Holiday Gatherings
How was your Thanksgiving? I hope you celebrated the holiday in a pleasant setting with folks whose company you enjoyed, and with plenty of good food. I hope you participated in some interesting conversations or joined in some fun games. I hope your NFL team put on a decent show.[i] I hope you had – and will continue to have – many reasons for which to be thankful, that you acknowledged them, and will continue to do so.
At some point during our family’s celebration of this uniquely American holiday,[ii] I almost always find myself apart from the rest of the group, observing how others are interacting with one another, sometimes recalling how they may have handled certain challenges during the year,[iii] and often wondering what sort of future awaited them.[iv]
A Time for Observation
Oddly enough, perhaps for some, my thoughts will also drift toward certain clients,[v] especially those with whom I have been discussing succession in the family business.
I wonder whether any of these business owners are discretely watching their scions during the holiday festivities, taking mental notes of incidents that may influence their thinking; for example, who drank too freely, spoke too loosely, failed to control their emotions, shared the amount they had carelessly bet on the outcome of a football game, displayed too much “affection” with their latest significant other, or acted disrespectfully around the family or other guests.
Reconsidering One’s Plan
I imagine that the dispositive scheme incorporated by the individual taxpayer (the “Grantor”)[vi] in the irrevocable trust (the “Trust”) they established for the benefit of Grantor’s daughter (“Daughter”) and her descendants (the Grantor’s grandchildren), and that is the subject of the IRS private letter ruling (“PLR”)[vii] described below, may have been influenced by the behavior of these beneficiaries at their family’s Thanksgiving or other holiday gathering.
After discreetly observing the natural objects of their bounty, the Grantor may have concluded that, instead of terminating the Trust and distributing its assets outright to Daughter‘s descendants at a date certain, as the Grantor had originally planned, it would be more prudent to extend the duration of the Trust and the protection it afforded the Trust’s assets.
However, before modifying its dispositive terms, the Trust asked the IRS to consider the generation-skipping transfer (or “GST”) tax[viii] consequences of the proposed change.
GST Tax
The GST tax is imposed on the occurrence of any one of three “events”: a taxable distribution,[ix] a taxable termination,[x] or a direct skip.[xi] Each of these events involves the actual or deemed transfer to a beneficiary who is at least two generations younger than the transferor. Thus, only transfers to grandchildren or younger generations are subject to the tax; such transfers may be made in trust or outright.
As stated earlier, Grantor established the irrevocable Trust for the benefit of Daughter and her descendants.[xii] The Trust was created prior to September 25, 1985, and it was represented to the IRS that no “additions” were made to the Trust after such date.
Exempt Trust
This date is significant because the GST tax generally will not apply to any generation-skipping transfer under a trust that was irrevocable on September 25, 1985 (an “exempt effective date trust”).[xiii]
For example, assume individual Taxpayer established an irrevocable trust (“Trust-1”) early in 1985 for the benefit of Taxpayer’s child (“Child”) and Child’s issue (“Child’s Issue,” including Taxpayer’s 1 year old grandchild, or “GC”) all of whom were alive at the time Trust-1 was created. Trust-1 was to be construed under and regulated by the laws of State.
Assume further that Taxpayer immediately funded Trust with a $400,000 cash gift – the amount of the federal gift tax exemption in 1985 – without incurring a federal gift tax liability. No other additions were ever made to Trust-1 and the trust agreement was never modified.
Trust-1 provides that income and principal may be distributed to any or all of Child and Child’s Issue at the discretion of the trustee. Upon the death of Child, all interests in the trust were held by Child’s Issue, all of whom were skip persons as to Taxpayer.
Assume for our purposes that, under State’s rule against perpetuities, the trust would continue for 21 years following the death of Grandchild. Let’s say GC (born in 1984) survives Child and Child’s other Issue, and lives for 90 years, until 2074; adding 21 years brings us to 2095, which is the year in which Trust-1 would terminate in accordance with State’s rule against perpetuities.[xiv]
Assume Trust-1’s principal grows 5% annually (after income taxes) from its inception. By 2095, the value of Trust is over $85 million.
During the 110 years of its existence (which began in 1985), Trust-1 made distributions from income to Child and to Child’s Issue. Such distributions carried taxable income from the trust to the distributees,[xv] but none of the distributions were subject to federal gift tax. Moreover, none were subject to GST tax.
