By Anthony Diosdi
Trusts have become increasingly sophisticated vehicles for managing wealth. When a settlor (the person or entity that establishes a trust), he or she must evaluate the income, gift, estate, generation-skipping transfer tax (“GST”), and state tax aspects associated with establishing a trust. In cases of more complex trusts, there are roles to evaluate. For example, evaluating the income, gift, estate, and GST tax aspects of a trust might involve considerations of the rights, interests, and powers of the settlor, beneficiaries, trustee, distribution advisor, investment advisor, and trust protector.
For federal tax purposes, a power held by a trust advisor or trust protector generally is evaluated in the same manner as if it was held by a trustee. A trust advisor or trust protector sometimes holds a power in a non-fiduciary capacity, even if it might be a power that a trustee ordinarily would hold in a fiduciary capacity. Whether a trust advisor or trust protector holds a power in a fiduciary capacity does not always affect taxation, but it can affect whether the power is created in the same manner as if held by the trustee and is thus often a critical aspect when determining the income, gift, estate, GST, and state income tax ramifications of the trust’s design. This article addresses each of those potential ramifications.
The Definition of the term Trust
The word “trust” is used to describe many property arrangements which have little in common with each other except that they were traditionally enforced by the Chancellor in the court of equity. Under the entity classification regulations, a trust is an arrangement in which a trustee takes title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. See Treas. Reg. Section 301.7701-4(a). The allocation of trustee powers- e.g., distribution powers, investment powers, and administrative powers- among a trustee and one or more other trust officials ordinarily does not interfere with the arrangement being classified as a trust.
Potential Income Tax Consequences Associated with a Trust
While trusts are popular vehicles for transfer tax minimization, they still require an analysis of their features to determine the income tax status and an analysis of any transactions between the settlor and the trust. Who the decision makers are and what powers those persons hold may affect how contributions to and distributions from the trust or its settlor is taxed, among other things. What’s more, a change in office or responsibility of a trustee or other official during the trust’s term could change the income tax consequences associated with the trust. Two areas that-depending on the allocation of powers and responsibilities amongst various trust officials- may significantly affect the income tax status of the trust are whether the trust will be treated as a domestic or foreign trust and whether the trust will be treated as a grantor or non grantor trust. Each of these areas is discussed in turn below.
Grantor Trust v. Nongrantor Trusts
A trust can be taxed as either a grantor or non-grantor trust. If a trust is considered a grantor trust, all items of income, deductions, and credit are not taxed at the trust level, but rather on the personal income tax return of the individual who is considered the grantor of the trust for income tax purposes. Similarly, to the extent a trust is a grantor trust with respect to a beneficiary, the beneficiary must report the trust’s income, deductions, and credits on the beneficiary’s personal income tax return. The simplest form of a grantor trust would be a revocable living trust. An irrevocable trust can also qualify as a grantor trust under Internal Revenue Code Section 672(f) if the only beneficiaries that may receive distributions during the grantor’s lifetime are the grantor or the grantor’s spouse.
A trust can also be a non-grantor trust. An example of a non-grantor trust is when the person who sets up the trust has no rights, interest, or powers over the trust assets. To the extent that a trust is not a grantor trust with respect to the settlor or beneficiary, it is a non-grantor trust, and the incidence of tax falls on the trust, the beneficiaries, or partly both. Trusts are taxed at rates applicable to individuals, albeit with no progression through the brackets, and are entitled to the preferential capital gain rates. The design and administration of a trust-including the allocation of powers among the trust officials- will affect the taxation of the settlor, trust, and beneficiaries. The grantor trust rules contain several provisions that specifically refer to a power held by a trustee and speak to whether the power affects whether a trust is a grantor trust with respect to a settlor. For example, under Section 674(c), an independent trustee’s discretionary distribution power will not cause a trust to be a grantor trust with respect to the settlor. Under Section 675(3), an independent trustee’s power to loan trust assets to the settlor will not cause a trust to be a grantor trust with respect to the settlor if the loan provides for adequate interest and adequate security.
