (this could be the grantor or a beneficiary) who “engages in a

transaction with that trust that constitutes a sale, exchange, or comparable transaction.”

If this proposal were enacted, it would eliminate sales to defective grantor trusts.

Nevertheless, until that happens, this technique is still viable, and works extremely well in

our low interest rate environment.

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3. QPRTs (qualified personal residence trusts). QPRTs offer a discounted way to give a

personal residence to, say, children. With a QPRT, Mom, for example, transfers her

vacation home to a trust and retains the right to use it for a term of years, and get the

property back if she dies during the term. If she’s still alive at the end of the term, the

property passes, say, to her daughter. With interest rates so low, Mom’s retained

interests are worth much less than they would be if rates were higher; the corresponding

gift to her daughter (her future right to receive the property) is therefore greater.

Nevertheless, because Mom’s property may have declined in value in this still-

challenging economy, she may get some mileage from the QPRT; furthermore, the $5

million exclusion amount ($5.25 million in 2013) helps mitigate any gift tax “friction” from

the transaction. Note, however, that this generous exclusion amount may make a

straight gift more appealing, as it also avoids the mortality risk inherent in a QPRT.

Example. Mom is 60, and wants to give her $2.5 million Martha’s Vineyard vacation

home to her daughter. She sets up a QPRT in April 2013, when the 7520 rate is 1.4%.

The trust will last for 10 years. If Mom survives the term, the property passes to her

daughter; if Mom doesn’t survive the term, the property goes to her estate. When Mom

creates the trust, her retained interests in the house are worth a little over 25%, or nearly

$650,000; the corresponding gift to her daughter is about 75%, or $1.85 million. Mom

has more than enough of her $5.25 million exclusion amount to shelter this gift (she’s

basically only out of pocket the cost of creating the trust and appraising the house). Mom

survives the 10-year term, and her daughter owns the property, which is now worth about

$3.7 million (about a 4% growth rate). The QPRT effectively “freezes” the value of Mom’s

house – another way of saying that appreciation passes to her daughter gift-tax free.

(Note that if Mom wishes to keep using the house after the QPRT is over, she must pay

her daughter fair market rent. In addition, Mom’s daughter will take Mom’s “adjusted

basis” in the house; thus, if Daughter sells the house, she’ll pay the same capital gains

tax that Mom would have paid.)

4. Intra-family loans. Suppose Mom and Dad loaned their child money to buy a house or

start a business. Although they faithfully memorialized the loan with a note and their child

is paying them interest on it, they might prefer to simply cancel the outstanding

indebtedness. The increased $5 million exclusion amount ($5.25 million for 2013) may

make it possible to exercise this generosity gift-tax free.

VI. Estate Tax Basics. The above discussion addresses the transfer tax regime that ATRA has

made permanent. What now follows is a more basic discussion of transfer taxes – in other

words, how estate and gift taxes interact, and how GST factors into the equation.

A. Calculating the estate tax. In essence, the estate tax is imposed on the decedent’s

property to the extent the decedent’s taxable estate exceeds the decedent’s available

applicable exclusion amount (this amount is reduced by lifetime gifts; what is left reflects

the amount the decedent can protect from estate tax). Here’s how the taxable estate is

computed:

1. Start with: The “gross estate,” which encompasses ALL of a decedent’s property

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2. Subtract: Deductions, including those for debts, and funeral and administration expenses

(e.g., executors’ commissions and attorneys’ fees), property passing to the surviving

spouse or charity, and state estate taxes

3. Total equals: “Taxable estate”

4. Add: “Adjusted taxable gifts” – as in lifetime gifts made after 1976 that eroded the

decedent’s applicable exclusion amount, may have triggered gift tax AND are not

included in the decedent’s gross estate (this ensures that the decedent is in the highest

possible tax bracket)

Tentative estate tax is figured on the taxable estate plus adjusted taxable gifts, from which

hypothetical gift tax is subtracted. That is, if the decedent made any adjusted taxable gifts,

gift tax is calculated on those gifts using the rates in effect at the decedent’s death, and then

subtracted from the tentative estate tax. From this amount, the applicable exclusion amount,

which consists of the $5 million “basic exclusion amount” (indexed for inflation) plus any

“deceased spousal unused exclusion,” is subtracted. Credits, if any, for foreign death taxes

or for previously taxed property are also subtracted to arrive at the net estate tax. GST, if

any, is added in, to arrive at the total transfer taxes owed.

B. Gross estate. The gross estate consists of the decedent’s property. Such property can be

obvious – such as bank and brokerage accounts, IRAs, or homes – or it can be less obvious,

such as trust property over which the decedent had certain powers that the tax law treats as

“ownership.” Here is a run-down on selected property interests:

1. Transfers with retained life estate. If the decedent transferred property during his life,

either outright or in trust, and retained the right to enjoy the property or receive income

from it – or could designate who could enjoy that property – then the property will be

includible in the decedent’s estate UNLESS the decedent made a “bona fide sale” of the

property for which he received “adequate and full consideration in money or money’s

worth.” IRC Sec. 2036(a).

Example – trust interest. Dad creates a QPRT (qualified personal residence trust – see

V.A.3. above) because he wants to give his Sag Harbor vacation home to Daughter. The

trust’s term is the shorter of 10 years or until Dad’s death. Unfortunately, Dad dies in

Year 7. Dad’s retained interests in the property mean that its fair market value is

included in his estate. Because of this, the QPRT – even though it was previously

reported as a gift on Dad’s gift tax return – is not considered an “adjusted taxable gift,”

and any of Dad’s applicable exclusion amount used in creating the QPRT is effectively

“restored” in the estate tax computation.

Example – tangible property. Mom has a cherished painting by a lesser-known artist.

She’d like Son to have it now. Mom gets the property appraised, tells Son that it now

belongs to him, and files a gift tax return reporting the gift. But…the painting never

makes it out of Mom’s living room. She dies, and the painting is included in her estate

because she never gave up dominion and control over it.

2. Revocable transfers. If the decedent transferred property, either outright or in trust, and

retained the right to affect the enjoyment of that property because he could “alter, amend,

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revoke, or terminate” that interest, then the property will be includible in the decedent’s

estate UNLESS the decedent made a “bona fide sale” of the property for which he

received “adequate and full consideration in money or money’s worth.” IRC Sec.

2038(a).

Example – trust for self. Mom wants to make sure that if she becomes disabled or

incompetent, a vehicle is in place to see to her needs; she’d also like to simplify the

administration of her estate once she’s gone. She therefore creates a Revocable Trust

(also known as a “living trust”), to which she transfers her bank and brokerage accounts,

and creates a “pour-over will” to transfer her remaining property to the Trust at her death.

Mom can revoke or amend the trust, which provides that the trustees (she and her

daughter) will pay her whatever income or principal she needs. When Mom dies, the

trust is fully includible in her estate because of her retained interests.

