July 29, 1998
The Honorable William V. RothThe Honorable Bill Archer
Chairman, Committee on FinanceChairman, Committee on Ways and Means
United States SenateUnited States House of Representatives
104 Hart Senate Office Building1236 Longworth House Office Building
Washington, D.C. 20510Washington, D.C. 20515
Dear Chairmen Roth and Archer:
We enclose a legislative proposal concerning the generation-skipping transfer tax (GST tax). The proposal seeks to eliminate tax traps that may cause massive liabilities for taxpayers and their advisors. The proposal would automatically allocate GST exemption to those transfers to which most taxpayers would want to allocate exemption and would allow the IRS to grant relief to taxpayers who inadvertently fail to allocate GST exemption. It would also allow validation of exemption allocations that were technically flawed, allow retroactive allocation of exemption in cases of unnatural order of death and permit division of trusts to allow taxpayers to maximize the benefit of the exemption without overly complex planning and drafting. The proposal is not intended to effect any changes in tax policy. Rather, it suggests technical changes that would allow more taxpayers to fully utilize the exemption from GST tax that Congress decided taxpayers should have when the tax was enacted in 1986.
While we do not purport to be revenue estimators, our experience suggests that any revenue implications of this proposal are likely to be minimal because taxpayers can achieve the same results now, but only with great care and complex planning. If this proposal does decrease revenue, it would only be because it simply allows more affected taxpayers to obtain the full benefit of the GST exemption. That is a benefit that can be achieved under current law with sophisticated and complicated drafting, but which some taxpayers currently forfeit through inadvertent mistakes arising from the complexity of this area of the law, and other taxpayers may choose to forfeit in preference for more simple and understandable documents.
This proposal was drafted by members of a multi-professional task force* including members of many committees of the American Institute of CPAs (AICPA), the American Bankers Association, the American College of Trust and Estate Counsel (ACTEC) and several bar associations. The Tax Section and the Real Property, Probate and Trust Law Section of the American Bar Association (ABA) and ACTEC plan to submit this proposal under separate cover as well.
Serious liability problems exist under current law. Missed allocations often create significant potential GST tax liability because a missed allocation usually affects a tax computation that will be made many decades in the future. At that time, the amount subject to GST tax as a result of the missed allocation may have increased exponentially. The potential liabilities are so large that many practitioners consider the preparation of gift tax returns to be too risky for the fees involved and are declining to prepare such returns. Taxpayers need professional assistance in preparing gift tax returns at a realistic price. This proposal would reduce the incidence of liability due to a missed allocation by making the allocation automatic when allocation most commonly makes sense, by validating GST exemption allocations that are technically flawed and by allowing the IRS to grant relief to taxpayers who inadvertently fail to allocate GST exemption. The proposal makes the GST tax rules fairer by making the benefits of the GST exemption more accessible to the taxpayer who does not have sophisticated advisors.
Under current Treasury regulations, to get the full benefit of the GST exemption, separate trusts can be created, one of which is entirely exempt from GST tax and one of which is not. Once a trust is created, however, a severance of the trust into exempt and nonexempt trusts is not allowed under Treasury Regulations. For example, if a taxpayer creates a trust for the taxpayers five children and one child dies, the regulations do not allow the trust to be severed so that GST exemption can be assigned to the one-fifth of the trust that will primarily benefit the deceased childs children. However, if five separate trusts had been created instead of one, this problem would have been avoided. The costs and complexities of drafting and administering multiple trusts could be reduced significantly if the rules were more user-friendly. Such a pointless exercise engenders disrespect for the tax system. It also encourages taxpayers to create multiple trusts, something Congress has sought to discourage in the past.
The GST tax applies even to those who are not wealthy. For example, suppose that an individual funds a trust with $100,000 to benefit his or her child until the child attains the age of 25. If the child dies at age 24 leaving two young children when the trust is worth $200,000, and the interest passes to the two children, the GST tax would be $110,000. GST tax will apply because the grandparent who created the trust, not expecting his or her child to die before reaching age 25, did not allocate GST exemption to the trust. It is too late to allocate GST exemption after the child dies because the taxable event has already occurred. If the grandparent had allocated GST exemption when the trust was created, there would be no GST tax. To fix this anomaly, the proposal would allow retroactive allocation of exemption when a child dies before his or her parent who created the trust. The GST tax was not intended to and should not be used to penalize taxpayers when their children die prematurely if the transferor is still alive.
We hope you will give this important proposal favorable consideration. We would be happy to meet with you or your staff to discuss these matters.
If you have any questions or would like to schedule a meeting to discuss this further, please call John H. Gardner, at (202) 467-3870; Carlyn S. McCaffrey, at (212) 310-8136; Pam H. Schneider, at (215) 988-2771; Lloyd Leva Plaine, at (202) 383-0100; Ellen K. Harrison at (202) 467-7275; or Eileen R. Sherr, AICPA Technical Manager, at (202) 434-9256.