Foreign Trust vs. Domestic Trusts
Under Section 7701(a)(3)(E), a trust is a domestic trust if it meets the court test and the control test. Under Section 7701(a)(31)(B), a trust is a foreign trust if it fails either the court test or the control test. A trust satisfies the court test if a court within the United States can exercise primary supervision over the trust’s administration. A trust satisfies the control test if one or more U.S. persons have the authority to control all substantial decisions of the trust. Substantial decisions include: 1) whether and when to distribute income or principal; 2) the amount of any distributions; 3) the selection of a beneficiary; 4) whether a receipt is allocable to income or principal; 5) whether to terminate the trust; 6) whether to compromise, arbitrate, or abandon claims of the trust; 7) whether to sue on behalf of the trust or to defend suits against the trust; 8) whether to remove, add, or replace a trustee; 9) whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee in a manner that would cause a domestic to become a foreign trust (or vice versa); and 9) investment decisions, except to the extent they are made by an investment advisor hired by a U.S. person and the U.S. person can terminate the investment advisor’s investments powers at any time.
If a trust official, who is not a U.S. person, has the power to make any of these substantial decisions, the trust potentially would fail the control test, causing the trust to be classified as a foreign trust for federal tax purposes. If, however, one or more US persons can trump the non-US person’s exercise of the power to make a substantial decision, the decision is controlled by US persons.
There are special rules regarding the U.S. federal taxation of foreign trusts. Prior to 1974, a U.S. person could transfer assets to a foreign trust for the benefit of his or her family. Provided that the trust was not a grantor trust under Sections 671 through 678 of the Internal Revenue Code, such a trust was able to make investments offshore free of U.S. federal income tax. In response, Internal Revenue Code Section 679 was enacted to make virtually all foreign trusts settled by U.S. persons for U.S. beneficiaries taxable for U.S. income tax purposes as grantor trusts, and new reporting requirements were imposed. Reports of abuse led to legislation that imposed expanded reporting requirements on U.S. grantors and beneficiaries of foreign trusts. U.S. grantors and beneficiaries of foreign trusts are now required to file Forms 3520 and 3520-A with the IRS. In addition, the U.S. “owner” of a foreign trust is required to ensure that the trust appoints a U.S. person to act as the trust’s U.S. agent for purposes of the reporting requirement. There must be a binding written contract with the foreign trust that enables the agent to comply with requests by the IRS to examine trust books and records or to take testimony, or to comply with summons for the same. If the trust does not have a U.S. agent, the IRS may determine the amounts required to be taken into account for U.S. tax purposes with respect to the foreign trust by the U.S. owner, and can impose penalties under Internal Revenue Code Section 6677.
A U.S. person who receives a distribution, directly or indirectly, from a foreign trust is required to report a number of the matters relevant to the trust on Form 3520 and potentially on Form 3520-A, including the name of the trust and the aggregate distribution received during the taxable year. For this purpose, a distribution from a foreign trust includes any gratuitous transfer of money or property from a foreign trust, whether or not the trust is deemed to be owned by another person. A reportable distribution from a foreign trust includes the receipt of trust corpus and the receipt of a gift or bequest, even though such amounts may not be taxable. The failure of a U.S. person to report a distribution from a foreign trust can result in a penalty up to 35 percent on the gross amount of the unreported portion of the distribution.
Foreign trusts are also a tax trap for U.S. beneficiaries of such a trust. The throwback rule effectively results in federal tax being levied at the recipient’s highest marginal income tax rate for the year in which the income or gain was earned by the trust. This means any capital gains accumulated by a foreign trust for distribution in a later taxable year will lose its favorable rate and instead be taxed at ordinary rates. In addition, the throwback rule adds an interest charge to the taxes on a throwback distribution in order to offset the benefits of tax deferral. The interest charge accrues for the period beginning with the year in which the income or gain is recognized and ending in the year of the distribution, and is assessed at the rate applicable to underpayment of tax, as adjusted compounded daily.