Example – trust for someone else. Grandma creates a trust for Grandson. The trust

gives the trustee full discretion to distribute income and principal to Grandson (in other

words, distributions are not limited by an “ascertainable standard,” such as “health,

education, maintenance and support”). Grandma and Grandpa are trustees. Grandma

dies and the trust is includible in her estate because of her unlimited control as trustee

over distributions to Grandson.

Example – UGMA or UTMA account. Years ago, Dad wanted to set dollars aside for

his daughter’s college education, and created an account under UGMA (Uniform Gifts to

Minors Act), for which he selected an age 21 termination. Dad has steadily made annual

exclusion gifts to the account, which is now governed by UTMA (Uniform Transfers for

Minors Act), because the state updated its laws. Dad dies when his daughter is 20, and

the account has not yet been turned over to her. Because Dad both contributed to the

account AND was its custodian, it is fully includible in his estate: from the IRS’s

perspective, he never gave up control of the dollars and could direct what happened to

them.

3. Joint interests. There are different types of jointly held property, with different rules for

includibility depending on the type of tenancy and the identity of the joint tenant. With a

“tenancy in common,” the ownership interest does not automatically pass to the

surviving owner at the first owner’s death; rather, the owner disposes of his portion of the

asset under his will. With a “joint tenancy with right of survivorship” (JTWROS), the

property automatically passes to the surviving owner at the first owner’s death. A

“tenancy by the entirety” is similar to a joint tenancy, except that it can only exist

between a husband and wife, and can only be severed by death or mutual consent.

When the owner of a tenancy in common dies, the value of his fractional interest is

includible in his estate, and may be eligible for valuation discounts. The general rule for

includibility with a JTWROS is that the full value of the property is includible in the estate

of the first owner to die except to the extent the surviving owner can prove his or her

contribution to the property’s purchase price. With a tenancy by the entirety – or a

JTWROS if spouses are the only joint owners – half of the value of the property is

included in the estate of the first spouse to die regardless of which spouse purchased the

property, provided that the surviving spouse is U.S. citizen (if not, then the general

JTWROS rule applies). IRC Sec. 2040.

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Example – two siblings. Frankie and her brother, Johnny, own Blackacre as joint

tenants with right of survivorship. Frankie put up 50% of the purchase price, and Johnny

put up the other 50%. Frankie dies, and the property automatically passes to Johnny.

Because Johnny has kept excellent records that prove his 50% contribution towards

Blackacre, only 50% of its value is included in Frankie’s estate.

4. General power of appointment. If the decedent has an interest in property, and can

appoint that property to himself, his estate, his creditors, or the creditors of his estate,

that “general power of appointment” will make the property includible in his estate. If the

power is limited to a specific class of beneficiaries, such as “surviving issue, per stirpes,”

– in other words, the power excludes the decedent, his estate, his creditors and the

creditors of his estate – then the property will not be includible in the decedent’s estate.

IRC Sec. 2041.

Example – trust beneficiary. George is the beneficiary of a trust his mother created for

him many years ago. At his death, he can appoint the trust property to anyone he

wishes, including himself. If he doesn’t exercise the power, the property will pass to his

surviving issue, per stirpes. George dies without exercising the power. The trust is

includible in his estate because he could have exercised the power in favor of himself.

5. Life insurance. If the proceeds are payable to the decedent’s estate or the decedent

had any “incidents of ownership” over a life insurance policy on himself – such as the

ability to change the beneficiaries or borrow against the policy – then the policy proceeds

will be includible in his estate. IRC Sec. 2042.

6. Certain gifts within 3 years of death. If, within three years of death, the decedent

transferred an interest in property or gave up a power over property, and that interest or

power would have made the property includible in the decedent’s estate because there

was a retained interest under IRC Sec. 2036, a reversionary interest under IRC Sec.

2037, a power to amend or revoke under IRC Sec. 2038 or a transfer of life insurance

under IRC Sec. 2042, then the property will still be includible in the decedent’s estate

under IRC Sec. 2035(a).

Example. Dad owns an insurance policy on his own life. He wants to get it out of his

taxable estate and transfers it to an irrevocable trust to benefit Mom and their children.

Dad dies two years after the transfer. The insurance proceeds are still includible in his

estate because Dad died within three years of the transfer. By contrast, if Dad created

an insurance trust and the trustee bought the insurance, the three-year rule wouldn’t

apply.

7. Gift tax on gifts made within 3 years of death. If the decedent makes a gift within three

years of death and pays gift tax on that transfer, the gift tax will be includible in the

decedent’s estate (it’s effectively a “phantom asset”). IRC Sec. 2035(b).

Example. It’s 2008, and Mom has already used up her $1 million gift tax exclusion. She

gives Daughter $500,000 to help her buy a house. Mom files a gift tax return and pays

the resulting gift tax. Mom dies a year later. The gift tax is includible in her estate, and

subject to estate tax.

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C. Valuing the property. Valuation of a decedent’s property can be difficult if the property is not

readily marketable or is illiquid. Putting that potential difficulty aside, the general rule is that

property is valued at its date-of-death value, unless the executor elects to value all of the

property in the gross estate as of 6 months after the decedent’s death (the executor can only

elect alternate valuation if it reduces the value of the gross estate AND the combined estate

tax and GST owed). IRC Sec. 2032.

Property is valued at its “fair market value,” which is defined as “the price at which the

property would change hands between a willing buyer and a willing seller, neither being

under compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

Treas. Reg. § 20.2031-1(b). In terms of marketable stocks and bonds, for example, fair

market value is the mean between the highest and lowest quoted selling prices on the

valuation date. See Treas. Reg. § 20.2031-2. If there is no ready market for property, the

services of a qualified appraiser will be required to determine the property’s value; as the

numerous valuation cases between the IRS and taxpayers illustrate, valuation is often more

art than science – and can vary widely.

D. Deductions – “reasonable and necessary.” Typical deductible expenses include

“reasonable” funeral expenses, necessary administration expenses (e.g., executors’

commissions, attorneys’ and accountants’ fees, filing fees, etc.), and debts of the decedent.

If the administration expenses aren’t essential to administering the estate but are incurred for

the “individual benefit” of the estate’s beneficiaries, the expenses are not deductible. See

Treas. Reg. § 20.2053-3(a).