On Child’s death, and on the death of any of Child’s Issue, no part of Trust-1 was, or will be, included in the gross estate of such beneficiary for purposes of the federal estate tax.
When Child dies, even though all the remaining interests were held by Child’s Issue (skip persons, relative to Taxpayer), there was no taxable termination to which the GST tax could have applied.
At the end of the perpetuities period (in 2095), the termination of Trust-1 and the distribution of its assets to its then living beneficiaries may carry out some previously undistributed taxable income,[xvi] but no gift tax or GST tax will be incurred.
Based on the foregoing, one can appreciate the importance of preserving a trust’s status as an exempt effective date trust, which brings us back to Grantor and the PLR considered herein.
The Dispositive Provisions of Trust
The trust agreement authorized the trustees of Trust to pay out or use part or all of the trust income and principal to or for the benefit of Daughter and her descendants at such times and in such amounts as the trustees, in their sole judgment and discretion, deemed best to provide for such beneficiaries’ support, education, health, maintenance, comfort and well-being.
On Daughter’s death, the property remaining in Trust was to be divided per stirpes[xvii] into trusts for Daughter’s then living descendants.[xviii] The trustees of each such trust for a descendant of Daughter were authorized to pay out or use part or all of the income and principal of that trust to or for the benefit of that descendant, his or her descendants, and their respective spouses, at such times and in such amounts as the trustees in their sole judgment and discretion deemed best to provide for their support, education, health, maintenance, comfort and well-being.
When a descendant of Daughter – for whose benefit a trust was established upon Daughter’s death – attained X years of age, one-half of that trust’s property was to be distributed to such descendant. When the descendant attained Y years of age, all of that trust’s property was to be distributed to the descendant.
If a descendant died after a trust was set apart for the descendant, but before receiving all of that trust’s property, that descendant’s trust was to be distributed as that descendant directed in their will, except the descendant could not appoint the property to themselves, their estate, their creditors, or the creditors of their estate.[xix]
The foregoing dispositive provisions, which became applicable following Daughter’s death, were the subject of the change to the duration of the Trust, described below.
Trust Division
At some point after Trust’s creation, but before the ruling request, its trustee divided Trust into separate trusts, one for the benefit of each child of Daughter – Grandchild A and Grandchild B – containing the same dispositive provisions as Trust.[xx] Accordingly, each such trust provided that after the death of Daughter, when the child-beneficiary of the trust attained X years of age, one-half of that trust’s property was to be distributed to the child, and when the child-beneficiary attained Y years of age, all of that trust’s remaining property was to be distributed to the child.
Duration of the Trust
At the time of the ruling request, Daughter was living, as were Grandchild A and Grandchild B, each of whom had already attained Y years of age. Trust-A was the trust for the benefit of Grandchild A and Trust-B was the trust for the benefit of Grandchild B. Thus, upon Daughter’s death, Trust-A and Trust-B would terminate and Grandchildren A and B would take their respective trust’s properties outright. (The following discussion will focus on Grandchild A.)[xxi]
The applicable State law provided that the Probate Court (the “Court”) could modify the administrative or dispositive terms of a trust or terminate a trust if, because of circumstances not anticipated by the settlor, such modification or termination would further the purposes of the trust. To the extent practicable, the modification had to be made in accordance with the settlor’s probable intention. The Court could also modify the administrative terms of a trust if continuation of the trust on its existing terms would be impracticable or wasteful or impair the trust’s administration. Upon termination of a trust, the trustee would distribute the trust property as ordered by the Court.