This issue concerning the trust’s status as a domestic or foreign trust can arise unexpectedly. Consider an incomplete nongrantor (“ING”) trust, in which the settlor, the settlor’s spouse, the settlor’s siblings, and the descendants of the settlor’s siblings are beneficiaries. With an ING, an individual (called the “grantor”) irrevocably transfers intangible assets, such as securities, to a trust that is a resident of Nevada, Delaware, Wyoming, or South Dakota while remaining a contingent beneficiary of the trust. The grantor has no ability to receive distributions from the ING without the consent of at least one other non-spousal beneficiary of the trust. This individual is known as an “adverse party.” However, a grantor maintains the ability to allocate trust principal to anyone other than himself or his spouse. Because the grantor retains the ability to appoint the trust principal, the transfer to an ING is characterized as an incomplete gift for gift tax purposes. In other words, the grantor retains certain powers over the ING, but these powers will not be deemed substantial enough so that the grantor will be regarded as having retained control for federal gift tax purposes, thereby avoiding being subject to the gift tax rules.
Typical of ING trust, this trust has a beneficiary committee, which has two powers. By majority action, the committee members may direct a distribution to the settlor or the settlor’s spouse, subject to the settlor’s consent. By unanimous action, the committee members may direct a distribution to any beneficiary. Assume that, at the trust’s inception, the settlor and beneficiaries are US persons and the trust is a domestic trust. What happens if one of the siblings, who is a member of the committee, subsequently becomes a non-U.S. person? Unless the sibling ceases to serve as a member of the committee, the ING would become a foreign trust.
Gift Tax Considerations
Federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest, or inheritance. This transfer tax takes the form of a gift tax in the case of completed lifetime gifts and an estate tax in the case of property owned by the decedent at the time of death, certain lifetime transfers, annuities, joint tenancy property, property over which decedent had, exercised or released a general power of appointment, life insurance, and certain qualified terminable interest property.
A federal gift tax is imposed on the value of lifetime gifts. For gift tax purposes a gift is defined as the transfer of property for less than adequate and full consideration in money or money’s worth, other than a transfer in the “ordinary course of business.” A transfer of an asset to a trust may be treated as a taxable gift to the trust or the trust’s beneficiaries. The gift tax is imposed only upon so-called completed gifts. A transfer for less than adequate and full consideration in money or money’s worth is a completed gift for gift tax purposes only if the enjoyment of the transferred property is placed beyond the donor’s dominion and control. The dominion and control test is explained as follows:
As to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit to another, the gift is complete. But if upon the transfer of property (whether in trust or otherwise) the donor reserves any power over its disposition, the gift may be partially complete and partially incomplete, depending upon all the facts in the particular case. See Treas. Reg. Section 25.2511(b).
If the donor transfers property outright and the transferred property is beyond the donor’s dominion and control, the gift is complete for gift tax purposes. Alternatively, if the donor retains any power to regain possession or ownership of the property or retains the power to determine who shall enjoy the benefits of the property, the gift is incomplete and no taxable gift is made until the donor’s dominion and control terminate over the transferred property. In many cases, however, the donor’s dominion and control will not terminate in the donor’s lifetime. In this case, more likely than not, the property will be included in the donor’s gross estate for estate tax purposes and not be included in the donor’s gift tax base. For example, if Mary transfers property into a revocable trust, no gift occurs when the trust is created because Mary retains dominion and control over the transferred property. If two years later Mary releases the power of revocation, a gift occurs at the time since after the release Mary no longer has dominion and control. If Mary fails to release the power during her life and dies in possession of the power, the property in that trust is included in Mary’s gross estate.
Mary is deemed to retain dominion and control even though the power she retains cannot be exercised for her pecuniary benefit. For example, suppose Mary transfers property in trust to pay the income to Alice, Bob, and Charlie from time to time as Mary directs. Upon Mary’s death the trust terminates and the principal is distributable to Alice, Bob, and Charlie. In this case, Mary retains dominion and control over the income interest but no dominion and control over the value of the remainder interest. Thus, the gift of the income interest is incomplete; the gift of the remainder interest is complete. In other words, in measuring whether there is a completed gift, each interest in the trust is considered separately.
