Twice in one week at the end of August, the IRS issued regulations designed to combat the practice known as springing cash value arrangements (see Section 17.3, Subdivision A of this Service). On August 22 it published Temporary Regulations governing the valuation of annuities distributed to Roth IRAs (for a full account and analysis see Tax News August 23, 2005, New Regulations Curb Springing Cash Value Arrangements in Roth IRA Annuity Exchange Transactions). On August 26 the IRS issued Final Regulations under I.R.C. §402(c), effective August 29, 2005, regarding the amount includible in a distributee’s income when life insurance contracts are distributed by a qualified retirement plan. Treas. Dec. 9223 (Aug. 29, 2005). The regulations also deal with the treatment of property sold by a qualified retirement plan to a plan participant or beneficiary for less than fair market value. At the same time, the IRS has also finalized regulations under I.R.C. §§79 and 83 regarding the amounts includible in income when an employee is provided permanent benefits in combination with group-term life insurance or when a life insurance contract is transferred in connection with the performance of services.
This Service has covered the IRS’s efforts to curb springing cash value arrangements in Section 17.3, Subdivision A and in numerous Current Comments and Tax News, including:
These Final Regulations do little more than finalize the Proposed Regulations the IRS issued in 2004 (69 Fed. Reg. 7384, February 15, 2004). Even so, they provide a useful occasion to review how the IRS brought the springing cash value problem on itself, and how it proposes to solve the problem through regulation.
Unclear Regulations Give Rise to the Problem
What is a springing cash value arrangement? Such arrangements were developed at least in part to minimize the income taxes applicable with respect to distributions of life insurance policies from qualified plans—since such distributions represent taxable income to the recipient measured by the cash value of the policy at the time of the distribution. (See C 04-06, IRS Issues Guidance on Valuation of Life Insurance in Qualified Plans, for a discussion of the §412(i) perceived abuses that gave rise to the regulations.) The idea is to keep the stated cash values during early policy years artificially low in relation to the premiums paid by the plan for maintenance of the policy and to distribute it at this low cash value, letting the cash value later “spring” back to the level it would have reached absent the arrangement. Thus, the distribution is taxed at an artificially low rate and the distributee ultimately enjoys a much higher, untaxed cash value.
How is such a valuation game even possible? Because of slackly written regulations. Treas. Reg. §1.402(a)-1(a)(1)(iii) provides, in general, that a distribution of property by a qualified plan shall be taken into account by the distributee at its "fair market value." However, Treas. Reg. §1.402(a)-1(a)(2) of the regulations provides, in general, that upon the distribution of an annuity or life insurance contract, the "entire cash value" of the contract must be included in the distributee’s income. Neither term is defined and nowhere are their interrelations set forth. Little wonder, then, that marketers constructed products with depressed cash surrender values, construing those as the “entire cash value” and that as equivalent to the “fair market value.”
Similarly, I.R.C. §79(a)(1) provides that the cost of group term life insurance provided by an employer on the life of an employee is included in the employee’s income to the extent the coverage exceeds $50,000 (less the cost covered by the employee, if any). If the policy includes “permanent benefits” (essentially, an economic value that extends for more than a policy year), the amount taxable to the employee is determined by a formula set forth at Treas. Reg. §1.79-1(d)(2), which included, before it was amended by these regulations, “the net level premium reserved at the end of that policy year for all benefits provided to the employee by the policy or, if greater, the cash value of the policy at the end of that policy year.”
Further, there was a conflict between statute and regulations with respect to I.R.C. §83. The statute provides that when any property is transferred to a person in connection with the performance of services, the service provider must include in income the excess of fair market value (with qualifications) over the amount paid for the property, but before being amended by these regulations, Treas. Reg. §1.83-3(e) provided that “in the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, only the cash surrender value of the contract is considered to be property.”
But the IRS was not alone responsible for the confusion. The Department of Labor got into the act with Prohibited Transaction Exemption 77-8, 1977-2 C.B. 425 (subsequently amended and re-designated as P.T.E. 92-6). P.T.E. 92-6 specifies the parties to whom a plan may sell an insurance contract (pertinently, the insured plan participant or a relative who is the policy’s beneficiary). However, it also states that fair market value and cash surrender value may diverge, and that when the former exceeds the latter when a contract is sold, the difference is not a distribution from the plan.