1. Marital deduction – U.S. citizen surviving spouse. If the decedent leaves property to

his surviving spouse, the gift generally will postpone estate tax until the surviving

spouse’s death, provided she’s a U.S. citizen. If the gift is outright, there is no issue with

respect to the deduction. If the gift is in trust, it qualifies for the marital deduction only if it

qualifies as one of the following three trusts:

a. Qualified Terminable Interest Property (QTIP) trust. With a QTIP trust, the

surviving spouse must receive all of the trust’s income, at least annually for life, and

no one else may have an interest in the trust property during her life; she may, but

need not, have an interest in the trust’s principal. At the surviving spouse’s death,

the property is includible in her taxable estate, but passes according to the trust’s

provisions. The surviving spouse may, but need not, have a testamentary limited

power to appoint the trust property. The decedent’s executor must elect QTIP

treatment on Form 706 (because so many executors have inadvertently forgotten to

make this election, the form now assumes that the election has been made). IRC

Sec. 2056(b)(7).

b. General power of appointment (GPA) trust. As with a QTIP trust, the surviving

spouse must receive all of the trust’s income, at least annually for life, and no one

else may have an interest in the trust property during her life. In addition, the

surviving spouse must have the power, exercisable during her life or at death, to

appoint the trust principal to herself or her estate. IRC Sec. 2056(b)(5).

c. Estate trust. With an estate trust, no one can have any interest in the trust other

than the surviving spouse, who need not have any interest in it during her life; at her

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death, all of the trust property must pass to her estate, where she directs what

happens to the property. (This type of trust is very rare.) Treas. Reg. § 20.2056(c)-

2(b)(1)(iii).

2. Marital deduction – non-citizen surviving spouse. If the surviving spouse is not a

U.S. citizen, the marital deduction will only be available if the decedent leaves property to

a qualified domestic trust (QDOT). In addition to having terms similar to a QTIP trust,

the QDOT must have at least one trustee who is a U.S. citizen or domestic corporation,

and no distribution (other than income) may be made from the trust unless the trustee is

authorized to withhold estate tax from the distribution. IRC Sec. 2056A. In a nutshell, the

QDOT is “pay-as-you-go,” in that every current principal distribution triggers the same

estate tax that would have been payable in the deceased spouse’s estate if the

distributed property had been taxable in his estate; at the surviving spouse’s death,

whatever remains in the trust will also be subject to estate tax (again, as if the property

had been taxable in the deceased spouse’s estate). (By contrast, a QTIP trust – see

above – is “pay-once-you’re-gone,” in that whatever remains in the trust at the surviving

spouse’s death is includible in her estate, and subject to estate tax.) Note that if the

deceased spouse leaves property outright to his non-citizen spouse, she can create a

QDOT for the property so as to avail herself of the marital deduction. IRC Sec.

2056(d)(2)(b). (In this case, the QDOT will be a grantor trust for income tax purposes.)

Note re: portability and non-citizen spouses. Under the proposed portability

regulations issued on June 18, 2012 (T.D. 9593), the surviving non-citizen spouse

generally will not be able to use any of the deceased spouse’s unused exclusion (DSUE)

in her own applicable exclusion amount until the QDOT has made its final distribution or

her death, whichever happens sooner. See § 20.2010-3T(c)(2).

3. Charitable deduction. If the decedent leaves property “to or for the use of” a charity, the

gift will be eligible for an estate tax charitable deduction. In general, the gift can be

outright or in trust. With a wholly charitable trust, such as a private foundation, the entire

gift is deductible. With a charitable remainder trust (CRT), the present value of charity’s

remainder interest is deductible; with a charitable lead trust (CLT), the present value of

charity’s “up-front” interest is deductible. IRC Sec. 2055. The charity need not be a U.S.

charity. Treas. Reg. § 20.2055-1(a)(4). (Note that for the income tax deduction, the

charity must be a U.S. charity.)

4. State death tax deduction. If the decedent’s estate pays any state estate taxes, these

are deductible against the decedent’s gross estate. Note that the state death tax

deduction under IRC Sec. 2058 is in lieu of the former state death tax credit under IRC

Sec. 2011, which the 2001 Act phased out during 2002 – 2004. Although the deduction

helps mitigate the cost of state estate taxes, it is not as beneficial as the former credit, a

revenue-sharing arrangement between the states and Uncle Sam (the credit didn’t

increase a decedent’s estate tax, but meant that Uncle Sam got fewer estate tax dollars).

E. Disclaimers. If the decedent leaves property to someone, that individual can disclaim – or

refuse – the property. In that case, the “disclaimant” is treated as having predeceased the

decedent, and the property is treated as passing directly from the decedent to the beneficiary

who’s next in line. For the disclaimer to be “qualified,” so that the disclaimant is NOT treated

as making a gift to the successor beneficiary, the disclaimant must satisfy the following

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requirements: a) refuse the property in writing; b) refuse the property not later than 9 months

after the later of the transfer creating the interest OR the day the disclaimant turns age 21; c)

not accept any of the interest or its benefits; AND (d) the property must pass without any

direction from the disclaimant, either to the decedent’s spouse or someone other than the

disclaimant. See IRC Sec. 2046, which refers you to IRC Sec. 2518.

Example. Dad leaves his residuary estate to his “surviving issue, per stirpes.” He is

survived by his son and daughter, and their respective children. Daughter is very successful,

and wants to disclaim 50% of her residuary share, so that it passes directly to her children.

She follows the disclaimer rules to the letter, and the disclaimed property is treated as

passing from Dad to his grandchildren. Although the property is potentially subject to GST,

Dad’s remaining GST exemption covers it.

F. When the 706 is due. Form 706 is due 9 months after the decedent’s death, although a six-

month automatic extension of time to file can be requested by filing Form 4768.

VII. Gift Tax Basics. The gift tax applies when a U.S. citizen or resident gives away tangible or

intangible property; the gift tax applies to non-residents if they give away what is considered “U.S.

situs property,” such as real estate and tangible personal property located in the U.S. (the tax has

a broader reach if the individual is considered an “expatriate” and is caught under the relatively

new rules of IRC Sec. 877 and IRC Sec. 877A, a discussion of which is beyond the scope of this

outline). As mentioned above, the applicable exclusion amount applies against gift or estate tax,

and consists of the basic exclusion amount ($5 million, indexed for inflation, or $5.25 million in

2013) and, if there’s a surviving spouse, the deceased spousal unused exclusion amount. (If no

DSUE is applicable, the applicable exclusion amount is the same as the basic exclusion amount.)

The gift tax equals the tentative tax on the current gift PLUS prior taxable gifts over the tentative

tax on prior gifts, against which the “applicable credit amount” – which equals the tax on the

applicable exclusion amount – is applied. If any amount remains, that is the gift tax owed.

A. Exclusions from gifts. Certain gifts, discussed below, don’t “count” against a donor’s AEA,

and therefore don’t erode it. These gifts are “extras”:

1. Annual exclusion gifts. In 2013, a donor can give away $14,000 a year ($28,000 if his

spouse consents) to as many people as he wishes, without eroding any of his AEA.

(Annual exclusion gifts are indexed for inflation.) IRC Sec. 2503(b). Note that if the

donor is making a gift in trust, the gift must be considered a “present interest” – or

something to which the beneficiary has unfettered access for a period of time – to be

eligible for this exclusion. To ensure this treatment, gifts in trust typically involve so-

called “Crummey notices,” which the Trustee sends to the beneficiary, informing her of

the gift in trust, and giving her a minimum period (say, 30 days) to withdraw the

contribution. To the extent the beneficiary does not act, the property remains in trust.