A more common example occurs where a donor retains a power over transferred property that is exercisable only with the consent of an adverse person. Under the gift tax rules, if a donor retains a power over transferred property that is exercisable only with the consent of an adverse person, the gift of the interest in which there is adversity is complete. See Treas. Reg. Section 25.2511-2(e). Thus, if Doris transfers property in trust to pay the income to Lauren for life, remainder to Arthur and Doris retains the power to accumulate the income for ultimate distribution to Arthur, the gift of the income interest is incomplete because of Doris’ retained power; the gift of the remainder is complete. Further, the entire trust is included in Doris’ gross estate under Internal Revenue Code Section 2036 because of her retained power. If, however, Doris’ power to accumulate income was exercisable only with Lauren’s consent the gift of the income and remainder interests would be complete. The gift of the remainder interest is complete because Doris retains no dominion and control over that interest; the gift of the income interest is complete because Doris’ power is exercisable only with Lauren’s consent and Lauren has an interest that would be adversely affected if Doris exercised the power. Nonetheless, the entire trust is included in Doris’s gross estate under Section 2036 of the Internal Revenue Code because of her co-held power to accumulate the income.
A substantial adverse interest exists only if there is a substantial economic interest that could be prejudiced or destroyed if the power over the interest was exercised. For example, suppose Mary creates a revocable trust under which income is payable to Allan and the remainder is distributed to Betty. Mary retains the power to revoke the trust only with Allan’s consent. In this case there is a completed gift only of the income interest. Allan has no economic interest in the remainder interests distributable to Betty when he dies.
While sometimes an incomplete gift is desired on a transfer to a trust, settlors often are looking to achieve gift, estate, and GST tax savings by making a completed gift to a trust. A trust advisor’s or trust protector’s powers, however, may cause a transfer to a trust to be an incomplete gift. For example, in PLR 7935082, a bank created a charitable trust. The bank was the initial trustee, and an employee of the bank was the initial trust advisor. Under the terms of the trust, the trustee would distribute the trust’s net income annually to one or more charitable organizations, the trust would terminate ten years after its creation and the trustee would distribute the remainder to the settlor. The trust advisor would designate the charitable organizations to which the trustee must distribute the trust’s net income. Noting that a transfer by a corporation is a gift to the transferred from the shareholder of the corporation, the IRS concluded that the transfer of property to the trust was an incomplete gift, because the trust advisor had the power to designate which charitable organization would receive distributions from the trust each year. The IRS observed that a completed gift would occur when the trust advisor irrevocably designated a charitable organization to receive net income.
In PLR 201507008, a settlor created a self-settled trust of which the settlor and her descendants were the beneficiaries. The trust had a trustee, distribution advisor, and trust protector, none of whom were or could be a beneficiary or a person related or subordinate to the settlor. The distribution advisor had the power to direct the trustee to distribute trust property to the settlor and, subject to the settlor’s consent, the power to direct the trustee to distribute trust property to any of the settlor’s descendants. If no one was serving as a distribution advisor, the trustee had the power to distribute trust property to the settlor and, subject to the settlor’s consent, the power to distribute trust property to any of the settlor’s descendants. Subject to the trust protector’s consent, the settlor had the power to appoint the trust property to her father’s descendants (other than herself, her creditors, her estate, or the creditors of her estate) and a foundation. She could exercise this power during her life or upon her death.The IRS ruled that the settlor’s transfer of the property to the trust was an incomplete gift. Under the gift tax regulations, a transfer to a trust is an incomplete gift if the settlor retains any power over the property’s disposition. This includes a power exercisable by the settlor in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or its income. In this ruling, the settlor held a power in conjunction with the distribution advisor, who did not have a substantial adverse interest in the disposition of the trust property. Together, the settlor and distribution advisor controlled distributions to the beneficiaries and thus controlled the disposition of the trust property. Accordingly, this caused the settlor’s transfer of property to the trust to be an incomplete gift.