Sincerely,
John H. GardnerCarlyn S. McCaffrey
On behalf of the Multi-Professional Organization GST Exemption Allocation Task Force (see list enclosed)
Members of the Multi-Professional Organization GST Exemption Allocation Task Force include:
Byrle M. AbbinAICPA Trust, Estate, and Gift Tax Committee Advisory Member
Robert A. BlumeAICPA Trust, Estate, and Gift Tax Committee Member
Cynthia L. BrownDC Bar Estate, Trusts, and Probate Section Member
Sandra S. ByrdAmerican Bankers Association Trust Committee Chair
Evelyn M. CapassakisAssociation of the Bar of the City of New York Estate and Gift Tax Committee GST Tax Reform Subcommittee Chair
John H. GardnerAICPA Trust, Estate, and Gift Tax Committee Chair
Carol A. HarringtonAttorney, acting on her own behalf
Ellen K. HarrisonAttorney, acting on her own behalf
Catherine V. HughesAttorney, acting on her own behalf
Gregory F. JennerAttorney, acting on his own behalf
David E. LajoieAICPA Trust, Estate, and Gift Tax Committee Member
Charles A. LowenhauptAttorney, acting on his own behalf
Carlyn S. McCaffreyAttorney, acting on her own behalf
Judith A. McCormickAmerican Bankers Association Senior Trust Counsel
Joseph W. MooneyAmerican Bankers Association Trust Committee Member
Anne J. OBrienDC Bar Estate, Trusts, and Probate Section Member
Lloyd Leva PlaineAttorney, acting on her own behalf
Roby B. SawyersAICPA Trust, Estate, and Gift Tax Committee Member
Pam H. SchneiderAttorney, acting on her own behalf
Eileen R. SherrAICPA Trust, Estate, and Gift Tax Committee Technical Manager
George L. Strobel, IIAICPA Trust, Estate, and Gift Tax Committee Member
cc:Members of the House Ways and Means Committee
Members of the Senate Finance Committee
Mr. Franklin Polk, Majority Staff Director/Chief Counsel, Senate Committee on Finance, SD-219
Mr. Mark Prater, Majority Chief Tax Counsel, Senate Committee on Finance, SD-219
Mr. Tom Roesser, Majority Tax Counsel, Senate Committee on Finance, SD-219
Mr. Mark Patterson, Minority Staff Director/Chief Counsel, Senate Committee on Finance, SH-203
Mr. Nicholas Giordano, Minority Chief Tax Counsel, Senate Committee on Finance, SH-203
Mr. Maury Passman, Minority Tax Counsel, Senate Committee on Finance, SH-203
Mr. A. L. Pete Singleton, Majority Chief of Staff, House Committee on Ways and Means, LHOB-1102
Mr. James Clark, Majority Chief Tax Counsel, House Committee on Ways and Means, LHOB-1135
Mr. Timothy Hanford, Majority Tax Counsel, House Committee on Ways and Means, LHOB-1135
Ms. Janice Mays, Minority Chief Counsel, House Committee on Ways and Means, LHOB-1106
Mr. John Buckley, Minority Chief Tax Counsel, House Committee on Ways and Means, LHOB-1106
Ms. Lindy Paull, Chief of Staff, Joint Committee on Taxation, LHOB-1015
Mr. Melvin Thomas, Jr., Senior Legislation Counsel, Joint Committee on Taxation, LHOB-1618
Mr. Donald Lubick, Assistant Secretary for Tax Policy, U.S. Treasury Department, Room 1000 MT
Mr. Jonathan Talisman, Deputy Assistant Secretary, U.S. Treasury Department, Room 1334 MT
Mr. Joseph Mikrut, Tax Legislative Counsel, U.S. Treasury Department, Room 1332 MT
Ms. Beth Kaufman, Attorney-Advisor, Treasury Office of Tax Legislative Counsel, Room 1317 MT
Mr. Stuart Brown, Chief Counsel, Internal Revenue Service, Room 3026 IR
Mr. George Masnik, Chief, Branch 4, CC:DOM:P&SI:BR4, Internal Revenue Service, Room 5431 IR
*The multi-professional organization task force that developed and supports the proposal includes members from the:
American Institute of Certified Public Accountants (AICPA) and its Trust, Estate, and Gift Tax Committee;
American Bankers Association and its Trust Taxation Committee;
American College of Trust and Estate Counsel (ACTEC); and
Association of the Bar of the City of New York Estate and Gift Tax Committee and its GST Tax Reform Subcommittee and the DC Bar Estate, Trusts, and Probate Section and DC Bar Legislative Affairs Committee.
**Although some of us are members of ACTEC, and hold committee, or officer positions with that organization, this letter has been written in our individual capacities, to express our own views and not the view of ACTEC. Although some of us have clients affected by the federal tax rules applied in the areas addressed by this letter, none of us (nor the firm of any of us) have been engaged by a client with respect to the specific subject matter of this letter.