The IRS does not like Crummey trusts, as it generally believes there is a tacit

understanding that the beneficiary won’t exercise the withdrawal power, and that the

present interest is illusory. It is therefore important that the Trustee scrupulously send

the Crummey notices, since in an audit of the donor’s estate, the IRS may request copies

of the notices.

Note re: Crummey trusts and “hanging powers.” If the donor is funding a trust with

annual exclusion gifts and the beneficiary does not exercise his withdrawal right, the

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lapse of this right will be a taxable gift to the extent it exceeds the greater of $5,000 or 5%

of the property over which the power could be exercised. IRC Sec. 2514(e). To avoid

this taxable gift, the trust often gives the beneficiary a so-called “hanging power” – that is,

a continuing right to withdraw the amount that would otherwise be a gift. (See VIII.D.

below for possible GST complications.)

Note re: 529 plans. Gifts to 529 plans (tax-preferred accounts to save for a child’s

higher education) are eligible for special treatment: the donor may use five years’ worth

of annual exclusion gifts to “front-load” the account and get a jump on tax-deferred

growth. Thus, if Grandma sets up a 529 plan for Granddaughter, she can contribute

$70,000 in one year; if Grandpa consents, Grandma can contribute $140,000 in one year.

Note: if Grandma dies in Year 3 of this gift, the “unused” annual exclusion gifts (those for

Years 4 and 5) will be includible in her estate.

2. 2503(c) trusts. Gifts in trust for a minor will be considered “present interests” (and

therefore annual exclusion gifts) IF the property can be expended for the minor, and i) the

minor is entitled to the property at age 21, and ii) the property is payable to the minor’s

estate if he dies before age 21. In practice, these trusts are useful if a donor does not

want the nuisance of annual Crummey notices; on the other hand, the beneficiary can

take the trust property at age 21 (often the beneficiary is given, say, 30 days after

reaching age 21, to terminate the trust; if he doesn’t, the trust continues pursuant to its

terms). IRC Sec. 2503(c).

3. Gifts for tuition or medical expenses. In addition to annual exclusion gifts, a donor can

pay anyone’s tuition or medical expenses and NOT erode any of his applicable exclusion

amount; the payment must be made directly to the school or the medical provider. IRC

Sec. 2503(e). Note that under Treas. Reg. § 25.2503-6(b)(3), “medical expenses” also

include health insurance premiums.

Example. Grandma wants to help pay for Grandson to attend Princeton. Her payment

to Princeton for Grandson’s tuition is a non-taxable gift. If she also pays for Grandson’s

other expenses there, such as books and room and board, those payments will be

considered gifts to him, which her annual exclusion may be insufficient to cover; the gifts

therefore may erode part of Grandma’s $5.25 million AEA (the 2013 number), and could

potentially trigger GST. Note that Grandma can’t write the tuition check to Grandson – it

must be payable to the school.

B. Split gifts. If a donor is married, and her spouse consents, then a donor’s gift will be treated

as being made half by the donor, and half by her spouse. IRC Sec. 2513. The practical

effect of this is that if Mom, for example, has all the money, but Dad consents, Mom can give

her Daughter $10.5 million in 2013 WITHOUT triggering any gift tax (in effect, Mom is also

using Dad’s $5.25 million AEA). Dad signifies his consent on the gift tax return.

C. Spousal gifts. There is an unlimited marital deduction for spousal gifts, provided that the

donee spouse is a U.S. citizen – if not, the donor spouse can only give the donee spouse

$143,000 a year without eroding any of her $5.25 million AEA (the 2013 inflation-adjusted

numbers).

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D. Valuation. Although the generous exclusion amount ($5.25 million in 2013) gives donors

more breathing room, direct, unfettered gifts of property are generally valued at 100 cents on

the dollar, and more quickly erode a donor’s AEA. To “stretch” this exclusion, therefore,

donors often seek to make discounted gifts. These can include GRATs (grantor retained

annuity trusts) or QPRTs (qualified personal residence trusts – see V.A.1. and .3 above), or

gifts of interests in entities such as limited liability companies or family limited partnerships,

which impose restrictions on the entity members or limited partners and can therefore garner

valuation discounts. Note that when making gifts of hard-to-value property to family members,

donors have been successfully employing “defined value clauses,” which seek to limit the

property given away to a fixed dollar amount; if the IRS successfully challenges that valuation

on audit, the clause will reallocate the excess gift to a charitable donee (see Estate of Petter,

653 F.3d 1012 (9th

Cir. 2011)), or even to the donors themselves (see Wandry v.

Commissioner, T.C. Memo. 2012-88). Be aware, however, that in its Action on Decision,

issued on November 13, 2012, the IRS announced its continuing opposition to Wandry-type

clauses.

E. Tax exclusive vs. tax inclusive. Although gift and estate tax rates are the same (up from

35% to 40% under ATRA), the gift tax is cheaper than estate tax because of how it is

calculated. That is, the gift tax is “tax exclusive,” whereas the estate tax is “tax inclusive.” In

other words, with the gift tax, the donor only pays gift tax on what he transfers; with the estate

tax, the testator pays estate tax not only on the transferred property, but also on the dollars

used to pay the estate tax (it’s a tax on tax). This is easily illustrated using a 50% rate.

Assume that Dad has already used up his AEA, and gives Son $1,000,000. At a 50% rate,

the gift tax is $500,000, and Dad is out of pocket $1.5 million (in terms of total dollars, this

makes for an effective tax rate of 33%). If Dad instead gives Son $1,000,000 under his will,

he needs $2 million: $1 million for the legacy, and $1 million for the estate tax (i.e., at a 50%

rate, the estate tax equals 100% of the legacy). Note that only Connecticut has a gift tax, but

about twenty states (including New York, New Jersey and Connecticut) have an estate tax: if

a donor removes property from his estate while he’s alive, he may also save state estate tax.

VIII. GST basics. The GST, or generation-skipping transfer tax, is difficult to master, and offers many

traps for the unwary. The GST applies to so-called “generation-skipping transfers,” which are

best illustrated in the separate attachment that is part of this presentation. Nevertheless, here is

an overview of the GST and its terminology.

A. The “Players” – Who?

1. Skip Person. An individual who is two or more generations below the transferor’s

generation –

Example: Grandchild is a skip person vis-à-vis Grandma

or a trust – if all of the interests are held by skip persons

Example: a trust that is solely for grandchildren or more remote descendants

– or if no person has an interest in the trust, and no distributions will be made to non-skip

persons after the transfer to the trust. IRC Sec. 2613(a).

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Example: Grandma sets up a trust for grandchildren and more remote descendants, but

requires that income be accumulated for 10 years.