Estate Tax Considerations
A federal estate tax, in common with the federal gift tax, is a tax on the privilege of transferring property at death. The tax is measured against a tax base that includes not only the assets of decedent’s probate estate but also certain gifts by the decedent during life that are deemed to be the equivalent of testamentary transfers either because the decedent retained an interest or power over the gift. Items included in a decedent’s gross estate are reduced by other items to calculate a decedent’s taxable estate.
The gross estate is computed by taking into account the following:
1. Property owned at death.
2. Certain property transferred within three years of death.
3. Lifetime transfers in which the decedent retained an interest for life.
4. Certain lifetime transfers taking effect at the decedent’s death.
5. Revocable transfers.
7. Joint powers of appointment.
8. Life insurance.
9. Life insurance.
10. Qualified Terminable Interest Property.
The deductions available to compute the decedent’s taxable estate are:
1. Debts, expenses and taxes.
3. Charitable deduction.
4. Marital deduction.
The gross estate includes the value of all interests in property owned by the decedent at the time of death, including real property, tangible and intangible personal property, such as stocks, bonds, notes, and cash. The decedent’s property interest must have been a beneficial interest. Thus if a decedent owned property merely as a trustee at the time of his death, the property is not included in the decedent’s gross estate. The gross estate includes the value of all property to the extent of the decedent’s interest therein transferred by the decedent during life, in trust or otherwise, for less than adequate and full consideration in money or money’s worth under which the decedent retained 1) for his life; 2) for any period not ascertainable without reference to decedent’s death; or 3) for any period that does not in fact end before the decedent’s death; either the possession or enjoyment of, or the right to receive the income from, the transferred property, or the right to designate the person who shall enjoy the transferred property or income therefrom.
The most common example of a retained life estate transfer that is included in the decedent’s gross estate occurs where a decedent transferred property in trust and retained the income interest in the trust for life. Similarly, if a decedent transferred real property and retained a legal life estate in the property, then at death the real estate would be included in the decedent’s gross estate. A transfer with a retained life estate also occurs where the decedent retains the right to have the income used to discharge decedent’s legal obligations, such as the support of the decedent’s dependents. Transfers with a retained life estate also include transfers in which a decedent did not retain any economic benefit but retained the power, exercisable alone or in conjunction with any other person, to designate the persons who shall possess or enjoy the transferred property or the income therefrom. Thus, if John creates a trust for the primary benefit of Alice, Bob, and Charlie and retains the power to determine their respective shares of the income for his life, the trust is included in John’s gross estate for purposes of the estate tax.
The statute also applies where there is one or more income beneficiaries and the decedent retains the power to direct that income be accumulated for ultimate distribution to the remainderman of the trust. For example, if Mary creates a trust to pay the income to John, remainder to John’s children and retains the power to accumulate and capitalize the income, the trust is included in Mary’s gross estate because her retained power permits her to shift the enjoyment of the income from John to his children.
There is some disagreement, however, whether a power to accumulate income is a power to designate under Section 2036 of the Internal Revenue Code where there is only one income beneficiary who will ultimately receive the accumulated income at the termination of the trust. Suppose John created a trust for the primary benefit of Alice to terminate when Alice dies or reaches age 25, whichever first occurs. Upon the termination of the trust the corpus and any accumulated income would be paid to Alice or her estate. John retained a power exercisable prior to Alice attaining age 25 to pay the income to Alice or accumulate the income for ultimate distribution to her. If John dies before Alice attains age 25, is the trust included in his gross estate under Section 2036? Arguably Section 2036(a)(2) is inapplicable because it requires a power to designate among “persons” and in this case there is only one beneficiary, namely, Alice. Therefore, the decedent’s power is only a power that affects Alice’s time of enjoyment of the trust income, not who shall enjoy the income.