The trustee of Trust-A petitioned the Court to modify the terms of Trust as they applied to Trust-A. Pursuant to the petition, Trust-A was modified to provide that, following Daughter’s demise, the trust property was to continue to be held and administered in trust for Grandchild A’s lifetime, rather than be distributed outright to Grandchild A.[xxii]
Significantly, upon the death of Grandchild A, any remaining undistributed principal and income was to be distributed in such manner as Grandchild A directed or appointed, including the power to appoint such property to her creditors or the creditors of her estate, by making a specific reference to this general power of appointment in her last will and testament.[xxiii]
The Court subsequently ordered that Trust-A be modified, contingent upon receiving a favorable ruling from the IRS. According to the Court, circumstances had changed such that it was in the best interests of Grandchild A that Trust-A should not terminate upon the death of Daughter, but instead should last for the lifetime of Grandchild A. The Court found that, because of the relatively large values of the assets within Trust-A, Grandchild A would continue to need guidance, management, investment advice, and distribution assistance from a professional trustee. The modification to keep Grandchild A’s inheritance in trust for her lifetime furthered the essential purpose of Trust-A to provide financially for Daughter’s descendants (i.e., Grantor’s grandchildren).
Ruling Requested
The trustee requested a ruling that, after the proposed modification of the terms of Trust-A, Trust and Trust-A would remain exempt from the application of the GST tax as effective date trusts, and that no distribution from or termination of any interest in Trust or Trust-A would be subject to the GST tax, except to the extent any additions were made to the trusts after such date.
As we shall see, certain modifications with respect to a trust that is otherwise exempt from the GST tax – such as Trust – may cause the trust to lose its exempt status.
IRS’s Analysis
The Code imposes a tax on every generation-skipping transfer,[xxiv] which is defined as a taxable distribution, a taxable termination, or a direct skip.[xxv]
However, as stated earlier, the GST tax will not apply to a GST under a trust that was irrevocable on September 25, 1985 – i.e., an effective date trust – except to the extent that such transfer was made out of corpus that was added to the trust after such date (or out of income attributable to corpus so added).[xxvi] In other words, the addition of property to an otherwise exempt effective date trust may expose a subsequent GST with respect to such trust to the GST tax.
An effective date trust may also lose its GST tax exempt status if the trust is “modified.”[xxvii]
Thankfully, the modification of the governing instrument of an exempt effective date trust by judicial reformation, or nonjudicial reformation that is valid under applicable state law, will not cause an exempt trust to be subject to the GST tax if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation[xxviii] than the person or persons who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. A modification of an exempt trust will result in a shift in a beneficial interest to a lower generation beneficiary if the modification can result in either an increase in the amount of a GST or the creation of a new GST.[xxix]
According to the IRS, the proposed modification of Trust-A, under State Law, provided that Grandchild A’s interest in Trust-A would continue to be held in trust for the exclusive benefit of Grandchild A during their lifetime. Instead of terminating upon the death of Daughter, Trust-A would continue to be a trust until the death of Grandchild A. The assets of Trust-A would be subject to Grandchild A’s testamentary general power of appointment, and would be included in Grandchild A’s gross estate for federal estate tax purposes.
Based on the foregoing, the IRS concluded that the proposed modification of Trust-A would not result in a shift of any beneficial interest in the trust to any beneficiary who occupied a generation lower than the persons holding the beneficial interests. In addition, the proposed modification of Trust-A would not extend the time for vesting of any beneficial interest in the modified trust beyond the period provided for in the original trust.
Accordingly, the IRS found that after the proposed modification of Trust-A, Trust and Trust-A would remain exempt from the application of the GST tax, and that no distribution from, or termination of any interest in, Trust or Trust-A would be subject to the GST tax.
Observations
It is probably safe to say that the estate tax and its backstops – the gift and GST taxes[xxx] – were not enacted for the purpose of generating revenue for the federal government to squander but, rather, to prevent the concentration of wealth in the hands of small few.[xxxi]
The GST tax, which is the subject of this post, was enacted, in part, to prevent wealthy individuals from using trusts to benefit several generations of these individuals’ families[xxxii] while avoiding the estate and gift taxes. The GST tax rules seek to accomplish this goal by imposing the tax on, or with respect to, gifts and bequests by an individual transferor to, or in trust for, transferees who are two or more generations younger than the transferor.[xxxiii]
As the estate, gift and GST tax exemptions have increased over time,[xxxiv] the ability of an individual taxpayer to transfer property to a trust tax-free has been greatly enhanced.
Today, each individual has a lifetime GST tax exemption[xxxv] – $13.61 million in 2024 and $13.99 million in 2025 – that can be allocated to transfers made by that individual to a grandchild or other “skip person,” whether directly or in trust.[xxxvi]
An allocation of GST exemption[xxxvii] to a trust has the potential to exclude from GST tax not only the value to which GST exemption was allocated, but also all subsequent appreciation on that value during the existence of the trust.