2. Non-Skip Person. Any person who is not a skip person (really, that’s what the Code

says!). IRC Sec. 2613(b).

Example: A child is a non-skip person vis-à-vis Parent; a generation-skipping trust for

children and more remote descendants is a non-skip person as long as the children are

still alive – once the last child is gone, the trust becomes a skip person.

3. Transferor. The individual making the transfer to the skip person. IRC Sec. 2652(a).

Note that if spouses are gift-splitting, each spouse is treated as the transferor with

respect to his or her transfer.

Example: Grandma is the transferor when she makes a gift to Grandchild.

B. Types of generation-skipping transfers – What?

1. Direct Skip. A transfer to a skip person that is subject to estate or gift tax. IRC Sec.

2612(c).

Example: Grandma leaves Grandson $100,000 under her will.

Example: Grandma and Grandpa transfer $2,000,000 into a trust for their grandchildren

and more remote descendants.

2. Taxable Distribution. Any distribution from a trust (other than a taxable termination or a

direct skip) to a skip person. IRC Sec. 2612(b).

Example: Grandma has already used up her GST exemption. She sets up a spray trust

for children and grandchildren. The trustee distributes income to Grandchild.

Note: Grandma’s creation of this trust is not a direct skip (although it is subject to gift tax)

because the trust is not a skip person. Had the trust been solely for grandchildren and

more remote descendants, it would have been a skip person and Grandma’s transfer

would have been a direct skip subject to GST. Grandma’s payment of GST would mean

that each generation of beneficiaries moves up a level, so that grandchildren would be

treated as children, great-grandchildren would be treated as grandchildren, etc. Because

of this shift, subsequent distributions to grandchildren would not be treated as taxable

distributions. Note that this trust is a “GST Trust,” and that Grandma’s creation of it is

an “indirect skip” (see 4. below).

a. Tax-free distributions. Some distributions are free from GST. IRC Sec. 2611(b).

Thus, for example, if the trustee makes a direct tuition or medical payment for a skip

person, this is not a taxable distribution. IRC Sec. 2611(b)(1). Note, however, that

President Obama’s Fiscal Year 2014 Budget proposes to change this commonly held

understanding of the statute, and “clarify” that this tuition and medical exclusion is only

available for living donors. (See III.G. above.)

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3. Taxable Termination. The termination (by death, lapse of time, release of power, or

otherwise) of an interest in property held in trust unless after that termination a non-skip

person has an interest in the property OR there can never be distributions from the trust

to a skip person. IRC Sec. 2612(a).

Example: Grandma sets up a non-exempt spray trust for children and more remote

descendants. Its current beneficiaries are Children, Grandchildren and Great-

Grandchildren. The last surviving child dies, and the current beneficiaries are now

Grandchildren, Great-Grandchildren and Great-Great-Grandchildren. At that child’s

death, there is a taxable termination, and the trust is subject to GST. All of the

beneficiaries move up a generation, so that Grandchildren are treated as Children, Great-

Grandchildren are treated as Grandchildren and Great-Great-Grandchildren are treated

as Great-Grandchildren. Distributions to Grandchildren will no longer be subject to GST.

When all of the Grandchildren die out, there will be another taxable termination and all of

the beneficiaries again will move up a generation.

4. Indirect skip. The 2001 Act brought us IRC Sec. 2632(c), and an important rule: if the

transferor makes an “indirect skip” to a “GST Trust,” any unused portion of the

transferor’s GST exemption will be deemed allocated to this transfer unless the transferor

affirmatively elects out of this rule on a timely filed gift tax return. An “indirect skip” is

any lifetime transfer (other than a direct skip) subject to gift tax that is made to a “GST

trust;” a “GST trust” is any trust that could have a generation-skipping transfer with

respect to the transferor unless it meets one of six exceptions. The automatic allocation

is irrevocable as of the due date for a gift tax return (including extensions) – even if a

gift tax return is not filed. This can be a significant trap for the unwary, especially with

respect to insurance trusts that are NOT intended to be generation-skipping trusts.

Whenever dealing with any trust, it is critically important to understand whether, and to

what extent, the GST may apply, and to not simply rely on deemed allocation rules (see

D. below).

C. Other key terms.

1. Interest. A person has an interest in property held in trust if the person:

a. has a right (other than a future right) to receive income or corpus from the trust;

b. is a permissible current beneficiary of income or corpus and is not a charity; OR

c. is described in IRC Sec. 2055(a) and is a charitable remainder annuity trust or

unitrust, or is a pooled income fund. IRC Sec. 2652(c).

Note: the key thing to remember is that only present interests count for purposes of

determining who or what has an “interest” in trust and whether a trust is, for example, a

skip person. Also, note that charities are assigned to the transferor’s generation, and that

under IRC Sec. 2652(c)(1)(B), a charity’s discretionary interest in trust income or

principal is not sufficient to give charity an “interest” in that trust. Finally, under IRC Sec.

2652(c)(2), an interest which is used “primarily” to postpone or avoid GST will be ignored.

2. GST Exemption. The GST exemption represents the amount of property that a

transferor can protect from GST. Under original IRC Sec. 2631, the GST exemption was

$1 million; in 1998, it was indexed for inflation. The 2001 Act continued that indexing

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through 2003, but as of 2004, increased the exemption to equal the applicable exclusion

amount. Although 2010 dawned with no GST, the 2010 Act reinstated it to January 1,

2010, but with a 0% tax rate (for 2010 only) and a $5 million exemption. The 2010 Act

also provides that the GST exemption equals the basic exclusion amount ($5 million,

indexed for inflation, or $5.25 million in 2013), a change that is now permanent under

ATRA. Note that the GST exemption is NOT portable, unlike the deceased spouse’s

unused exclusion amount (DSUE).

Example: In 2013, Grandma and Grandpa each have an applicable exclusion amount of

$5.25 million and a $5.25 million GST exemption. Together, they can protect $10.5

million from gift and estate tax and GST. If Grandpa dies in 2013, however, without

taking advantage of his $5.25 GST exemption, that dies with him, even though Grandma

can “inherit” his unused $5.25 million exclusion amount, which will let her protect $10.5

million from gift or estate tax in 2013.

3. Inclusion Ratio. The inclusion ratio reflects what portion of the property involved in the

transfer is subject to GST. The inclusion ratio is defined as 1 minus the applicable

fraction that pertains to the trust, or the property involved in the direct skip. IRC Sec.

2642(a)(1).

Example: If a trust’s inclusion ratio is zero, it is not subject to GST; if the trust’s inclusion

ratio is one, it is fully subject to GST. If the trust’s inclusion ratio is greater than zero and

less than one, the trust is partially subject to GST, and all distributions from the trust will

be partially subject to GST.

