Estate Planning Alert

February 14, 2002 Advisory


Introduction

Trusts are frequently used by our clients as a component of an overall wealth transfer strategy. The trust terms often create the potential for distributions to multiple generations of beneficiaries. This Alert describes an important change in the tax law that will affect clients who have created such trusts.

New Law Changes GST Exemption Automatic Allocation Rules

As a result of the Economic Growth and Tax Relief Reconciliation Act (the "Act") signed into law by President Bush in 2001, significant changes have gone into effect regarding the automatic allocation of generation-skipping transfer tax ("GST") exemption. These changes will result in unintended GST exemption allocation for many taxpayers unless affirmative steps are taken.

Imposition of GST and the GST Exemption

Gratuitous transfers to "skip persons" are generally subject to GST. A skip person is an individual assigned to a generation that is two or more generations below that of the transferor; commonly a grandchild. The most significant relief from imposition of GST is the GST exemption, which allows every individual to transfer a certain amount of property during life or at death (currently $1,100,000) to skip persons without incurring GST.

Traditional Automatic Allocation Rules

The Internal Revenue Code attempts to minimize inadvertent imposition of GST by providing for the automatic allocation of GST exemption to certain types of transfers. Prior to the Act, GST exemption was automatically allocated only to outright transfers to skip persons or to transfers into trusts established solely for the benefit of skip persons.

Expansion of Automatic Allocation Rules

The Act expands the automatic allocation rules to include transfers to "GST trusts," which are defined as trusts that could have a generation-skipping transfer with respect to the transferor. As a result, for transfers made in 2001 and thereafter, GST exemption may be automatically allocated to trusts established primarily for children, or a spouse and children, because grandchildren become beneficiaries in the event of a child's untimely death. Consequently, GST exemption may be wasted on transfers to trusts that will not make distributions to skip persons.

Undesirable Automatic Allocation to Common Types of Trusts

Although the Act provides exceptions that will prevent a number of trusts that could have a generation-skipping transfer from being deemed a GST trust, several common trusts will not be excluded from characterization as a GST trust. Most notably (but not exclusively), a typical insurance trust benefiting a surviving spouse and continuing after the death of the surviving spouse until children reach specified ages will, in many cases, be a GST trust. Accordingly, GST exemption will be automatically allocated to transfers (premiums paid in 2001 and thereafter) made to these trusts which are deemed to be GST trusts. The automatic allocations will often not be what the transferor expects since in most cases the trust assets will be distributed to non-skip persons (spouse and/or children).

Undesirable Allocation to Trusts Subject to an ETIP

A significant concern also arises in connection with trusts that are subject to an Estate Tax Inclusion Period ("ETIP"). A trust is subject to an ETIP if the trust property would be included in the grantor's estate if he or she died during the trust term. The most common examples of trusts subject to an ETIP are Qualified Personal Residence Trusts ("QPRT"s) and Grantor Retained Annuity Trusts ("GRAT"s). GST exemption may be automatically allocated to QPRT or GRAT property at the conclusion of the term of the grantor's retained interest (if this occurs in 2001 or thereafter), regardless that no additional transfers are made to the QPRT or GRAT, and notwithstanding that the primary beneficiaries may be children.

Election Out of Automatic Allocation Rules

Taxpayers can opt out of the GST exemption automatic allocation rules on a timely filed gift tax return (April 15, 2002 for 2001 transfers). The election can be with respect to a particular transfer, or a single election can be made to not have the automatic allocation rules apply to any and all transfers made by the transferor to a particular trust.

Conclusion

Grantors who have made contributions to trusts in 2001, or who may have a trust subject to an ETIP as of December 31, 2000, should obtain advice to determine what elections, if any, should be made on 2002 gift tax returns regarding the application of the automatic allocation rules to their trusts.

Questions?

Please feel free to call or email us to discuss how these complex rule changes may affect your estate planning goals.

This document is intended as an informational reminder and does not constitute legal advice for any specific factual situation. If you would like more information or would like to discuss a particular situation, contact a member of Wiggin & Dana's Trusts and Estates Department .