Under Internal Revenue Code Section 2642(f)(1), the grantor of a trust cannot effectively allocate generation-skipping transfer (GST) tax exemption to property transferred until the close of the estate tax inclusion period (ETIP). The ETIP is the period of time after a transfer during which the value of the property transferred would be includible in the transferor's gross estate (other than by reason of IRC Section 2035, which brings certain transfers within three years of death back into the taxable estate) if the transferor died.1 A transfer of property to a grantor retained annuity trust (GRAT), for example, is subject to the ETIP rule because, although the grantor makes an inter vivos transfer, the property is still included in the grantor's estate if the grantor dies prior to the end of the GRAT term.

Because a transfer to a GRAT is subject to the ETIP rule, pursuant to IRC Section 2642(f)(1), GST exemption may not be allocated to the property transferred to the GRAT until whichever is earlier: the end of the GRAT term or the grantor's death. Therefore, it appears that for the GRAT property passing to the remainderman to be GST-exempt, the grantor must allocate GST exemption to the remainder property at the end of the GRAT term. Notwithstanding, the GST regulations seem to permit the creation of a GRAT in which the property passing to the remainderman is GST-exempt even if no GST exemption is allocated to this property. This apparent mathematical anomaly results in a valuable planning option.

THE INCLUSION RATIO

The rate of GST tax to which a trust is subject is equal to the IRC Section 2641(a) “inclusion ratio” multiplied by the maximum federal estate tax rate. If the inclusion ratio is zero, the rate of GST tax is also zero, and the trust is exempt from GST tax. The inclusion ratio is equal to one minus the IRC Section 2642(a) “applicable fraction.” The applicable fraction represents the portion of trust property to which GST exemption has been allocated. The numerator of the applicable fraction is the amount of the GST exemption that has been allocated to the trust.2 The denominator is the fair market value of the property transferred to the trust at the time of the transfer, less any federal estate or gift tax actually recovered from the trust attributable to such property and less any charitable deduction allowed with respect to the transfer.3 If the numerator and denominator are the same, the applicable fraction is one, the inclusion ratio (one minus the applicable fraction) is zero and the trust is exempt from GST tax.

The inclusion ratio of an existing trust must be redetermined when property is added to such a trust.4 Under Treasury Regulations Section 26.2642-4(a), the applicable fraction of a trust is redetermined when property is added to a trust. The numerator of the redetermined applicable fraction is the sum of the amount of the GST exemption (if any) applied to the property added and the non-tax portion of the trust, (that is to say, the value of the trust assets immediately prior to the addition multiplied by the then applicable fraction.5 The denominator of the redetermined applicable fraction is the value of the trust property immediately after the addition).6

In general, if property is added to an existing trust with an inclusion ratio of zero and GST exemption equal to the value of such property is not allocated to the trust, the addition will cause the re-computed inclusion ratio to be greater than zero, but less than one (a “mixed inclusion ratio”). With a mixed inclusion ratio, a trust would be subject to GST tax. But, as we know, the ETIP rule prohibits the allocation of GST exemption to the remainder interest upon creation of a GRAT. Thus, one would assume that, if the remaindermen of a GRAT is a trust with an inclusion ratio of zero (a “GST-exempt trust”), the addition of the remainder property to the GST-exempt trust upon termination of the GRAT term would cause the trust to have a mixed inclusion ratio.

But a careful reading of the GST regulations addressing the re-computation of the inclusion ratio of a trust upon an addition thereto, indicates that the inclusion ratio of a GST-exempt trust that is the remainderman of a “zero-ed out” GRAT still may have an inclusion ratio of zero after the receipt of the terminating distribution from the GRAT.

