THE GST TAX—A DEEP DIVE: WHAT EVERY DEVELOPMENT OFFICER NEEDS TO KNOW

Nancy E. Dempze

Charles R. Platt

Hemenway & Barnes LLP

Boston, Massachusetts

Hemenway & Barnes ©2014 960826

Background—Transfer Taxes

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Background—Transfer Taxes

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• Federal estate tax is designed to impose a tax on the transfer of wealth at death

• The Federal gift tax is imposed on gifts during life—

without a gift tax the estate tax could be easily avoided through lifetime (or even deathbed) giving

• The Federal generation-skipping transfer (“GST”) tax is

imposed on transfers that would otherwise avoid estate or gift tax at one generational level

Background—Transfer Taxes

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• While the current estate tax rate is 40%, at times it has been much higher

• For instance, in the late 1970s and early 1980s the top estate tax rate was 70%, and it has been as high as 77%

• Thus for wealthy families, there has always been and continues to be a tremendous financial incentive to minimize this tax.

Before 1976

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Before 1976

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• Prior to 1976, there was an estate tax but there was no generation-skipping transfer tax

• Wealthy families (with the help of savvy estate planning lawyers) came to realize that by transferring assets to grandchildren and great-grandchildren, they could bypass estate tax in the “skipped” generations

• This could be done through outright gifts or the use of trusts

Tax Savings Could Be Huge

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• With a 40% estate tax, if a great-grandparent left $1,000,000 to grandparent, who spent only the income and left the remaining principal to parent, who spent only the income and left the remaining principal to great-grandchild, the great-grandchild would be left with $216,000

• If instead, the great-grandparent left $1,000,000 for the

great-grand-child directly, there would be only one imposition of estate tax, and the great-grandchild would receive $600,000—almost 3x as much

The Tax Reform Act of 1976

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• There was a widespread belief that this “skipping” of generations of estate tax was a form of tax avoidance

• In the Tax Reform Act of 1976, a generation-skipping transfer tax (Chapter 13 of the Internal Revenue Code) was introduced to impose an additional tax on generation-skipping transfers

• However the rules were extremely complex, there was a lengthy transition period, and the law was largely ignored before being repealed

1986

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Tax Reform Act of 1986

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• In 1986 the Generation-Skipping Transfer (“GST”) Tax was revamped and set the framework for the GST tax as we know it today

• Fundamentally the idea of the GST Tax is to neutralize the tax savings that would otherwise be realized by skipping a generation of estate tax

• Thus the GST tax is an additional tax levied at 40%

When Is GST Tax Imposed

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• 3 Scenarios Where a GST tax can be Incurred

• Direct Skip

• Taxable Distribution

• Taxable Termination

Direct Skip

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Direct Skip

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• A direct skip is the most obvious event that can trigger GST tax—a direct skip occurs when someone gives (during life) or leaves (at death) assets to a recipient two or more generations below them ( a “skip person”)

• An outright gift or bequest

• A gift or bequest to a trust whose sole

beneficiaries are skip persons

Taxable Distribution

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• A taxable distribution occurs when a trust makes a distribution to a beneficiary who is a skip person relative to the person who established the trust (only if the initial transfer to the trust was not already a GST event)

• Example: Grandparent establishes a trust for

benefit of children and grandchildren. Funding the trust is not a GST event b/c the trust has beneficiaries other than skip persons—but a distribution from the trust to a skip person is a “taxable distribution” that will incur GST tax

Taxable Termination

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• A taxable termination occurs when a trust that had been established for the benefit of skip persons and non-skip persons now can only benefit skip persons

• This will usually be a death—for instance,

Grandmother establishes a trust for all of her descendants. At the death of the last of her children, this will be a taxable termination, because all of the remaining beneficiaries are skip persons.

Who is responsible for the tax?

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• Direct Skip: The transferor

• Taxable Distribution: The recipient

• Taxable Termination: The trust

Who is responsible for the tax?

