2012 Estate Planning. Martin Inc. Shenkman
an unlimited amount of money to pay for a grandchild’s qualified education or medical expenses. These gifts will not be subject to either gift or GST tax.
•GST Exemption: A lifetime exemption is allowed that permits an individual to transfer up to $5.12 million of cash, or other property, in 2012 to skip persons without triggering a GST tax. In 2013, the GST exemption is scheduled to decline to $1 million as inflation adjusted. This is at the heart of much of your 2012 planning.
PLANNING NOTE: The possible creation of a difference in the amount of (de-unification of) the estate and GST exemptions in 2013, if the law in fact reverts to the pre-2001 law, may require that your will or revocable trust be revised to permit a proper funding of the excess GST exemption amount (e.g., the inflation-adjusted GST exemption over the static $1 million estate exemption) otherwise that excess amount, which could grow in future years free of GST tax, could be wasted.
•Certain Transfers: Transfers that meet the following three requirements are also excluded from GST taxation: (1) the property transferred was previously subject to the GST tax; (2) the transferee (recipient) in that prior transfer was a member of the same generation as the current transferee; and (3) the transfer does not have the effect of avoiding the GST tax.
Inclusion Ratio: The Key to GST Tax Trust Planning in 2012
To understand the use of the GST exemption and President Obama’s proposed changes, another important concept must be introduced: the inclusion ratio. The portion of a trust that is exempt from the GST tax is determined by the trust’s inclusion ratio. (Another way of saying this is that the inclusion ratio determines the portion of the trust that, in effect, is subject to the GST tax.) A trust’s inclusion ratio is established when you as the transferor make a completed gift to the trust and allocate your GST exemption (either under the Code’s automatic allocation rules or using a gift tax return to affirmatively allocate GST exemption) to the trust. The inclusion ratio is: [1 - the applicable fraction]. The applicable fraction, when a transferor makes a gift to a trust, is determined as follows:
One approach to addressing the potential GST tax problems associated with long-term trusts is to allocate your GST exemption to the trust. If you allocate any portion of your GST exemption to the trust, that portion of the exemption is considered used, whether or not a GST tax is ever incurred. However, if you allocate GST exemption to a trust, and the trust property never passes to a skip person, you will have wasted that portion of your exemption. You should analyze all the relevant factors and consider the likelihood of the trust incurring a GST tax in the future before committing to allocate GST exemption. This is especially difficult because of the uncertainty as to what the GST exemption will be after 2012. If it appears likely that the trust will incur a GST tax, then you may benefit your heirs by allocating GST exemption to the trust. If the likelihood of a GST tax appears small, then perhaps GST exemption should be reserved for other planning opportunities.
PLANNING NOTE: Less than 2 percent of term life insurance policies ever pay off on the death of the insured. The policies are generally cancelled long before death. So if you plan to establish an irrevocable life insurance trust (ILIT) in 2012 (e.g., to take advantage of the large gift tax exemption and transfer a large amount of cash to the trust in order to avoid future Crummey powers), evaluate whether or not GST exemption should be allocated. If you knew for certain that the exemption would drop to $1 million in 2013 and not increase again in the future, it might make sense to use up GST exemption regardless of the likelihood of benefit: If you don’t use it, you will lose it. On the other hand, allocating what remains of your GST exemption to an inefficient trust, like an insurance trust holding term insurance, would be a waste of a valuable exemption if the law is not so harshly changed in 2013.
A better approach might just be to design a better trust in 2012 and instead of using a rather plain vanilla ILIT, use a DAPT-ILIT combination. The domestic asset protection trust (DAPT) is explained in more detail in Chapter 5. A key feature of a DAPT is that you may be a discretionary beneficiary of the trust. The concept of an ILIT that holds insurance on your life can be combined with a DAPT to which completed gifts are made, so in effect you are a beneficiary of a trust that owns life insurance on your life. This might avoid the need to have multiple trusts. You can use assets transferred to the DAPT to pay insurance premiums. When a DAPT structure is used in this manner, GST exemption would likely be allocated to the trust. There are obviously technical complications to creating and maintaining such a trust so refer to Chapter 5.
GST Automatic Allocation Rules
The mechanism by which GST exemption is allocated to a trust is complex and you should be careful in how you address GST allocations on federal gift tax returns (Form 709) for the 2012 year, especially with consideration to the automatic allocation rules.
In very simple terms, if assets are given to a trust that could benefit your grandchildren or more remote descendants (skip-persons), distributions to them from that trust would be subject to GST tax. To minimize the number of taxpayers to which the GST tax applies, each taxpayer is afforded an exemption from the GST tax. The 2010 Act increased this GST exemption to $5 million inflation adjusted, which is $5.12 million in 2012. If a proper amount of the donor’s GST exemption is allocated to the gift to the trust (i.e., the trust has an inclusion ratio of zero), the trust can be made entirely exempt from the GST tax. If $5.12 million was given to the trust (and assuming no other gifts are ever made to the trust), and $5.12 million of GST exemption was allocated to protect that gift, then the trust would be exempt from GST tax for as long as it lasts. No matter how large the trust may grow in value, and no matter to whom distributions are eventually made, and no matter for how long assets grow inside the trust, no GST tax will apply. The GST tax rules automatically allocate your GST exemption in certain instances in order to assist taxpayers in avoiding running afoul of the complex GST allocation rules.
Unfortunately, the automatic allocation rules don’t always work as intended and can result in a waste of your GST exemption. Moreover, unless the law is changed, the automatic allocation rule ends this year and, most important for some, it is possible that the automatic allocation rules will be treated as if they were never enacted. If this occurs, then after this year, the trust would no longer be exempt from GST tax. In effect, allocations made automatically to a trust in years before 2013 would be treated as if they were never made. This could upset the planning for many existing trusts. While most estate planners anticipate that these rules will be continued to avoid this problem, as with so many tax issues, there is simply no guarantee.
PLANNING NOTE: Be aware that 2012 may present a different planning paradigm. If the GST exemption declines from $5.12 million to an inflation-adjusted $1 million in 2013, allocating a disappearing GST exemption in a less than optimal manner may be far preferable than not allocating exemption dollars that may simply disappear. When making GST allocation decisions on 2012 gift tax returns, absent any certainty in the law at that time, you should be cautious to weigh these issues. Prudent planning may require extending 2012 gift tax return filing dates as long as possible in the hope that the new law will become known during that period. (However, we may end up with another two-year bandaid like Congress put on the estate tax system in 2010.)
PORTABILITY OF UNUSED EXEMPTION DOES NOT NEGATE NEED FOR PLANNING