ZERO-ED OUT GRATS

Let's suppose that property valued at zero is added to a GST-exempt trust with $1,000 in assets and GST exemption is not allocated to the property. According to Treasury Regulation Section 26.2642.4(a), the numerator of the redetermined applicable fraction is the sum of (1) the amount of the GST exemption (if any) applied to the property added and (2) the value of the trust assets immediately prior to the addition multiplied by the then applicable fraction. In this case, the redetermined numerator would be $1,000: the sum of (1) zero, the amount of GST exemption allocated to the added property, and (2) $1,000 multiplied by one, the value of the trust assets immediately prior to the addition multiplied by the then applicable fraction. The denominator of the redetermined applicable fraction is the value of the trust property immediately after the addition. As the addition of property valued at zero would not change the value of the trust assets, the value after the addition would remain $1,000. As the redetermined numerator and the redetermined denominator both equal $1,000, the redetermined applicable fraction remains one and the inclusion ratio remains zero. As the foregoing demonstrates, if the value of the property added to a trust is zero immediately after the addition, then both the numerator and the denominator of the redetermined applicable fraction will be the same. In the case of such an addition to a GST-exempt trust, the applicable fraction will remain one and the inclusion ratio will remain zero after the addition.

In an economically zero-ed out GRAT, the annuity is set so that the present value of the annuity payments, determined as if payable for a fixed term (not the shorter of, a term or the grantor's life, even if that is the case) and using the IRC Section 7520 rate as the discount rate, is exactly equal to the value of the property transferred to the GRAT,7 resulting in a remainder (and gift in the case of a fixed-term GRAT) valued at zero.

Accordingly, if the remainder of a zero-ed out GRAT8 is deemed to be added to a GST-exempt trust upon creation of the GRAT designating the GST-exempt trust as remainderman, the inclusion ratio of such trust should remain zero because the value of the interest added is zero. The subsequent distribution of property to the GST-exempt trust from the GRAT upon its termination should not affect the inclusion ratio of the trust because such distribution merely represents a maturation of a property interest already held by that trust.9 Nevertheless, it is important to note that under IRC Section 2611, the termination of the GRAT would result in a taxable termination (and therefore trigger GST tax), if at such time at least one non-“skip person”10 does not have an interest in the GST-exempt trust.

TIMING OF ADDITION

This result is, of course, dependent on whether the GRAT remainder interest is deemed to be added to the GST-exempt trust upon creation of the GRAT, when the remainder property is valued at zero, or upon distribution of the property in respect of such remainder interest at the termination of the GRAT, when the remainder would presumably have a value greater than zero. In the case of the latter, the GST-exempt trust clearly would have a mixed inclusion ratio if no GST exemption were allocated to the remainder property.

The GST provisions under the IRC do not address when a remainder interest distributable to a trust should be deemed to be have been added to such trust for GST tax purposes. IRC Section 2652(c)(1), however, provides that a person has an “interest in property held in trust” if such person “has a right (other than a future right) to receive income or corpus from the trust” or “is a permissible current recipient of income or corpus from the trust…” The term “interest in property held in trust” is used to identify the beneficiaries of a trust for purposes of determining whether a trust is a skip person or whether a “taxable termination”11 has occurred. Accordingly, under IRC Section 2652(c)(1), a remainder interest is not an “interest in property held in trust” for purposes of making such determinations.

It could be argued that IRC Section 2652(c)(1) should be broadly interpreted to disregard future interests for purposes of determining when additions have been made to a trust. But such a broad interpretation is contrary to the express provisions of IRC Section 2642(d), which provide that “if a transfer of property is made to a trust in existence before such transfer, the applicable fraction for such trust shall be re-computed as of the time of such transfer in the manner provided in paragraph (2).” IRC Section 2642(d) clearly requires the re-computation of the applicable fraction at the time “property” is transferred. The term “property” is much broader than the IRC Section 2652(c)(1) defined term of “interest in property held in trust.” Unless expressly provided otherwise, the meaning of “property” should encompass both current and future interests in trusts. Therefore, the fact that a remainder interest in trust is not an “interest in property held in trust” should not be relevant to the issue of when a remainder interest distributable to a trust is deemed to be added to the remainderman trust under IRC Section 2642(d).

We were unable to find any case law or rulings addressing when a remainder interest distributable to a trust should be deemed to be have been added to such trust for GST tax purposes. However, as a matter of property law, a remainderman has a vested property interest in a trust at the time of its creation.12 In addition, the creation of a remainder interest is a completed transfer for gift tax purposes.13 Accordingly, the remainder interest in a GRAT should be deemed to have been added to a GST-exempt trust when the GRAT is created. Thus, the addition of a zero-ed out GRAT remainder to a GST-exempt trust should not change the trust's inclusion ratio.