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• Taxable Distributions and Taxable Terminations are

actually taxed at a much higher effective rate than Direct Skips

• Assume goal is to get $1,000,000 to grandchild

– Direct Skip: Grandparent gives $1,000,000 to Grandchild and pays $400,000 in GST tax (40% * $1,000,000)—total cost = $1,400,000

– With a taxable distribution or taxable termination, the 40% applies to the entire trust or distribution, including the tax—you pay tax on the tax.

– So in order to get the grandchild $1,000,000 net of tax, there needs to be a distribution of $1,666,6667 and total GST tax is $666,667

Who is a skip person?

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Who is a skip person?

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• In family context, a skip person is someone 2 or more generations removed

from the transferor • However, there is a “predeceased ancestor” exception—if there is a

grandparent, parent, and grandchild, and then the parent dies—the grandchild is “stepped up” a generation for GST tax purposes, and a transfer from the grandparent to the grandchild will no longer incur GST tax.

• With trusts, this only applies if the parent was deceased at the time the trust was established (not at time of distribution)

• A similar rule applies if someone dies within 90 days after receiving property at death—if grandparent makes a bequest to child, if living, or if not, to grandchild, and child survives grandparent but dies within 90 days of grandparent’s death, the bequest to the grandchild is not a GST transfer

Who is a skip person?

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• Outside family context, a skip person is someone more than 37.5 years

younger than the transferor • But a person is considered to be in the same generation as his or her

spouse if the transferor is in the spouse’s family • So if a 90 year old grandparent makes a gift to his 30-year old daughter-in-

law, this will not be a generation-skipping transfer, because the daughter-in-law will be considered only one generation lower by virtue of marriage to the grandparent’s child

Charities as Beneficiaries of Trust

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• Any charity or governmental entity is assigned to the same generation as a transferor

• However, if a trust is set up so that charities are discretionary, but

not mandatory recipients of income or principal, they won’t be considered to have an interest in the trust for the purposes of determining when a direct skip or taxable termination occurs

• So if a grandparent transfers assets to a trust over which the trustee has discretion to distribute among grandchildren and charities, the distribution to the trust will be a direct skip

GST Annual Exclusion

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• A person can give $14,000 ($28,000 if married and splitting gifts) per year to skip persons without triggering GST tax

• These amounts are adjusted upward for inflation periodically

• For transfers in trust to qualify for this exclusion, the trusts

must have very specific terms with withdrawal powers for the beneficiary

Medical and Education Payments

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• Any payments made directly to medical or education providers are exempt from GST tax

• For education—only tuition, not books or lodging • Payments to 529 plans for grandchildren qualify

Grandfathered Trusts

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• Trusts established and funded before 1986 are exempt from GST tax

• Must be careful not to do anything

that would be considered a modification of such a trust—otherwise risk losing grandfathered status

GST Exemption

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• Much like the estate tax and the estate tax exemption, each person is allotted a “GST exemption,” which can be allocated to shield assets from the imposition of GST tax where it would otherwise occur

• Current GST Exemption is $5,340,000 per person, and is

indexed for inflation • If GST exemption is allocated to a trust at time of transfer,

future distributions to skip persons will not incur a GST tax

GST Exemption

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• As is the case with gift tax and estate tax exemption, GST exemption used during life will reduce the amount available at death

• GST exemption is automatically allocated in certain instances (for

instance, to direct skips, and to trusts with provisions that are such that they are likely to benefit skip people)

• When filing a gift tax return, you can also elect to allocate GST

exemption to a transfer (or elect to “opt out” of allocating GST exemption to a transfer that would otherwise qualify for automatic allocation)

Why You Care About GST Tax

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Why You Care About GST Tax

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• When people consider planning issues relating to the GST tax, the goal is generally to maximize assets passing to future generations--charitable distributions not likely to be a major component of a GST plan

• However, it is important for charitable planners and

development officers to understand the GST tax—since it is likely to be a factor in the estate plans of the very wealthy—the same people who are most likely to make significant provisions for charity

Why You Care About GST Tax

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• Important to be knowledgeable about implications of GST taxes and strategies to address GST tax, as GST considerations may affect donors’ overall appetite for charitable giving