Early Examples of the Concept
What to apply, then, in the various possible situations in which a plan could transfer a life policy to a participant? Fair market value or cash surrender value? The IRS was not finished sowing confusion. The earliest precursor to a discussion of springing cash value was probably Rev. Rul. 59-195. Here, the Service held that when an employer has purchased a life policy on an employee and paid premiums, then sold it with premiums remaining, the value for gain purposes in the year of purchase should be computed along the lines of § 25.2512–6 of the Gift Tax Regulations, under which “the value of such a policy is not its cash surrender value but the interpolated terminal reserve at the date of sale plus the proportionate part of any premium paid by the employer prior to the date of the sale which is applicable to a period subsequent to the date of the sale,” except—of course!—when “because of the unusual nature of the contract such approximation is not reasonably close to the full value.” Which right away raises the question “why not just use the full value, whatever that is, and be done with it?” but more on that later.
Who knows who first devised a springing cash value policy, but the first time the IRS discussed a recognizable example was in Notice 89-25 [1989-1 C.B. 662], Q&A-10. There, a qualified plan purchased a life insurance policy on the life of the account owner, with a single premium of $400,000. After two years the policy was distributed to the insured, with a stated cash surrender value of $112,360 and “life insurance reserves” of $426,596. At the end of the fifth policy year, the surrender value sprang from $126,248 to $489,908, matching the reserve amount. Thus, the account owner would have been taxed on only $112,360 but would have a policy with a value of $489,908.
In Notice 89-25, it was enough for the IRS to make the obvious response and lay down, along the lines of Rev. Rul. 59-195, that the policy reserves “represent a much more accurate approximation of the fair market value of the policy when distributed than does the policy’s cash surrender value.” Unfortunately, the ingenuity of marketers easily found ways around this pronouncement, as the Preamble to the Final Regulations notes:
Since Notice 89-25 was issued, life insurance contracts have been marketed that are structured in a manner which results in a temporary period during which neither a contract`s reserves nor its cash surrender value represent the fair market value of the contract. For example, some life insurance contracts may provide for large surrender charges and other charges that are not expected to be paid because they are expected to be eliminated or reversed in the future (under the contract or under another contract for which the first contract is exchanged), but this future elimination or reversal is not always reflected in the calculation of the contract`s reserve. If such a contract is distributed prior to the elimination or reversal of those charges, both the cash surrender value and the reserve under the contract could significantly understate the fair market value of the contract.
Springing cash value had come into its own.
And so it was that the IRS came to ask, by 2004, the question posed above: Why not just recognize the “full value” or “fair market value” when a qualified plan distributes a life policy to a participant (or other permissible distributee)? The question answered itself, and the Proposed Regulations embodied “the requirement that a distribution of property must be included in the distributee’s income at fair market value is controlling in those situations where the existing regulations provide for the inclusion of the entire cash value.” The IRS simply replaces the problematic terms with “fair market value” where possible (Treas. Reg. §1.79-1, §1.402(a)-1(a)(1)(iii), and §1.402(a)-1(a)(2)), and amends §1.83-3 to provide that the “policy cash value” and all other rights under the contract, rather than the cash surrender value, is treated as property for purposes of a transfer in connection with the performance of services (with a grandfather clause for split-dollar contracts entered into before September 17, 2003, the effective date of the final split-dollar regulations).
Determining “Fair Market Value”
there’s more to it than that. It is necessary to define “fair market
value” (or “full value”) for these purposes. It cannot quite be “fair
market value” in the usual sense of the term, i.e. what a willing buyer would
pay a willing seller. This sense only applies when there is a real market
of buyers and sellers engaging in arm’s-length transactions (the
However, all the Proposed Regulations say about fair market value is contained in a parenthetical:
Thus, these proposed regulations provide that, in those cases where a qualified plan distributes a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, the fair market value of such a contract (i.e., the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed) is generally included in the distributee’s income and not merely the entire cash value of the contracts.