Note: it is undesirable for a trust to be partially subject to GST. That is because it is not

an efficient use of the GST exemption and administratively, it is much cleaner to have a

trust that is either fully protected from GST or fully subject to it – not something in

between.

a. Treatment of Direct Skips that are Nontaxable Gifts. Under IRC Sec. 2642(c), if a

direct skip is a nontaxable gift, its inclusion ratio is zero. Thus, if Grandma gives

Grandson an annual exclusion gift of $14,000, it automatically has a zero inclusion

ratio, and is protected from GST. Grandma’s direct payments of Grandson’s tuition or

medical expenses are not considered generation-skipping transfers under IRC

2611(b)(1). Similarly, Grandma doesn’t have to allocate any GST exemption to her

annual exclusion gifts into a trust for Grandchild if Grandchild is the only beneficiary

AND the trust is includible in Grandchild’s estate for estate tax purposes.

4. Applicable Fraction. A fraction used to determine how much of the property involved in

the transfer is subject to GST. Its numerator is the amount of GST exemption allocated

to the trust (or allocated to the direct skip property), and its denominator is the value of

the property transferred to the trust (or involved in the direct skip), reduced by any federal

estate tax or state death tax recovered from the trust (relating to the property) or any

charitable deduction allowed with respect to the property. IRC Sec. 2642(a)(2).

Example: In 2012, Grandma and Grandpa haven’t used any of their respective GST

exemptions. They now fund a trust for their descendants with $10.24 million and allocate

their exemptions to the gift. The applicable fraction for this $10.24 million trust is 1:

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$10.24 million of GST Exemption/$10.24 million gift. The trust’s inclusion ratio is

therefore zero (1 minus the applicable fraction of 1), and the trust is fully protected from

GST.

Example: At her death, Grandma has no more GST exemption left. Under her will, she

creates a GST trust for her descendants, and contributes $2 million to the trust. The

applicable fraction for this $2 million trust is zero (0 GST exemption/$2 million legacy).

The trust’s inclusion ratio is therefore 1 (1 minus 0), and the trust is fully subject to GST.

D. Allocation of exemption. Once made, an allocation of GST exemption is irrevocable. IRC.

Sec. 2631(b). When allocating exemption, it is advisable to use a formula provision that will

allocate the largest amount of exemption necessary to produce a zero inclusion ratio (lifetime

allocations are recorded on a gift tax return, and testamentary allocations are recorded on an

estate tax return). There are three deemed allocation rules: 1) deemed allocations to certain

lifetime direct skips; 2) deemed allocations to “indirect skips” to “GST trusts” (mentioned

above); and 3) deemed allocations of any remaining GST exemption at an individual’s death.

Because of these deemed rules, it is advisable to affirmatively show on the relevant tax return

whether exemption is allocated to a specific transfer, or whether you wish to opt out of a

deemed allocation rule. A solid paper trail makes it much easier to know the extent to which

donors have used their GST exemptions, and how much they have left. The point of these

deemed allocation rules is to make sure that generation-skipping transfers are protected from

GST and not inadvertently exposed to it because of the failure of the donor (or, more likely,

his tax preparer!) to allocate GST exemption to the transfer.

Note re: Crummey trusts: it is generally not a good idea to fund a generation-skipping trust

with annual exclusion gifts, since the Crummey withdrawal holders can become transferors

with respect to the additions. As mentioned in the Gift Tax section (see VII.A.1), unless the

additions are limited to the greater of $5,000 or 5% of the trust principal (a “5 & 5 amount”),

the beneficiaries should have “hanging powers” (the continuing right to withdraw annual

contributions in excess of the 5 & 5 amount) so that the lapse of their withdrawal power is not

a taxable gift. If the beneficiary dies with hanging powers outstanding, he has an includible

asset in his estate and therefore becomes the transferor as to that amount – thereby wasting

part of Mom and Dad’s GST exemptions. (The same is true even if the addition is limited to

the 5 & 5 amount if the beneficiary dies during the limited withdrawal period.)

E. Qualified severances. If someone’s will doesn’t create separate GST trusts, but has

boilerplate language that permits creating such trusts or such trusts are permitted under local

law, a “qualified severance” can help. Prior to the 2001 Act, the only option was to sever the

trust under IRC Sec. 2654(b) and Treas. Reg. § 26.2654-1(b) before filing the transferor’s

estate tax return. Thus, there could be no “after the fact” division once GST exemption had

been allocated to the trust. The 2001 Act liberalized these rules, so that under IRC Sec.

2642(a)(3), effective as of January 1, 2001, if a single trust is split in a “qualified severance,”

the resulting trusts will be treated as separate trusts for GST purposes. On August 2, 2007,

the IRS issued final regs under 2642(a)(3) (T.D. 9348), and clarified that qualified severances

under IRC Sec. 2642(a)(3) are prospective from the date of severance, and typically occur

after a trust has been in existence for some time; they can apply to trusts that may or may not

be includible in the transferor’s estate. The final regs are effective for severances occurring

on or after August 2, 2007.

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F. The Tax Itself. So how much is the GST? How is it calculated and who pays it?

1. The amount of tax. The amount of tax imposed by the GST is the “taxable amount”

times the “applicable rate.” IRC Sec. 2602.

a. The “taxable amount” depends on what kind of generation-skipping transfer is

involved. With:

i. a taxable distribution, the taxable amount is the value of property received by the

transferee minus any expense incurred by the transferee in connection with the tax.

If the trust making the taxable distribution pays the GST due on the distribution, the

payment is also treated as a taxable distribution. IRC Sec. 2621.

ii. a taxable termination, the taxable amount is the value of all property subject to the

taxable termination, minus a deduction for expenses (similar to a section 2053

deduction) relating to the property. IRC Sec. 2622.

iii. a direct skip, the taxable amount is the value of the property received by the

transferee. IRC Sec. 2623.

2. The “applicable rate” is the top Federal estate tax rate times the inclusion ratio of the

transfer. IRC Sec. 2641. Thus, if the transferred property has an inclusion ratio of 1,

and the top transfer tax rate is 40%, the GST rate on the transfer is also 40%.

3. Credit for state GST. Prior to January 1, 2005, if a taxable distribution or taxable

termination occurred “at the same time as and as a result of” someone’s death, a credit

of up to 5% was allowed for any state GST actually paid in connection with the transfer.

IRC Sec. 2604.

4. Note about New York’s GST credit. New York’s estate tax and GST laws work off the

federal tax laws that were in effect “on or before July 22, 1998,” the date the IRS

Restructuring and Reform Act of 1998, Pub. L. 105-206, was enacted. (On the GST

front, that Act authorized indexing the original $1 million GST exemption for inflation.)

Because of this “frozen” reference to federal tax law, New York does not recognize the

following changes under the 2001 Act: 1) the increasing GST exemption, 2) lower

transfer tax rates, and 3) the phase-out of the state death tax credit and the state GST

credit. Thus, even though the federal credit for state GST disappeared in 2005, New

York still collects its GST tax on taxable distributions and taxable terminations occurring

at the same time as and by reason of an individual’s death. The rate is 2.75%, which is

55% of the federal GST credit under pre-2001 Act law.