• For instance: “I’d love to be able to give more to XYZ

Organization but I’m also concerned about education and opportunities for my grandchildren”

Charitable Remainder Trusts

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• With a charitable remainder trust (CRT), the trustees make distributions to individual beneficiaries for a term of years (or for the remainder of an individual’s life), with charitable organizations receiving the remaining trust assets when the trust ends

• The transferor receives a charitable deduction for both

income and gift tax purposes equal to the amount of property that will be expected (based on IRS-proscribed assumed interest rate) to pass to charity at the termination of the CRT

Charitable Remainder Trusts

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• Because all charities are deemed to be in the same generation as the transferor, and because a charity will always have a remainder interest in a CRT, a transfer to a CRT will never be a direct skip, and a CRT can never have a taxable termination

• However, it would be possible to have a taxable distribution from a CRT, if assets are distributed from the CRT to a skip person

• If the transferor believes that transfers will likely be made to skip

persons, the transferor can elect at the outset of the trust to allocate GST exemption to the CRT

Charitable Remainder Trusts

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• In calculating the amount of GST exemption necessary to make the

CRT GST-exempt, the charitable deduction is factored in, thereby reducing the amount of GST exemption necessary to allocate

• To make the trust fully GST-exempt, the transferor would need to

allocate an amount of GST exemption equaling the amount transferred to the CRT less the amount qualifying for the charitable deduction

Charitable Lead Unitrusts

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• With a charitable lead unitrust (CLUT), a charity or charities receive a percentage of the trust assets each year for a term of years; at the end of the term of years, an individual or individuals receive the assets remaining in the trust

• Through calculations using the IRS-proscribed interest rate, one can

calculate at the outset of the trust how much is expected to pass to the remainder beneficiary—this is necessary to calculate to determine the amount of the taxable gift (if any)

• If it is possible that the remainder beneficiary will end up being a

skip person, the transferor can prevent the imposition of GST tax at the termination of the trust by allocating GST exemption at the outset

Charitable Lead Unitrusts

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• The amount of the GST exemption necessary to allocate to make the CLUT fully GST-exempt is the amount that is expected to pass to the individuals using the IRS-proscribed interest rate calculation

Charitable Lead Annuity Trusts

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• With a charitable lead annuity trust (CLAT), a charity or charities receive a fixed amount each year for a term of years; at the end of the term of years, an individual or individuals receive the assets remaining in the trust

• As with CLUTs, through calculations using the IRS interest rate, one

can calculate at the outset of the trust how much is expected to pass to the remainder beneficiary—this is necessary to calculate to determine the amount of the taxable gift (if any)

Charitable Lead Annuity Trusts

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• However, there is an important difference between CLATs and CLUTs with respect to GST tax

• With a CLAT, the transferor can allocate GST exemption to the

amount that is expected to pass to the individuals using the 7520 rate calculation—however this does not ensure that the remainder will end up being wholly GST-exempt

• If the CLAT outperforms the IRS-proscribed interest rate, so that

more assets end up passing to the remainder beneficiary than expected, then either (i) the remainder interest will be partially GST-exempt, or (ii) additional GST exemption will need to be allocated to make it wholly GST-exempt

Other Considerations

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• When there are multiple family trusts in place, it is important to consider their status with respect to GST tax and making distributions

• For instance, if there are two trusts, both for the benefit of family

members and charities, but one was established and fully funded before 1986 (thereby exempt from GST tax), and the other funded after 1986 without any allocation (automatic or affirmative) of GST tax, then any distributions to charity, should, all other things considered, be made out of the post-1986 trust, since the other trust is GST-protected and has the flexibility to benefit future generations without attendant GST tax

Planning Opportunities

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Contact Information

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Nancy E. Dempze, ndempze@hembar.com, 617-557-9726 Hemenway & Barnes LLP 60 State Street Boston, MA 02109 Charles R. Platt, cplatt@hembar.com, 617-557-9757 Hemenway & Barnes LLP 60 State Street Boston, MA 02109