PROPOSAL FOR CERTAIN AMENDMENTS TO THE
GENERATION-SKIPPING TRANSFER TAX
BACKGROUND
A generation-skipping transfer tax (GST tax) is imposed on transfers outright or in trust to beneficiaries more than one generation below the transferor's generation at the maximum gift and estate tax rate (55%). To determine the rate applicable to a particular transfer, the 55% rate is multiplied by the inclusion ratio (a fraction based on the amount of GST exemption allocated to the transfer). A trust that has a zero inclusion ratio is exempt from GST tax.
Every individual is allowed a $1 million GST exemption (indexed for inflation) which may be allocated to any property subject to estate or gift tax. Married couples may treat transfers as made one-half by each spouse, in effect giving them a combined $2 million GST exemption.
If GST exemption is allocated to a lifetime transfer to a trust on a timely filed gift tax return, the portion of the trust protected is generally based on the value of the property at the time of the transfer. However, if the allocation is not made on a timely filed gift tax return, the portion of the trust protected is based on the value of the property at the time of the allocation. Except in limited cases, GST exemption allocated after a GST taxable transfer has occurred will not reduce the GST tax on that transfer. The planning necessitated by the rules for allocating GST exemption are extremely complex. For example, GST exemption should be allocated to certain, but not all, transfers qualifying for the annual gift tax exclusion. This may require that a gift tax return be filed solely for the purpose of allocating GST exemption.
Under current law, even when it can be shown that the parties intended to make an allocation of GST exemption to a transfer, no relief is available for a failure to allocate. In addition, under current Treasury regulations, a trustee cannot sever a trust that is subject to the GST tax into two separate trusts, one exempt and one nonexempt, after the trust has been created. Taxpayers who can afford sophisticated advisers create multiple trusts to create separate exempt and nonexempt trusts.
REASONS FOR CHANGE
The current GST tax rules provide expensive "traps" for both taxpayers and practitioners. Taxpayer fairness and equity require that these rules be more user-friendly.
Consider the following examples:
1.A parent transfers $10,000 a year for 10 years to a discretionary trust for a child and such childs descendants which will terminate and distribute to the child when the child is age 35. If the child dies before attaining age 35, the trust is distributable to such childs descendants. If the child dies before age 35 survived by descendants when the trust assets are worth $100,000, a taxable termination will have occurred. Unless GST exemption was allocated before the child died, the GST tax would be $55,000. If an amendment is made to give an opportunity to retroactively allocate GST exemption when appropriate, GST tax can be avoided.
2. A parent transfers $1 million of stock to a trust to pay income to the parents child for life, remainder to the parents grandchild. If the full $1 million GST exemption is allocated to this transfer on a timely filed gift tax return, and the value of the stock is $5 million at the time that the property passes to the grandchild, no GST tax results. However, if the GST exemption is not allocated until the property has grown to $5 million, a GST tax of $2.2 million would result if, when the property passes to the grandchild, it is still worth $5 million.
3.A parent transfers $1 million to a trust to pay income to child until childs 35th birthday at which time the trust property will be paid to the child. If the child dies before his or her 35th birthday, the trust property will be paid to the childs children. The child dies before attaining age 35 at a time when the trust is worth $5 million. If no GST exemption is allocated before the child's death, there would be no opportunity to allocate GST exemption and a GST tax of $2.75 million would be imposed. If an amendment is made to give an opportunity to allocate GST exemption and the valuation date is not retroactive to the date of the original transfer and the allocation is made, a GST tax of $2.2 million will be imposed. By contrast, had the donor allocated GST exemption on a timely filed return, no GST tax would be due.
Example 1 illustrates the common mistaken belief that if transfers do not exceed $10,000 per year, the GST tax will not be applicable. Example 1 also illustrates that the GST tax can be imposed even where a transfer is much smaller than the amount of the GST exemption.
As shown in example 2, if GST exemption is intended to be allocated and is not and substantial appreciation occurs before the failure to allocate is discovered and corrected, the economic damage suffered by the family can be very large. Even when the need to make an exemption allocation is known, the manner and method for making an appropriate allocation is not intuitive and not readily discernable from the gift tax return and its instructions. Gift tax returns are frequently erroneously prepared.
In some cases, such as example 3 above, it is not expected that a transfer subject to GST tax will occur. Taxpayers should not be penalized for failing to anticipate the premature death of a child. In some cases, the failure to allocate GST exemption or the possibility of a transfer subject to GST tax may not be discovered for many decades.
Missed allocations of GST exemption create significant potential GST tax liability. The compounding factor and the impact of inflation can increase the GST tax liability exponentially. An accounting firm recently paid several million dollars to a qualified settlement fund to settle a case involving failure to allocate the GST exemption, the tax effects of which were the subject of PLR 9736032.
As a result, even where there has been a good faith effort to comply with the law, taxpayers are being faced with punishing tax consequences, and practitioners are being faced with enormous malpractice claims. In fact, some practitioners consider the preparation of gift tax returns to be too risky for the fees involved and are declining to prepare such returns. Consequently, taxpayers may be deprived of needed professional advice at a realistic price, and the IRS could be faced with a tremendous administrative burden. A legislative solution is needed to address these concerns and bring fairness and equity to this area of the law.