Generation-Skipping Transfer Tax

Beatrice Wingrave, a widow, wants to make a substantial outright gift directly to her granddaughter. The granddaughter parents, Beatrice daughter and son-in-law, are both living and financially comfortable. Beatrice adviser warns that this transfer can attract a THIRD federal transfer tax beyond the gift tax. That third tax is:

1. A.The alternative minimum tax, which is triggered by large lifetime gifts.Incorrect. The AMT is a parallel income tax calculation and has nothing to do with gifts.
2. B.The net investment income tax, which is imposed on transfers of appreciated property.Incorrect. The net investment income tax is an income tax surcharge on investment income, not a transfer tax.
3. C.The accumulated earnings tax, which applies when income is retained rather than distributed.Incorrect. The accumulated earnings tax applies to corporations retaining earnings, not to individual gifts.
4. D.The generation-skipping transfer tax, which applies to transfers to a skip person more than one generation below the transferor and is imposed in addition to gift or estate tax.Correct. A living-parent grandchild is a skip person, and GST tax stacks on top of the gift tax.

Why: The federal transfer tax system has three parts: gift tax on lifetime transfers, estate tax on transfers at death, and the generation-skipping transfer tax on transfers that jump a generation. A grandchild whose parent is still living is a skip person, more than one generation below the transferor, so a direct gift to her can trigger GST tax in ADDITION to gift tax. The GST tax exists precisely to stop families from avoiding a full round of estate tax at the middle generation by transferring straight to grandchildren.

Theodora Ashgrove contributes $40,000 this year to an irrevocable trust for her two grandchildren. The trust instrument gives each beneficiary the right, for 30 days following each contribution, to withdraw his or her share of that contribution. Her adviser explains that this CRUMMEY withdrawal power exists in order to:

1. A.Remove the trust assets from the grandchildren estates for generation-skipping tax purposesThe generation-skipping analysis depends on allocating GST exemption, not on the withdrawal power.
2. B.Convert what would otherwise be a gift of a future interest into a gift of a present interest, so the contributions can qualify for the annual gift tax exclusionCorrect. Present-interest status is the sole reason for the withdrawal window.
3. C.Make the trust revocable, so that Theodora can recover the funds if she later needs themThe trust remains irrevocable. The withdrawal right belongs to the beneficiaries, never to the grantor.
4. D.Shift the income tax liability of the trust to the grandchildren whether or not income is distributedTrust income taxation depends on distributions and the grantor trust rules, not on a Crummey power.

Why: The annual gift tax exclusion is available only for gifts of a PRESENT interest, meaning the donee has an immediate, unrestricted right to enjoy the property. A contribution to a trust whose distributions are deferred is a future interest and would not qualify. Granting each beneficiary a temporary right to withdraw the contribution creates the present interest, so contributions up to the annual exclusion amount per beneficiary escape gift tax and use no lifetime exclusion. The power lapses if not exercised, and the assets stay in the trust.

Rutherford Vale funds an irrevocable life insurance trust whose only beneficiaries are his four GRANDCHILDREN. Each year he transfers cash to the trustee to pay premiums, and each grandchild holds a temporary withdrawal right over his or her share so that the transfers qualify for the federal gift tax annual exclusion. Rutherford advisor tells him the gift tax side is handled but that a second transfer tax still requires attention. What is the issue?

1. A.The withdrawal rights cause the death benefit to be income-taxable to the grandchildren when paid.Wrong. Death proceeds paid to the trust remain excludable from gross income. Withdrawal rights are a transfer tax device and do not affect the income tax exclusion.
2. B.The trust must file for an exemption from the estate tax three-year rule before the transfers can qualify.Wrong. No such filing exists. The three-year rule concerns policies transferred by an insured, which is not what is described here.
3. C.Because the trust benefits multiple grandchildren rather than a single skip person, the transfers do not qualify for the generation-skipping annual exclusion, so exemption must be affirmatively allocated to the trust.Correct. The generation-skipping annual exclusion imposes single-beneficiary conditions that a pot trust fails, so allocation of exemption is required.
4. D.Grandchildren are not skip persons as long as their parent is still living, so no generation-skipping issue arises at all.Wrong. A grandchild is a skip person. The narrow rule that can move a grandchild up a generation applies where the grandchilds parent is DECEASED, which is the opposite of the fact stated.

Why: Transfers that skip a generation attract the GENERATION-SKIPPING TRANSFER tax in addition to gift or estate tax, and grandchildren are skip persons. The trap here is that the gift tax annual exclusion and the generation-skipping annual exclusion are NOT the same rule. A temporary withdrawal right makes a transfer a present interest and so qualifies it for the GIFT tax annual exclusion, but for a transfer in trust to qualify for the generation-skipping annual exclusion the statute imposes stricter conditions: the trust must be for a single skip person, no part of it may be distributable to anyone else during that persons life, and if that person dies before the trust terminates the assets must be includible in his or her estate. A single pot trust for four grandchildren fails those conditions. The consequence is that the transfers are not automatically exempt from generation-skipping tax, and the exemption must be affirmatively ALLOCATED to the trust so that the eventual death benefit passes free of it.