In most cases, as long as property remains in a trust, the death of a trust beneficiary typically will not trigger the imposition of estate tax on trust assets. This is because beneficiaries typically have no rights to the trust property that would cause the property to be includable in that beneficiary’s gross estate at death. At the termination of the trust, however, the trust assets are required to vest in one or more persons, at which point the assets become the property of those persons and reenter the gift and estate tax base.
At the time of the enactment of the current version of the GST tax provisions, the laws of most states included a common law Rule Against Perpetuities (“RAP”) or some statutory version of it requiring that every trust terminate no later than 21 years after the death of a person who was alive at the time the trust was created.
Thus, even an exempt effective date trust, like the one considered above, was expected to terminate, at which time its property would reenter the transfer tax system.
Today, many states either have limited the application of their RAP statutes (permitting trusts to continue for several hundred years),[xxxviii] or entirely repealed their RAP statute.[xxxix] In those states, trusts are permitted to continue in perpetuity and the property in those trusts has been permanently removed from the estate and gift tax base – a so-called “dynasty trust.”[xl]
Beginning with its second term,[xli] the Obama administration and, for its one term in office, the Biden administration annually sought to limit the ability of a wealthy individual to place property in a family trust that is shielded from GST Tax and thereby remove it from the estate and gift tax base.
However, after last month’s election results, it is unlikely we will see any movement on reducing the various transfer tax exemption amounts, let alone the enactment of legislation targeting dynasty trusts.
Of course, it’s only a matter of time before the political pendulum swings the other way, by which point the electorate may better understand how the transfer tax system works, or doesn’t.
As always, stay tuned.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Apologies, but there is one exception – the Dallas Cowboys. As much as I have respected individual players over the years – I put Roger Staubach, Eli Lilly and coach Tom Landry (my favorite after Bud Grant of the Vikings) at the top of that list – I can’t recall one time that I rooted for the Cowboys as a team. I just couldn’t.
[ii] On his first Thanksgiving in the White House, President Reagan said:
“Thanksgiving has become a day when Americans extend a helping hand to the less fortunate. Long before there was a government welfare program, this spirit of voluntary giving was ingrained in the American character. Americans have always understood that, truly, one must give in order to receive. This should be a day of giving as well as a day of thanks.”
The U.S. has consistently ranked as the most generous country, in terms of individual charitable giving and volunteering time. Charity is a fundamental part of our national culture and identity.
[iii] At least those of which I was aware. Let’s face it, folks regularly face many trials and tribulations all alone.
[iv] I find that a scotch or two facilitates this activity, even sharpens one’s faculties, at least momentarily. That said, it’s also the time I start to regret having a second helping . . . of almost everything.
[v] To work, generally. I can’t remember the last time I didn’t go to the office on the Friday and Saturday after Thanksgiving. I’m sure many – perhaps most – of you can commiserate.
[vi] Or, more appropriately, the Trustee of the Trust.
[vii] Private Letter Ruling 202446006 (11/15/2024).
[viii] Chapter 13 of the Code.
[ix] For example, a distribution of income or principal from a trust to beneficiary who is a skip person.
[x] For example, the termination of an interest in trust unless: a transfer subject to federal estate or gift tax occurs with respect to the property held in the trust at the time of the termination; immediately after the termination, a person who is not a skip person has an interest in the trust; or, at no time after the termination may a distribution be made from the trust to a skip person.
[xi] IRC Sec. 2611 and Sec. 2612.
[xii] Generally, Grantor’s grandchildren.
[xiii] The day before the House Ways and Means Committee began considering the bill containing the GST tax provisions that eventually became part of the 1986 TRA.
[xiv] Lives in being plus 21 years.
[xv] IRC Sec. 662.
[xvi] It may also carry out excess deductions from the trust’s final year, as well as loss carryovers. IRC Sec. 642(h).
[xvii] In brief, a method of dividing an estate where a class of distributees take the share that their deceased ancestor (say, a parent) would have been entitled to.
[xviii] No part of Trust property would be included in Daughter’s gross estate for tax purposes.