Section 2036 can apply even though the decedent was not the formal creator of the trust. For example, suppose John creates a trust to pay the income to Mary for life, remainder to their children. Mary also creates a trust to pay the income to John for life, remainder to their children. Formally, neither John nor Mary is the creator of the trust of which he or she is the income beneficiary. Nonetheless, Section 2036 could apply causing the trust formally created by John of which Mary is the income beneficiary to be included in Mary’s gross estate (and the trust formally created by Mary of which John is the income beneficiary to be included in John’s gross estate) if it is determined that the trusts were reciprocal. The basic notion underlying the reciprocal trust doctrine, as originally formulated, was that if two trusts were created in consideration of each other, the grantors of each trust would be switched for estate tax purposes to the effect that each would be deemed to be the substantive grantor of the trust formally created by the other.
If Section 2036 applies then the entire trust, not merely the value of the decedent’s retained interest, generally is included in the decedent’s gross estate. However, if the decedent retained only a portion of the income interest or the right to designate only a portion of the income, then only a like portion would be included in the decedent’s gross estate under Section 2036.
Generation-Skipping Transfer Tax Considerations
In addition to the gift and estate tax, a settlor of a trust should consider the GST when establishing a trust. The GST is incredibly complicated. This article will attempt to explain the mechanics of the generation-skipping tax. The estate tax does not apply to property passing as the result of the termination of an interest of a beneficiary in a trust having beneficiaries of different generations unless the beneficiary whose interest terminates has a general power of appointment. Transfer taxes on property passing into a trust providing benefits to beneficiaries of different generations generally are payable only when the trust is created. This permits persons of substantial wealth to avoid transfer taxes at each generation level through the use of so-called generation skipping trusts. Congress enacted Chapter 13 of the Internal Revenue Code for purposes of minimizing the opportunities to avoid transfer taxes through the use of such trusts.
With one exception the transferor, in the case of a transfer that is included in the transferor’s gross estate under Chapter 11 of the Internal Revenue Code is the decedent. See IRC Section 2652(a)(1)(A). In the case of a transfer that is included in the transferor’s gift tax base under Chapter 12, the transferor is the donor. Two special rules relate to the determination of who is the transferor. First, if one spouse makes a lifetime transfer to someone, other than the other spouse, and the spouses elect, under Section 2513 of the Internal Revenue Code to split this gift for gift tax purposes, then for purposes of Chapter 13 each spouse is deemed the transferor of one-half of the gift even though under state property law rules only one of the spouses was in fact the donor.
Second, if a donor spouse or a deceased spouse transfers property to the other spouse in a form that qualifies for the estate or gift tax marital deduction as qualified terminable interest property, the donor spouse or the estate of the deceased spouse may elect, for purposes of Chapter 13, not to treat such property as qualified terminable interest property. If no such election is made, then the donee spouse of qualified terminable interest property is treated as the transferor of such property. If an election is made, then the deceased spouse or the donor spouse is treated as the transferor for Chapter 13 purposes even though the property is later included in the transfer tax base of the donee spouse.
Under Chapter 13, it may be important at certain times to determine whether a person has an interest in a trust. Ordinarily the time a determination is to be made is when some other person’s interest has been determined. A person has an interest in a trust if the person has a present right to receive the income or corpus of the trust or is a permissible current receipt of either the income or corpus of the trust. However, the person with this permissible interest cannot be a charity unless the trust is either a charitable remainder trust or a pooled income fund.
Skip Person and Non-Skip Person
A “skip person” is a person who is assigned to a generation that is at least two generations below the transferor’s generation. A trust can be a skip person if 1) all present interests in the trusts are held by skip persons or 2) no person holds a present interest in the trust and after the transfer no distribution, including terminating distributions, can be made to a non-skip person from the trust. A non-skip person is a person who is not a skip person. To illustrate, suppose Amy creates a trust to pay the income to her son, Bernie, for life, remainder to his children (grandchildren of Amy). This trust is not a skip person because Bernie, who is assigned to the first generation below ASmy and therefore is not a skip person, has the present interest in trust. Bernie’s children, however, are skip persons. But if Amy transfers property in trust to pay the income to her grandchildren for their lives, the remainder to her great-grandchildren the trust is a skip person. Suppose the trust provided that if none of Amy’s great-grandchildren surviving Amy’s grandchildren, then upon the death of the survivor of them, the corpus would be distributed to Amy’s nieces and nephews. The nieces and nephews are in the first generation below the grantor’s generation and thus are non-skip persons. The trust is a skip person because all present interests are held by skip persons.