PLANNING IMPLICATIONS

Although the IRS is likely to disagree, the mathematical formula that the GST regulations provide for redetermining the applicable fraction upon an addition to a GST-exempt trust appear to produce an end run around the ETIP rules in the case of a zero-ed out GRAT. It therefore may be advisable to create a GST-exempt trust funded with a small amount, such as $5,000, and to designate such a trust as the remainderman of a zero-ed out GRAT. If the GRAT is very successful, it could be worthwhile for the taxpayer to make the IRS defend its own regulations.14

Endnotes

  1. IRC Section 2642(f)(3).
  2. IRC Section 2642(a)(2).
  3. IRC Section 2642(a)(2).
  4. IRC Section 2642(d).
  5. Treasury Regulations Section.26. 2642.4(a).
  6. Ibid.
  7. This annuity amount can be determined by dividing the amount transferred to the GRAT by the term factor in Table B of the Actuarial Tables, Book Aleph, Publication 1457
  8. It shouldn't matter if the zero-ed out GRAT is a fixed-term GRAT. Although the remainder interest in a GRAT that is not for a fixed-term is greater than zero for gift tax purposes, due to the application of the special valuation rules of IRC Section 2702, the special valuation rules of the section should not apply for GST tax purposes. The explanation to the original proposed IRC Section 2702 regulations states: “Although [sections 2701 and 2702] apply to determine the amount of the gift, they do not change the value of the property for other tax purposes.” Thus, in general, IRC Sections 2701 and 2702 do not apply for purposes of the generation-skipping transfer tax. 56 Fed. Reg. 14321, 14322 (April 9, 1991). Neither the final regulations nor the explanation accompanying them takes a contrary position. See Explanation preceding final regulations, 57 Fed. Reg. 4250, 4251 (Feb. 4, 1992).
  9. A similar result should be the outcome of a zero-ed out charitable lead annuity trust (CLAT). Although a CLAT is not subject to the ETIP rules so long as the grantor is not a remainderman, IRC Section 2642(e) was enacted to prevent the use of a (CLAT) to leverage GST exemption by changing the applicable fraction rules for CLATs and requiring the determination of the applicable fraction to be made at the end of the charitable term. Treasury Regulation Section 26.2642-3(b) defines the adjusted GST exemption for a CLAT as the amount of GST exemption allocated to the trust increased by an amount equal to the interest that would accrue, if an amount equal to the allocated GST exemption were invested at the rate used to determine the estate or gift tax charitable deduction, compounded annually, for the actual period of the CLAT. Nevertheless, the foregoing rules apply to the CLAT itself, not to a trust that is designated as the remainderman of a CLAT.
  10. A “skip person” is a person or trust assigned to a generation two or more generations below that of the transferor. IRC Section 2613(a). GST tax is imposed on transfers to skip persons.
  11. A “taxable termination” occurs whenever a beneficiary's interest in a trust terminates, unless immediately after the termination, at least one non-skip person has an interest in the trust, or at no time after the termination may a distribution (upon termination of the trust or otherwise) be made from the trust to a skip person, unless the possibility is so remote as to be negligible. IRC Section 2612(a). GST tax is imposed on taxable terminations.
  12. Ammco Ornamental Iron, Inc. v. Wing, 26 Cal. App.4th 409, 418 (Cal. Ct. App. 1994); In re Estate of Zukerman, 578 N.E.2d 248, 253 (Ill. App. Ct. 1991); Walz v. Walz, 423 N.E.2d 729, 733 (Ind. Ct. App. 1981); Lincoln Bank & Trust Co. v. Lane, 303 S.W.2d 273, 275 (Ky. Ct. App. 1957).
  13. Robinette v. Helvering, 318 U.S. 184, 187 (1943); Smith v. Shaughnessy; 318 U.S. 176, 178 (1943).; Lazarus v. Comm'r, 513 F.2d 824, 828 (9th Cir. 1975); Comm'r v. Procter, 142 F.2d 824, 825 (4th Cir. 1944).
  14. An existing GST-exempt trust could also be designated as the remainderman of a zero-ed out GRAT. It should be noted, however, that if the IRS prevails against the taxpayer, the GST-exempt trust would have a mixed inclusion ratio. In such case, the trust can be divided into two trusts in a “qualified severance” under IRC Section 2642(a)(3). This section, however, sunsets in 2011 under the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001.

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