Estate Plan Pitfall: Automatic Allocation of GST Exemption

Many estate planning clients put a lot of time, energy and money into structuring their estate plans in light of the uncertainties in our estate tax laws. These more complicated tax-motivated estate plans can produce additional tax problems for the unwary estate planning attorney and client.

Private Letter Ruling 200709010 addresses the situation where an estate planning client creates an estate plan intending to effectively use their $1 million generation skipping transfer tax exemption, but the client continues to make post-December 31, 2000 transfers to their irrevocable trust which benefits their grandchildren or other “skip persons.”

As the private letter ruling indicates, the transfers to such irrevocable trust are “indirect transfers” that automatically use up the estate planning client’s unused generation skipping transfer tax exclusion amount if the estate planning client does not elect out of the automatic allocation. This election has to be made by the client by filing an “election out” statement to their Form 709 Federal Gift Tax Return for the year in which the gift is completed.

If the estate planning client does not make this automatic allocation election, then the estate planning client may not have a sufficiently large generation skipping transfer tax exemption upon his or her demise, as may be required by the estate planning client’s estate planning documents.

Luckily the IRS, as is the case in this private letter ruling, is generally willing to allow estate planning clients to make this election by submitting a private letter ruling request prior to the IRS discovering the issue.

Clients who intend to take full advantage of their generation skipping transfer tax exemption should contact their estate planning attorney to review their estate plan in light of this issue.

Income Beneficiaries of Older Trusts Should Consider Making Unitrust Election

In a recent private letter ruling (15529705), the IRS has confirmed that a generation skipping transfer (GST) tax grandfathered trust will not lose its exemption if a court modifies the trust to permit the income beneficiary to receive unitrust payments.

The facts for the ruling are as follows. Taxpayer creates a testamentary trust (a trust in his/her will) that specifies that when the taxpayer dies the trust will pay income to taxpayer’s surviving spouse and upon spouse’s demise the trust will pay all income to the taxpayer’s children and, upon the childrens’ demise, to the childrens’ descendants.

The taxpayer and the taxpayer’s spouse die. The taxpayer’s children now want to petition the court to permit the trust to pay the children unitrust payments, rather than fixed payments. Unitrust payments are payments equal to a percentage of the trust assets (typically between 2% and 5%).

Absent a unitrust payout the trust would continue to pay all income to the trust beneficiaries. Income typically only refers to interest payments and dividends – not capital gains or gains associated with sell of investments. If there is no unitrust provision, the current income beneficiary (as opposed to future income beneficiaries, such as the taxpayer’s children’s descendants in this case) may prefer that the trustee invest primarily in income producing assets.

The problem with this is that investing a substantial portion of the trust assets in interest/dividend bearing investments will, as the argument goes, diminish the value of the trust assets over time because investments which have typically under performed capital gain assets, such as stocks.
In other words, the trustee may be able to maximize the value of the trust assets if he or she can invest a larger portion of the trust assets in stocks, grow the trust assets for the future beneficiaries.

Unitrust payments eliminate this conflict of interest between current income beneficiaries (such as the taxpayer’s children) and the future income beneficiaries (such as the taxpayer’s children’s descendants).

If the trust document does not provide for unitrust payments (or provide the trustee with the discretion to opt to start paying unitrust payments), the current income beneficiary (with the consent of the future income beneficiaries) must ask a court to alter the trust so that such payments can be made. This type of court intervention is very common, as the unitrust concept is relatively new compared to the age of a majority of trusts that exist today.

The problem addressed in this letter ruling arises when a trust was created before September 1985, the date that the generation skipping transfer (GST) tax was enacted. The GST tax only impacts trusts created after this date. Trusts created (and that were irrevocable) before this date are grandfathered or exempt from the GST tax.

So the question answered by this letter ruling is whether a GST tax exempt trust would lose its exemption if the court changed the trust to provide for unitrust payments. The IRS said that it would not.

Given this ruling, beneficiaries of older trusts should contact their estate planning attorneys to review whether they should modify their trusts to provide for unitrust payments.