Those who create or come into significant wealth often face difficult decisions about what to do with it. What is one to do with excess wealth—the wealth that will have no material impact on the owner’s life?
The most common solution is to simply do nothing and let the estate tax take about half of it, with survivors getting the rest. Others consider charitable options, which can produce current-year tax savings, allowing even more wealth to be available for charity for transfers to others.
Another option is to consider ways to pass the wealth down to the owner’s descendants or intended beneficiaries. For significant wealth, these multi-generational transfers typically involve dynasty trusts that benefit remote descendants.
Our tax system has numerous rules in place to discourage this type of tax planning or even prevent this last option. The generation-skipping transfer (“GST”) tax is one set of rules that can apply. This is a significant hurdle that must be considered if the goal is to pass wealth to those in different generations.
As the estate tax rules are set to sunset in 2026, post-mortem GST tax planning will be more important as these onerous taxes will apply to even more modest transfers. The IRS’s recent Private Letter Ruling 202425005 provides an opportunity to consider these rules and how, even after transfers are made and maybe even after the death of the trust settlor, strategic allocation of the GST exemption can be used to reduce taxes associated with dynasty trusts and multi-generational wealth transfers.
Contents
Facts & Procedural History
John Doe is a wealth creator. He started a business, scaled the business, and sold a majority stake in the business to an investor. John is now effectively retired but still handles some sales activities for the company.
The days of working with his business team, such as his corporate controller, admin, and staff, are gone. They are replaced with working with his financial team, including his investment advisor, CPA, and trusts and estates attorney.
John wants to set up a trust to pass wealth to his descendants. John’s children are all adults, mostly well off, and some have fallen out of favor based on their life choices, be it careers, marriages, or other lifestyle decisions. John has several grandchildren who have not yet reached an age to fall out of favor with him. John’s focus is on ensuring his grandchildren are provided for.
The financial team proposes a dynasty trust. The trust provides income for John’s children during their lifetimes with later distributions to sub-trusts for John’s grandchildren. This continues to great-grandchildren and so on in perpetuity until the trust assets are depleted. John makes substantial transfers to the trust over the years, including transferring part of the company stock he retained when he sold his business. John also transfers other assets to the trust.
Thus, in John’s case, his dynasty trust was structured to provide financial support to his children, grandchildren, and future descendants, allowing the assets to grow and benefit multiple generations without being depleted by transfer taxes at each generational level.
About the Dynasty Trust
A dynasty trust is an irrevocable trust designed to last for multiple generations. They are usually formed in states that allow trusts to exist in perpetuity.
The primary goal of the dynasty trust is to transfer wealth while minimizing estate, gift, and GST taxes, thereby preserving the family’s wealth across generations. To this end, dynasty trusts are often funded with appreciating assets or even insurance, such as split-dollar insurance, which can allow tax planning involving valuation concepts to reduce taxes (which is explained further, below).
In John’s case, his dynasty trust was structured to provide financial support to his children, grandchildren, and future descendants, allowing the assets to grow and benefit multiple generations without being depleted by transfer taxes at each generational level.
About the GST Tax
To consider this topic, we have to first address the GST tax.
The GST tax applies to transfers that “skip” a generation, thereby avoiding the gift and estate tax that would apply if the assets passed through the intermediate generation. Think of transfers from grandparents directly to grandchildren. Absent a first stop with the parents of the grandchildren, the government has lost out on one generation of gift or estate tax for the parents of the grandchildren.
A “skip person” is defined as an individual who is at least two generations younger than the transferor (the person making the gift or bequest). The most common examples of skip persons are the transferor’s grandchildren, as they are two generations below. Great-grandchildren and further descendants also qualify as skip persons since they are three or more generations below the transferor.
Additionally, unrelated individuals who are more than 37.5 years younger than the transferor are considered skip persons, but only if they are not related to the transferor. For instance, if John makes a transfer to a significantly younger family friend or even a young girlfriend, that individual may be classified as a skip person, but this rule wouldn’t apply to a younger spouse or in-law.
There are others who are not skip persons. John’s children are not skip persons because they are only one generation below him, and transfers to children are not subject to GST tax. Similarly, siblings of the transferor are not skip persons as they belong to the same generation. Nieces and nephews are also considered one generation below the transferor and are not skip persons; however, grand-nieces and grand-nephews, who are two generations below, would be classified as skip persons.
The GST tax is imposed at a flat rate equal to the highest estate tax rate. It is currently 40%. In addition to the high tax rate, what makes the GST tax particularly onerous is that the tax is in addition to any applicable gift or estate tax. This can result in a significant tax burden for wealth transfers across multiple generations. This is intentional and the intended result.
The GST Tax Exemptions
The rules also include a tax exemption to allow an amount to pass free of the GST tax. This is referred to as the GST tax exemption. The GST exemption allows individuals to transfer a specified amount of assets to skip persons or trusts that may benefit skip persons without incurring GST tax. For 2024, the GST exemption amount is $13,610,000 per individual, indexed annually for inflation.
