As of January 1, 2010, the federal estate, gift, and generation-skipping transfer (“GST”) tax laws changed significantly. One aspect of these changes has the potential to create havoc for people who have previously created irrevocable trusts which were intended to be exempt from GST tax (“GST trusts”). Advisors who have clients who are making gifts to GST trusts may want to have the clients change the way in which they fund those trusts for 2010, especially where the trusts hold life insurance policies.
As you should be aware, the estate and GST taxes were repealed as of January 1, 2010, although the gift tax remains in effect at a flat, 35% rate. The repeal of the estate and GST taxes, and the lower gift tax rate, are all set to expire at the end of this year, and for 2011 the estate, gift, and GST taxes are scheduled to take effect essentially under the same rules which were in place at the end of 2000.
One particular implication of the repeal and scheduled return of the GST tax is that clients who have irrevocable GST trusts may want to consider not making any gifts to that trust during 2010, unless the GST tax is reinstated during 2010 and prior to the date of the gift. One option would be simply not to make any gifts to a GST trust for 2010. Instead, clients could use their ability to make gifts under the gift tax annual exclusion for 2010 by making outright gifts to their desired beneficiaries, or by making transfers to third parties on behalf of the desired beneficiaries (to non-GST trusts, to custodial or 529 plan accounts, or in other ways).
If a client needs or wants to transfer assets to a GST Trust for 2010, the client could structure any such transfer as a loan instead of an outright gift. Any loan from the client to the trust would need to bear appropriate interest, and should be documented with appropriate paperwork. Another option would be to have the Trustee of the GST trust take out a loan from a third party for any amounts which the trust may need to pay its expenses for 2010 (such as any life insurance premiums which may become due on policies the trust owns).
The reason that a client with a GST trust may want to avoid making any gifts to that trust for 2010 if the GST tax is not reinstated prior to the gift date is that we do not currently know what the effect of any such gifts would be on the GST tax exempt status of a GST trust. If someone makes a gift to a GST trust during 2010, and if there is no GST tax and hence no GST tax exemption for 2010, it may not be possible for that person to make a timely allocation of GST tax exemption to the GST trust with regard to the 2010 gift. In addition, even if gifts to irrevocable trusts made during 2010 are given “grandfathered” status against future GST taxes, the transfers may not be grandfathered in a way which would avoid any negative effect on the GST tax-exempt status of the trusts to which they were made. For example, if the GST tax is repealed during all of 2010 but returns for 2011, the IRS could take the position that it is not possible for someone to make a timely allocation of GST tax exemption to a gift made to a GST trust during 2010, since there was no such thing as a GST tax exemption or a GST tax for 2010, and that the 2010 gift is not otherwise exempt from GST taxes. This position could result in the trust to which the gift was made having an inclusion ratio greater than zero for GST tax purposes, meaning that the entire trust could be exposed to GST tax even if all other transfers to the trust had been made fully exempt through GST exemption allocations. The maker of the gift would then need to make a late allocation of GST tax exemption to the GST trust in order to fully exempt it. Late GST tax exemption allocations are extremely complex and difficult, especially where a GST trust holds a life insurance policy and where gifts are being made each year. It would likely be better to try to avoid the potential need for a late allocation of GST tax exemption entirely, by avoiding any gifts to a GST trust for 2010 unless and until the GST tax is reinstated by legislation sometime during the year.
Another effect of the repeal and scheduled return of the GST tax is that clients who may have been relying on the automatic allocation of their GST tax exemptions to their GST trust gifts will no longer be able to do so. The automatic allocation rules, which were implemented in 2001 along with the rules which lead to the 2010 repeal, have not been made permanent by other legislation and were not part of the laws which are scheduled to return on January 1, 2011. This means that, if no new laws are put in place, each client who makes a gift to a GST trust will need to file a gift tax return for the year of the gift, even if that client did not make any taxable gifts for that year. The gift tax returns will once again be required so that the client’s GST tax exemption can be affirmatively allocated to the trust. In order for gift tax returns to be prepared and filed correctly, the client will also need to have good records showing each and every gift to the trust which was made in prior years, if gift tax returns were not actually filed for those years. Advisors should be preparing their clients who have GST trusts but who have been relying on the automatic allocation rules for the return of the annual gift tax return filing requirement.
If you have any questions regarding the issues discussed in this letter, please do not hesitate to contact us. We are also available to help you discuss these issues with your clients and take appropriate planning steps.
– Richard M. Morgan & Loraine M. DiSalvo