Instead of characterizing fair market value further, the Service issued Rev. Proc. 2004-16, which defined a safe harbor, a set of circumstances under which cash value could be regarded as fair market value:
Cash value (without reduction for surrender charges) may be treated as the fair market value of a contract as of a determination date [essentially, the date on which benefits are provided] provided such cash value is at least as large as the aggregate of: (1) the premiums paid from the date of issue through the date of determination, plus (2) any amounts credited (or otherwise made available) to the policyholder with respect to those premiums, including interest, dividends, and similar income items (whether under the contract or otherwise), minus (3) reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the date of determination and are expected to be paid.
(There is an identical characterization for variable contracts except that (2) reads: “(2) all adjustments made with respect to those premiums during that period (whether under the contract or otherwise) that reflect investment return and the current market value of segregated asset accounts.”)
Some of the technical details of this definition in application, including a discussion of the IRS’s example explaining how it applies to a springing cash value policy with an artificial surrender charge, are explained in CC 04-06, IRS Issues Guidance on Valuation of Life Insurance in Qualified Plans.
Rev. Proc. 2005-25
In response to comments on Rev. Proc. 2004-16, particularly about its failure to accommodate surrender charges, the IRS issued Rev. Proc. 2005-25, which expanded the safe harbors. It did so by introducing a forbidding formula (in variable and non-variable flavors) that—it’s important to note—is—at last !—a definition of fair market value that allows one to calculate this quantity. For a detailed explanation, see Tax News April 11, 2005, New Rev. Proc. 2005-25 Delivers Promised Guidance for Valuation of Life Insurance. Very briefly put, for an insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, fair market value can be measured as the greater of (a) the interpolated terminal reserve plus a pro rata portion of estimated dividends, and (b) the product of the PERC amount (variable or non-variable, as the case may be) and the “Average Surrender Factor.” Criterion (a) is the gift tax notion the IRS first used in Rev. Rul. 59-195. The PERC amount is calculated by adding Premiums and Earnings (including dividends) and subtracting Reasonable Charges (mortality charges and the like) not expected to be reversed at a later date. And the Average Surrender Factor is the greater of .7 and a fraction consisting of the surrender amount on the first day of the policy year over the PERC amount. This is essentially a way of factoring in the effect of surrender charges, and disregarding them if they reduce the value of the contract to less than .7 of what it would have been without them. Since, in order for springing cash value arrangements to have their desired effect, they would have to reduce the value of the contract substantially less than .7, this brain-cracking formula is what hides the true sting in the tail with respect to such arrangements.
The IRS states that there were no objections to the Proposed Regulations themselves during the comment period or at the public hearing, only to Rev. Proc. 2004-16. Thus, matters are essentially as they were when the Proposed Regulations were announced.
· When a qualified plan distributes a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, the policy`s fair market value is included in the distributee`s income. Fair market value is the policy`s cash value plus the value of all rights under the contract, including any supplemental agreements thereto. If such a distribution was not included in the distributee’s income under previous regulations, it is not included under the Final Regulations.
· When a qualified plan distributes an annuity contract, the distribution is treated as a lump sum distribution for 10-year averaging purposes under §402(e), even if it is not currently taxable.
· When a qualified plan distributes property to a participant or beneficiary for less than fair market value, the “bargain element” (the difference between the consideration and the fair market value) is a distribution under the plan. This requirement is effective only for transactions on or after August 29, 2005, the effective date of the Final Regulations, although such transactions result in income recognition if made after February 13, 2004, the effective date of the Proposed Regulations.
· “Fair market value” is substituted for “cash value” in regulations under §§ 79 and 83. Thus, the formula for determining permanent benefits under §79 now relies on fair market value. Similarly, the fair market value of property received as compensation is now included in income under §83. Note that the Final Regulations do not apply to split-dollar arrangements entered into before the effective date of the final split-dollar regulations and not materially modified since.
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GST Tax Update (CC 05-32)
This article is an overview of selected issues concerning recent changes, regulations, and revenue procedures in the generation-skipping transfer (GST) tax rules. Fortunately, since the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub L No 107-16, 115 Stat 38 (2001 Tax Act), there has been no new GST tax legislation; however, as discussed below, new regulations and revenue procedures have been issued, and the U.S. gift tax return has been updated to reflect the changes brought about by the 2001 Tax Act.