In addition to the lifetime GST exemption, there’s also an annual GST exclusion that mirrors the annual gift tax exclusion (currently $18,000 per recipient in 2024). This allows John to make transfers to skip persons, such as grandchildren, of up to this amount each year without using any of his lifetime GST exemption or triggering GST tax. These annual exclusion transfers can be made directly or to certain types of trusts, providing another tool for transferring wealth to future generations in a tax-efficient manner. Other than this brief mention, we don’t address this annual GST exclusion for this article, but just note that it is also part of the overall planning for GST taxes.
Key Aspects of GST Exemption Allocation
Under Section 2632(c), the GST exemption is automatically allocated to certain transfers made to “GST trusts” during the transferor’s lifetime.
A GST trust is generally defined as any trust that could have a generation-skipping transfer with respect to the transferor. More specifically, it includes trusts where a skip person (such as a grandchild) has an interest in the trust property, and distributions to non-skip persons are unlikely to exhaust the trust before the skip persons become entitled to receive distributions.
It is important to note that when a trust has both skip and non-skip beneficiaries, the initial transfer to the trust may not fully trigger GST tax. According to Regulation § 26.2612-1, a trust that benefits both skip and non-skip persons is classified as a non-skip person trust. This means that while the initial transfer to the trust does not immediately result in GST tax, future distributions to skip persons may still be subject to GST tax unless the GST exemption is properly allocated.
The inclusion ratio is a critical concept in GST tax planning. It determines the portion of a transfer that is subject to GST tax. The inclusion ratio ranges from zero to one:
- An inclusion ratio of zero means the GST exemption fully covers the transfer, resulting in no GST tax due on distributions to skip persons.
- An inclusion ratio between zero and one indicates that a portion of the transfer is covered by the GST exemption, while the remainder is subject to GST tax.
- An inclusion ratio of one means the transfer is fully subject to GST tax, with no exemption applied.
The inclusion ratio is calculated as 1 minus the “applicable fraction.” The applicable fraction is, generally, the amount of GST exemption allocated to the transfer divided by the value of the property transferred.
For example, if John transfers $10 million to a trust and allocates $5 million of his GST exemption to this transfer, the applicable fraction would be 0.5 ($5 million / $10 million). The inclusion ratio would then be 0.5 (1 – 0.5). This means that half of any future distributions to skip persons from this trust would be subject to GST tax.
Understanding and managing the inclusion ratio is crucial for effective GST tax planning. It allows for strategic allocation of the GST exemption to minimize future tax liabilities on distributions to skip persons.
With our facts, this means that John’s initial transfer to the trust may use up some or all of his GST exemption amount. This depends on the inclusion ratio and the allocation. For the purposes of this article, note that this allocation is automatic if John does not take action to elect out of the automatic allocation.
Transferors can elect out of the automatic allocation rules. By electing out, instead of relying on automatic allocation, taxpayers like John can manually allocate their GST exemption to specific transfers or trusts. This would require later gift tax returns and/or his estate tax returns to report the use of his exemption for trust distributions. This approach can allow for more strategic use of the exemption, ensuring it is applied where it can provide the most significant tax savings. The timing and method of allocating GST exemption can significantly impact its effectiveness.
In John’s case, he chose to make specific allocations over time to cover distributions to his grandchildren. At least that was what he intended to do. This election out typically has to be made on a timely filed gift tax return for the year of the transfer. John did not make this election, however, so the exemption was automatically allocated to the transfers to the trust by default. John had to go back and request a private letter ruling from the IRS as he failed to make the election. He asked permission from the IRS to make a late election, which the IRS granted.
Optimizing the GST Exemption
Leveraging Valuation Discounts
When transferring certain assets, such as interests in closely-held businesses or family limited partnerships, to the dynasty trust, John may be able to apply valuation discounts. These discounts, typically for lack of control and marketability, can reduce the gift tax value of the transferred assets, allowing John to transfer more economic value while using less GST exemption.
Life Insurance Strategies
Life insurance can be a powerful tool for leveraging GST exemptions. John’s dynasty trust could purchase a life insurance policy on his life using GST-exempt funds. Upon John’s death, the life insurance proceeds would be paid to the trust free of estate and GST taxes, potentially multiplying the effect of the allocated GST exemption.
One specific technique to consider is the use of split-dollar life insurance arrangements. These arrangements can allow for the purchase of a large life insurance policy with minimal gift tax consequences, while still providing significant benefits to the dynasty trust.
Using Grantor Trust Status
Structuring the dynasty trust as a grantor trust for income tax purposes can enhance the value of John’s GST exemption allocation. As the grantor, John would pay the income taxes on the trust’s earnings, allowing the trust assets to grow tax-free. This effectively permits additional tax-free transfers to the trust without using more GST exemption.
Sales to Intentionally Defective Grantor Trusts (“IDGTs”)
An advanced strategy involves John selling appreciated assets to an IDGT in exchange for a promissory note. If structured correctly, this transaction isn’t a taxable event, allowing John to transfer assets in excess of his GST exemption amount without incurring additional transfer taxes. The GST exemption is only needed for the initial “seed” gift to the trust.