G. Who’s responsible for the tax? This again depends on what type of generation-skipping

transfer is involved. IRC Sec. 2603. With

1. a taxable distribution, the transferee is liable for the tax.

Example: In 2009, when the top estate tax rate was 45%, Greta Granddaughter received

a taxable distribution of $20,000 from a trust with an inclusion ratio of 1. Greta owed

$9,000 of tax. If the trustee paid that $9,000 from other trust property, Greta was treated

as receiving a taxable distribution of $29,000, on which GST of $13,050 was payable.

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2. a taxable termination, if there’s a taxable termination or a direct skip from a trust, the

trustee is liable for the GST.

Example: In 2012, the last of Grandma’s children died. They were beneficiaries of a

non-exempt spray trust Grandma created for her descendants. As there were no longer

any non-skip persons with interests in the trust, there was a taxable termination, even

though the trust continues for Grandma’s grandchildren and more remote descendants.

At the surviving child’s death, the trust was worth $5 million. The trustee paid the $1.75

million of GST that was owed.

3. a direct skip, if there’s a direct skip (other than from a trust), the transferor is liable for

the GST. IRC Sec. 2603. His payment of the GST is also a taxable gift. IRC Sec. 2515.

Example: In 2012, Grandpa, who’d already used up his GST exemption, gave

Grandchild $1 million. In addition to whatever gift tax Grandpa owed on the $1 million, he

also owed gift tax on the $350,000 of GST.

H. Where does the tax money come from? Unless the governing instrument says otherwise

by specific reference to the GST, the GST is charged to the property involved in the

generation-skipping transfer. IRC Sec. 2603(b).

I. Where and When is the Tax Reported?

1. Form 706 – the estate tax return. In addition to being the form for reporting the

decedent’s estate tax and electing portability, if applicable, the 706 is where the executor

allocates GST exemption to generation-skipping transfers and pays any GST on direct

skips at a decedent’s death. GST transfers from the decedent’s estate are reported on

Schedule R, and transfers from a trust that was includible in the decedent’s estate are

reported on Schedule R-1. The 706 is due nine months after date of death, or fifteen

months after death with a filing extension.

2. Form 709 – the gift tax return. With the gift tax return, the donor allocates GST

exemption to inter vivos gifts in trust on Schedule D, which is also where the calculation

of GST on a direct skip is shown (remember that the payment of GST is also subject to

gift tax). The gift tax return is due on April 15th

of the following year, or October 15th

with

a filing extension. If the donor allocates exemption on a timely filed gift tax return, he

uses the value of the gift. IRC Sec. 2642(b)(1)(A). If the gift is subject to an ETIP (the

estate tax inclusion period, which precludes allocating exemption until, say, the grantor’s

interest in an irrevocable trust has terminated), the donor must use the value at the close

of ETIP. If the return is not timely, the donor uses the value of the gift when he makes

the allocation. IRC Sec. 2642(b)(3).

3. Form 706-GS(D-1) – notification of distribution from a generation-skipping trust. A

trustee of a trust from which a taxable distribution is made files two copies of this form –

one with the IRS and one with the beneficiary who received the distribution – by April 15th

of the subsequent year. The trustee must file this return even if the distribution isn’t

subject to GST because its inclusion ratio is zero. The following distributions are not

considered taxable distributions that must be reported: 1) the trustee’s direct payment of

tuition or medical expenses if that payment would have been excluded under IRC Sec.

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2503(e) if made by an individual; 2) a distribution of property that was previously subject

to GST if the person who received that prior distribution was in the same as, or lower,

generation as the recipient of the current distribution.

4. Form 706-GS(D) – the generation-skipping transfer tax return for distributions. The

recipient of a taxable distribution uses this return to report the distribution and pay GST, if

any. The recipient is not required to file this return if all distributions reported to the

recipient had a zero inclusion ratio. The return is due by April 15th

of the following year,

or October 15th

with a filing extension.

5. Form 706-GS(T) – the generation-skipping transfer tax return for terminations. The

trustee of a trust that has had a taxable termination files this return for the year the

termination occurred. The instructions to the form explain that in general “all taxable

terminations are subject to the GST tax,” although the following trusts are not subject to

GST: trusts that were irrevocable on September 25, 1985, and trusts that were

irrevocable on that date AND hold property for which a QTIP election was made.

Additions, including constructive additions (see below), to such irrevocable trusts can

subject part of the trust to GST. The trustee doesn’t need to file the return if all of the

property involved in the termination has been applied to the beneficiary’s medical or

tuition expenses, such that the payment would have been excluded under IRC Sec.

2503(e) if made by an individual. Note that “qualified severances” are also reported on

this form. See Prop. Reg. § 26.2642-6(b)(6) and VIII.E. above.

Note re: direct tuition and medical payments. As noted above (see III.G and

VIII.B.2.a), President Obama’s Fiscal Year 2014 Budget proposes to “clarify” that this

exclusion for direct tuition and medical payments under IRC Sec. 2611(b)(1) is ONLY

available to living donors. Yet the instructions to the 706-GS(D-1) and 706-GS(T) clearly

state that such direct payments are NOT generation-skipping transfers and need not be

reported. Thus, if the proposal is enacted, it would change the statute, rather than merely

“clarifying” it.

6. The bottom line. Trustees are supposed to file the 706-GS(D-1) and 706-GS(T) even if

the trusts in question have zero inclusion ratios. Trustees should therefore keep

excellent records (including old gift tax returns) to prove precisely what the transferor did

with respect to his exemption. Only trustees of trusts that pre-date the GST effective

date rules (see below) are exempt from the filing requirements.

J. Effective Date Rules. In general, the GST applies to generation-skipping transfers after

October 22, 1986. There are, however, certain exceptions to these rules.

1. Mental disability rule. If an individual was under a mental disability continuously from

October 22, 1986 until his death, and therefore couldn’t change the disposition of his

property, GST won’t apply to trust property includible in the incompetent’s estate or

property that is transferred as a direct skip (other than a direct skip from a trust) because

of the incompetent’s death. Treas. Reg. § 26.2601-1(b)(3).

2. Trusts that were irrevocable as of September 25, 1985. If a trust was irrevocable as of

September 25, 1985, the GST does not apply to the trust unless there is something about

the trust, such as a general power of appointment (discussed at 5. below), that

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“ungrandfathers” it – i.e., subjects the trust to GST. (A trust is considered irrevocable as of

September 25, 1985 unless the property would be includible in the grantor’s estate under

IRC Sec. 2038 (e.g., the trust is revocable by settlor, or the settlor has the power to

change beneficial interests) or the settlor has incidents of ownership over life insurance

such that it would be includible in his estate under IRC Sec. 2042. Treas. Reg. § 26.2601-

1(b)(1)(ii).)