[xix] It was not a general power of appointment. IRC Sec. 2514(c). Thus, the property that was subject to such power was not includible in the gross estate of the deceased descendant.
If the descendant failed to direct the disposition of any part of their trust, then that part of the descendant’s trust was to be distributed per stirpes among the descendant’s then living descendants, if any, and, if none, per stirpes among the descendants of Grantor’s descendant who was the deceased descendant’s nearest ancestor who has descendants then living.
[xx] The trustee had first requested a private letter ruling from the IRS that the proposed pro-rata division of Trust into separate trusts for the benefit of each child of Daughter would not cause Trust or any of the successor trusts to be subject to the GST tax. The IRS issued a favorable ruling.
[xxi] She was always Grandad’s favorite. (Please permit me some poetic license.)
[xxii] Makes you wonder what Grandchild A did with that drumstick at the family’s Thanksgiving celebration.
[xxiii] Compare this to the limited power of appointment that Grandchild A would have enjoyed prior to the modification, which would not have resulted in the inclusion of the trust property in Grandchild A’s gross estate.
If Grandchild A failed to effectively appoint any part of her trust, then such share of the trust would to be distributed per stirpes among her descendants then living and if none, then per stirpes among the descendants of Grantor who were still living.
[xxiv] IRC Sec. 2601.
[xxv] Under IRC Sec. 2611.
[xxvi] Section 1433(b)(2)(A) of the Tax Reform Act of 1986 (Pub. L. 99-514; the “Act”), and Reg. Sec. 26.2601-1(b)(1)(i).
[xxvii] Reg. Sec. 26.2601-1(b)(4)(i) provides rules for determining when a modification, judicial construction, settlement agreement, or trustee action with respect to a trust that is exempt from the GST tax under Reg. Sec. 26.2601-1(b)(1), (b)(2), or (b)(3), will not cause the trust to lose its exempt status. The rules of Reg. Sec. 26.2601-1(b)(4) are applicable only for purposes of determining whether an exempt trust retains its exempt status for GST tax purposes.
[xxviii] IRC Sec. 2651.
[xxix] Reg. Sec. 26.2601-1(b)(4)(i)(D)(1).
[xxx] Together with the estate tax, the “federal transfer taxes.”
[xxxi] More social engineering via the Code.
[xxxii] A class of beneficiaries that includes individuals who are complete strangers to the grantor – they have not yet been born.
[xxxiii] The GST tax is imposed as a flat tax rate equal to the highest estate tax rate (currently 40 percent) multiplied by the trust’s “inclusion ratio.” Generally, the inclusion ratio is determined by subtracting the “applicable fraction” from one. The numerator of the applicable fraction is the total amount of GST exemption allocated to the trust or transfer, and the denominator is the fair market value of the trust or property transferred. For example, if the amount of GST exemption allocated to the trust is equal to the value of property transferred to the trust, the inclusion ratio will be zero and the applicable tax rate will be 0 percent (40 percent multiplied by the inclusion ratio). Such a trust is described as being fully exempt from the GST tax.
[xxxiv] Especially after 2017.
[xxxv] Don’t forget the ability to “leverage” the exemption by valuation discounts and sales to so-called “intentionally defective” grantor trusts.
[xxxvi] The enhanced exemption, which was enacted as part of the 2017 Tax Cuts and Jobs Act (Pub. L. 115-97) is scheduled to expire after 2025, at which point it will be reduced by half. However, following Pres. Trump’s election to a second term and the GOP’s apparent control of Congress, the odds of such a reduction are greatly diminished.
[xxxvii] Allocating GST exemption does not directly exempt any assets or portion of a trust from tax. Rather, allocating GST exemption to a trust or transfer reduces the applicable rate of tax (from as high as 40 percent to as low as 0 percent) on generation-skipping transfers.
[xxxviii] See the Uniform Statutory Rule Against Perpetuities of 1986.
Arizona provides 500 years. Talk about wishful thinking.
[xxxix] South Dakota abolished the rule.
Delaware ‘s rule provides that interests in real estate must vest within 110 years; the rule does not apply to personal property, so a trust with such property may continue in perpetuity.
[xl] “Forever is a very long time.” Peter Pan?
[xli] The Fiscal Year 2012 Revenue Proposals.