Life Insurance Strategies
Life insurance can be a powerful tool for leveraging GST exemptions. John’s dynasty trust could purchase a life insurance policy on his life using GST-exempt funds. Upon John’s death, the life insurance proceeds would be paid to the trust free of estate and GST taxes, potentially multiplying the effect of the allocated GST exemption.
Married Couple Planning
For married couples like John and his wife, coordinating the use of both spouses’ GST exemptions can potentially double the amount transferred to the dynasty trust without incurring GST tax. This can be effective marital tax planning.
Care must be taken in structuring these transfers. A recent court case, Smaldino v. Commissioner, T.C. Memo. 2021-127, highlights potential pitfalls in this approach, particularly when attempting to use both spouses’ exemptions in quick succession. In Smaldino, the husband attempted to transfer LLC interests to his wife, who then purportedly retransferred those interests to a dynasty trust the next day. The intention was to use the wife’s gift tax exemption for this transfer. The tax court disregarded the transfer to the wife, treating the entire transaction as a direct gift from the husband to the dynasty trust. This does not foreclose on this planning, it just requires more attention to the steps to carry out the planning.
Charitable Lead Trusts (“CLTs”)
A charitable trust can be an effective way to leverage John’s GST exemption. By creating a trust that makes payments to charity for a set term, with the remainder passing to his grandchildren or the dynasty trust, John might be able to pass significant assets to skip persons free of GST tax while using only a fraction of his GST exemption.
Strategic Trust Distributions
If John’s dynasty trust is only partially exempt from GST tax, he can work with the trustee to make strategic distributions that preserve the GST tax-exempt portion of the trust. By making distributions to non-skip persons (like John’s children) from the non-exempt portion, the exempt portion can continue to grow for the benefit of skip persons (like John’s grandchildren).
Decanting Strategies
For existing trusts that aren’t optimized for GST tax purposes, decanting – essentially transferring assets from an existing trust to a new one with more favorable terms – might allow for more efficient use of allocated GST exemption or create opportunities for new exemption allocation. Decanting can be particularly useful if the existing trust doesn’t have optimal GST provisions, such as allowing for distributions to skip persons without proper GST tax planning. It can also be used to extend the term of a trust in a state that has repealed the rule against perpetuities, potentially extending the GST tax benefits for multiple generations.
Making Late GST Exemption Allocations
The GST exemption and planning are sometimes overlooked when trusts are set up.
This frequently occurs because many estate planning attorneys do not provide tax advice. Estate and trust attorneys often just provide estate and asset protection strategies. All is not lost in these situations. Many of the common tax planning options, such as those noted above, may still be available after the transfers are made and maybe even after the death of the trust settlor.
As this PLR shows, the IRS does have the power to allow late GST exemption allocations and the IRS often grants this type of relief. A significant amount of time can pass between the initial funding of the trust and the realization that the election needs to be made or corrected. This late relief can be used to correct oversights or to respond to changed circumstances during the trust creator’s lifetime, and may even allow post-transfer or even post-mortem tax planning.
In considering such requests, the IRS evaluates whether the taxpayer acted reasonably and in good faith, and whether granting relief will prejudice government interests. Reliance on a qualified tax professional who failed to make or advise making the election can be grounds for relief. This aspect of the ruling could be particularly relevant if John’s advisors or even his executor discovers that certain allocations were missed due to professional oversight, which might also involve missed tax planning that can be remedied at the same time.
The Takeaway
As the estate tax rules are set to sunset in 2026, now is a critical time to revisit and optimize GST tax planning strategies. This IRS PLR shows that it may not be too late to review and adjust estate plans to ensure that the GST exemption is used effectively, even post-transfer or post-mortem. Proper timing and filing of elections are crucial to maximizing the benefits of the GST exemption and preserving wealth across generations.
Special Considerations for Grandfathered Trusts
While most of this article focuses on dynasty trusts created under current law, it’s important to note that there are special rules for certain older trusts, often referred to as “grandfathered” trusts. These are trusts that were irrevocable on or before September 25, 1985, and they may be exempt from GST tax under certain conditions.
The GST tax law includes a grandfather provision that exempts transfers from trusts that were irrevocable on September 25, 1985, from GST tax. However, the extent of this exemption has been the subject of significant litigation, particularly regarding how it applies to powers of appointment granted in these older trusts.
Key court cases have shaped the interpretation of this grandfather provision:
- Simpson v. United States (1999): Initially, the Eighth Circuit Court of Appeals took a broad view, holding that the exercise of a general power of appointment granted in a pre-1985 trust was exempt from GST tax.
- Estate of Gerson v. Commissioner (2006) and Estate of Timken v. United States (2010): These later cases narrowed the interpretation, upholding IRS regulations that treat the exercise of such powers as subject to GST tax.
These cases demonstrate that while grandfathered trusts may offer some GST tax advantages, the exemption is not absolute. The exercise of powers of appointment or other actions that result in transfers from these trusts may still trigger GST tax liability.
For individuals who are beneficiaries of or have powers over grandfathered trusts, one has to carefully consider any action that might affect the trust’s grandfathered status. The rules are complex and have evolved over time, so strategies that may have worked in the past might not be effective under current interpretations.
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