3. Application to QTIP trusts. If the QTIP trust was in existence as of September 25,

1985, GST does not apply to the trust. Treas. Reg. § 26.2601-1(b)(1)(iii).

4. Additions to irrevocable trusts. If an addition is made to a trust that was irrevocable on

September 25, 1985, the trust will be deemed to consist of two portions: the

“grandfathered” portion (i.e., the portion that is not subject to GST) and the

“ungrandfathered” portion (i.e., the portion that is subject to GST, which consists of

property contributed after the effective date). Treas. Reg. § 26.2601-1(b)(1)(iv).

5. Constructive additions. A constructive addition refers to what may happen to

ungrandfather a trust because of the release, exercise or lapse of a general power of

appointment. Treas. Reg. § 26.2601-1(b)(1)(v). In other words, even if the holder of a

general power of appointment over a “grandfathered” trust does not exercise his power,

the lapse of the power is treated as if the holder withdrew the property and immediately

retransferred it to the trust. With respect to the exercise of a limited power of

appointment, there will not be a constructive addition if the exercise does not “postpone

or suspend the vesting, absolute ownership or power of alienation of an interest in

property” beyond the applicable perpetuities period for the trust. Treas. Reg. § 26.2601-

1(b)(1)(v)(B)(2).

6. Modifications to irrevocable trusts. Treas. Reg. § 26.2601-1(b)(4) sets forth the rules

regarding when a modification, judicial construction, settlement agreement or trustee

action may “ungrandfather” an otherwise grandfathered trust. In general, a trust will still

be grandfathered if the modification doesn’t change a beneficial interest to someone in a

lower generation or postpone the vesting period. Treas. Reg. § 26.2601-1(b)(4)(i)(D).

K. “Gallo exclusion” for direct skips to grandchildren. §1433(b)(3) of the 1986 Tax Reform

Act created a special rule for direct skips to grandchildren. It was known as the “Gallo

exclusion” after the family that lobbied for this transition rule; it provided that if Grandma or

Grandpa transferred no more than $2 million to a grandchild after September 25, 1985 but

prior to January 1, 1990, the transfer would not be considered a direct skip and would be

exempt from GST. If the transfer was in trust, the trust could only be for that grandchild and

had to be includible in the grandchild’s gross estate; if the transfer occurred after June 10,

1987 (and prior to January 1, 1990), the grandchild was required to receive all of the trust’s

income once he or she reached age 21. Because the grandchild was treated as having

moved up to the child’s generational level, no trust distributions to the grandchild would be

treated as taxable distributions.

IX. To wrap up. Although ATRA brought “permanent” stability to transfer taxes, “permanent” in tax

law parlance simply means that there is no built-in expiration date for the particular provision.

Nothing precludes Congress from revisiting ATRA at a later date, and as part of a possible

(larger) tax reform package. Yet it is difficult to believe that Congress would want to change

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these provisions any time soon, given how contentious ATRA’s last-minute negotiations were.

Nevertheless, transfer taxes are hot button items, with some passionately devoted to forever

eliminating them, and others equally devoted to increasing them. Still, once exclusion and

exemption amounts go up, they don’t seem to go down. May this guide be helpful to you!

The opinions and analyses expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank AG orany affiliate thereof (collectively, the “Bank”). Any suggestions contained herein are general, and do not take into account anindividual’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject tochange. No warranty or representation, express or implied, is made by the Bank, nor does the Bank accept any liability with respectto the information and data set forth herein. The information contained herein is not intended to be, and does not constitute, legal,tax, accounting or other professional advice; it is also not intended to offer penalty protection or to promote, market or recommendany transaction or matter addressed herein. Recipients should consult their applicable professional advisors prior to acting on theinformation set forth herein. This material may not be reproduced without the express permission of the author. "Deutsche Bank"means Deutsche Bank AG and its affiliated companies. Deutsche Asset & Wealth Management represents the asset managementand wealth management activities conducted by Deutsche Bank AG or its subsidiaries. Clients are provided Deutsche Asset &Wealth Management products or services by one or more legal entities that are identified to clients pursuant to the contracts,agreements, offering materials or other documentation relevant to such products or services. Trust and estate and wealth planningservices are provided through Deutsche Bank Trust Company, N.A., Deutsche Bank Trust Company Delaware and Deutsche BankNational Trust Company.

Skip Person - Individuals Skip Person - Trust Non-Skip Person - Trust

Sister GP (Transferor) Brother GP (Transferor) GP (Transferor)

GNephew GC GNiece

GC GCGC

GGC GGC

C C C

GC GC

GGC

Child Child Child

2 or more generations below Transferor (T)(“Non-Skip Person” = any person

who is not a Skip Person)

Interests are held by Skip Persons

Direct Skip Indirect Skip Taxable Distribution

GPGP

C

GC

GC GCGC

GGC

C C

GC GC

C C

GC GCGC

GCDistribution

GP

Transfer subject to gift or estate taxTO a Skip Person

Lifetime transfer subject to gifttax (other than a Direct Skip)TO a GST Trust

Any distribution from a trust (other thana Taxable Termination or a Direct Skip)TO or for the benefit of a Skip Person

Taxable Termination Generation Assignment – Non-Lineals

C C

GC GC

GGC GGC

C

GC GC

GGCTrust interest terminates and noNON-SKIP persons left- Everyone moves up a generation- Tax imposed

T Friend – born within 12 ½ years of Transferor (T)

(C) Friend – born within > 12 ½ years but ≤ 37 ½ years of T

(GC) Friend – born > 37 ½ years after T

Same rule every 25 years

GST IllustrationsBlanche Lark Christerson June 2013

The opinions and analyses expressed herein are those of the author and do not necessarily reflect those of DeutscheBank AG or any affiliate thereof (collectively, the “Bank”). Any suggestions contained herein are general, and do nottake into account an individual’s specific circumstances or applicable governing law, which may vary from jurisdictionto jurisdiction and be subject to change. No warranty or representation, express or implied, is made by the Bank, nordoes the Bank accept any liability with respect to the information and data set forth herein. The information containedherein is not intended to be, and does not constitute, legal, tax, accounting or other professional advice; it is also notintended to offer penalty protection or to promote, market or recommend any transaction or matter addressed herein.Recipients should consult their applicable professional advisors prior to acting on the information set forth herein.This material may not be reproduced without the express permission of the author. "Deutsche Bank" means DeutscheBank AG and its affiliated companies. Deutsche Asset & Wealth Management represents the asset management andwealth management activities conducted by Deutsche Bank AG or its subsidiaries. Clients are provided DeutscheAsset & Wealth Management products or services by one or more legal entities that are identified to clients pursuantto the contracts, agreements, offering materials or other documentation relevant to such products or services. Trustand estate and wealth planning services are provided through Deutsche Bank Trust Company, N.A., Deutsche BankTrust Company Delaware and Deutsche Bank National Trust Company.