Assignment of Generations
Chapter 13 sets forth detailed rules to determine a person’s generation assignment. These rules fall into three categories: rules relating to the generational assignments of lineal descendants of the transferor, rules relating to the generational assignment of persons related to the transferor by marriage, and rules relating to the generational assignment of persons who are not related to the transferor. These rules are:
1. The transferor’s children are assigned to the first generation below the transferor, the transferor’s grandchildren are assigned to the second generation below the transferor, the transferor’s great-grandchildren are assigned to the third generation below the transferor and so forth. The transferor’s siblings are assigned to the transferor’s generation; nieces and nephews are assigned to the first generation below the transferor, grandnieces, and grandnephews are assigned to the second generation below the transferor and so forth.
2. A lineal descendant of the grandparents of the transferor’s spouse, other than the transferor’s spouse who is always assigned to the same generation as the transferor, is assigned to the generation resulting from comparing the number of generations between the lineal descendant and the grandparent and the number of generations between the grandparent and the transferor’s spouse.
3. In determining the generation assignments of lineal descendants of the grandparents of the transferor or the transferor’s spouse, relationships created by adoption are treated as relationships by blood and relationships by half-blood are treated as relationships by whole blood.
4. A person who at any time was married to the transferor is assigned to the transferor’s generation. A person who at any time was married to a lineal descendant of the grandparents of either the transferor or the transferor’s spouse is assigned to the same generation as that lineal descendant.
5. If none of the foregoing rules apply, a person born no more than 121/2 years after the transferor is assigned to the transferor’s generation, a person born more than 121/2 years after the birth of the transferor but not more than 371/2 years after the transferor is assigned to the first generation below the transferor and every person in the next successive 25 year period is assigned to the next younger generation.
6. If, in applying the foregoing rules, a person could be assigned to more than one generation, such person shall be assigned to the youngest generation. For example, suppose Harry adopts his grandchild, Allan, who but for the adoption would be assigned to the second generation below Harry. Under the general rule relating to the generation assignment of adopted persons, Allan would be in the first generation below Harry. However, under a rule discussed in Internal Revenue Code Section 2652(e)(1), Harry is assigned to the second generation.
7. If an entity has an interest in property, every person having a beneficial interest in that entity is treated as having an interest in the property. Each such person is then assigned to a generation under the foregoing rules.
Generation Skipping Transfers and Multiple Skips
There are three types of generation skipping transfers. They are taxable terminations, taxable distributions, and direct skips.
A taxable termination means “the termination (by death, lapse of time, release of power, or otherwise) of an interest in property held in a trust unless:
(A) Immediately after such termination, a non-skip person has an interest in such property, or
(B) At no time after such termination may a distribution (including distributions on termination) be made from such trust to a skip person.
The amount taxed generally equals the value of property with respect to which the taxable termination has occurred. The tax is payable by the trustee of the trust.
For example, suppose Bess creates a trust to pay the income to her husband, Harry, for life, remainder to their surviving children for their lives and upon the death of the survivor of them to distribute the corpus equally to their surviving grandchildren. Harry is assigned to Bess’s generation and is a non-skip person, their children are assigned to the first generation below Bess. They are also non-skip persons. The grandchildren are assigned to the second generation below Bess and are skip persons. Harry dies survived by two children, Ann and Billy. No taxable termination then occurs, even though Harry’s interest terminates because immediately after this termination non-skip persons, Ann and Billy, have interests in the trust. Likewise if Ann dies survived by Billy, no taxable termination then occurs because Billy is a non-skip person. When he dies, survived by Bess’s grandchildren, a taxable termination occurs.
A taxable distribution means any distribution, including distributions of income from a trust to a skip person. In the case of a taxable distribution, the taxable amount is generally the value of the property received by the transferee and the tax is paid by the transferee. To illustrate, suppose Martha creates a trust to pay the income among her children and Martha creates a trust to pay the income among her children and grandchildren and their spouses in such shares as the trustee deems advisable. Upon the death of the survivor of them, the corpus is distributed to Martha’s surviving issue per stirpes. The children and their spouses are assigned to the first generation below Martha and their spouses are assigned to the first generation below Martha and, therefore, they are non-skip persons. The grandchildren and their spouses, however, have an interest in the trust. Distributions of income or corpus to Martha’s children and their spouses are not taxable distributions because the children are non-skip persons.
A “direct skip” is a transfer to a skip person that is subject to the estate or gift tax. In the case of a direct skip the taxable amount is the value of the property received by the transferee. In the case of a direct skip, other than a direct skip from a trust, the generation skipping tax is paid by the transferor. In the case of a direct skip from a trust, the tax is paid by the trustee. For purposes of determining whether a transfer is a direct skip, if the transfer is to the grandchild of either the transferor or the transferor’s present or former spouse and the parent of such grandchild is not living, the grandchild is treated as if she was a child of the transferor or the transferor’s spouse.
A special rule applies in the case of so-called multiple skips to assure that the generation skipping tax is assessed only once at each generation. If immediately after a generation skipping transfer the property is held in trust, for purpose of applying Chapter 13 to subsequent transfers from the portion of the trust representing a generation skipping transfer, the trust will be treated as if the transferor was assigned to the first generation above the highest generation of any beneficiary having an interest in the trust immediately after the transfer. For example, suppose Oscar creates a trust to pay income and corpus among his daughter, Dolly, his grandson, Felix and his great granddaughter, Greta. The trust will terminate upon the death of the survivor of them at which time the corpus and any accumulated income is payable to Greta’s surviving issue. If Dolly dies, survived by Felix and Greta a taxable termination occurs. Since following the termination of Dolly’s interest, the property continues to be held in trust, Section 2653 applies. Felix is the person with an interest in the trust assigned to the highest generation; therefore the transferor is presumed to be assigned to Dolly’s generation. Accordingly any distribution of income or corpus to Felix, who is now a non-skip person, is not a taxable distribution although distribution to Greta, who continues to be a skip person, would be taxable distributions. Furthermore, upon Felix’s death, another taxable termination would occur.
State Income Tax Considerations
The laws vary among the states; however, most states base state income taxation on the residence of the settlor, the trustee, the beneficiary, or a combination of those persons. California has special rules regarding the taxation of trusts. In general, a trust’s entire taxable income is subject to tax in California “if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident” of California. See Cal. Rev. & Tax. Code Section 17742(a). Thus, if all of the trustees or other noncontingent beneficiaries are California residents, all of the trust’s income is subject to tax in California. California Code of Regulations Title 18, Section 1772(b), defines a contingent beneficiary as one whose “interest is subject to a condition precedent,” meaning a condition must be satisfied in order for the beneficiary’s interest in the trust to vest or become noncontingent. Conversely, a beneficiary whose interest is vested is a noncontigent beneficiary. If a trust has a mix of California resident and nonresident fiduciaries or noncontigent beneficiaries, the trust’s income is apportioned using a two-tier apportionment formula. Under the two-tier approach, a trust’s taxable income is first apportioned pro rata according to the number of resident fiduciaries, with the remaining amount apportioned pro rata according to the number of noncontigent beneficiaries.
The foregoing discussion is intended to provide the reader with a basic understanding of the income, gift, estate, GST, and state tax considerations of holding property in trust. It should be evident from this article, however, that this is a relatively complex subject, especially if planning is required for the GST. In addition, it is important to note new federal and state tax laws continue to impact these subject areas. As a result, it is crucial that individuals or entities considering establishing a trust review the particular circumstances with a qualified tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted large law firms and accounting firms, and high-net worth individuals with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.