Increase in the GST Tax Exemption Amount and Lowering of the GST Tax Rate
Under the 2001 Tax Act, the GST tax exemption amount is currently equal to the estate tax applicable exclusion amount under IRC § 2010(c) for the year in which the GST transfer is made. In 2010, the GST tax will be repealed in its entirety, and there will be no GST tax exemption amount. IRC §§ 2631(c),2664. Then in 2011, the GST tax exemption will revert back to the amount it would have risen to, with inflation adjustments, under the tax regulations in force before the 2001 Tax Act. Thus, the GST tax exemption and GST tax rate is illustrated in the table below.
Distributions and Gifts in 2009 and 2010
In 2009, clients may want to consider making inter vivos gifts into GST trusts that are not direct-skip trusts, paying gift tax, and using their remaining GST tax exemption (since this exemption will disappear in 2010 and will reappear at only $1.1 million, plus post-2002 inflation adjustments, in 2011). An alternative, if direct skips can be made, would be to make direct skips in 2010 when there is no GST tax and the gift tax rate is 35 percent. In addition, in 2010 when there is no GST tax, non-GST tax-exempt trusts should make distributions to skip persons. Consider including a trust protector or special power holder in the trust instrument who is authorized to appoint the trust property to the grantor’s descendants, especially during the no GST tax window period of 2010. Because there will be no GST tax exemption available in 2010 (and thus no ability to allocate a person’s exemption to create a GST tax-exempt trust), it is uncertain whether or not, if other irrevocable trusts are established in 2010, they will be grandfathered from the GST tax once the pre-2001 Tax Act law returns in 2011.  If these trusts are not grandfathered from the GST tax, they will have an inclusion ratio of one.
GST tax exemption amounts
GST tax rate
$1,500,000 (no inflation adjustment)
$1,500,000 (no inflation adjustment)
$2,000,000 (no inflation adjustment)
$2,000,000 (no inflation adjustment)
$2,000,000 (no inflation adjustment)
$3,500,000 (no inflation adjustment)
$1,100,000 (plus post-2002 inflation adjustments)
In addition, especially during the no GST-taxwindow period of 2010, when non-GST-tax-exempt trusts should make distributions to skip persons, consider including a trust protector or special power holder in the trust instrument who is authorized to appoint the trust property to the grantor’s descendants.
Retroactive Allocation of GST Tax Exemption for a Nonskip Beneficiary’s Unnatural Order of Death While the Transferor Is Alive
The 2001 Tax Act allows a transferor to make a retroactive allocation of the transferor’s GST tax exemption for lifetime transfers to an inter vivos trust if a nonskip beneficiary of the trust dies after December 31, 2000, but before the transferor. IRC § 2632(d). The retroactive allocation does not protect against an unnatural order of death that occurs after the transferor’s death. Nor does the retroactive allocation apply to grantor-retained annuity trusts, qualified personal residence trusts, or any inter vivos trust that is subject to an estate tax inclusion period (ETIP), since IRC § 2642(f) prohibits the allocation of the transferor’s GST tax exemption while the trust is subject to possible inclusion in the gross estate of the transferor or of his or her spouse. Any allocation of the GST tax exemption during the ETIP period will not take effect until this period’s expiration and would be applied at the trust’s then fair market value.
retroactive allocation is available only if the predeceasing beneficiary was
both a nonskip person and a lineal descendant of the transferor’s grandparent
or of a grandparent of the transferor’s spouse, assigned to a generation
younger than the generation of the then living transferor. The value of the
property on the date that property was transferred to the trust is used to
determine the applicable fraction and inclusion ratio for the retroactive GST
tax exemption allocation on a chronological basis (i.e., to earlier transfers
first). The retroactive allocation of the GST tax exemption must be made on the
Caution: The new rule applies for retroactive allocations for nonskip beneficiaries dying after December 31, 2000, but will be automatically repealed when the 2001 Tax Act sunsets on December 31, 2010.
The 2001 Tax Act liberalizes the rules for severing a trust. IRC § 2642(a)(3). The act permits the qualified severance of an existing single trust (inter vivos or testamentary) into multiple trusts
· if the severance or division is permitted by state law or is authorized in the governing instrument;
· if the single trust is divided on a fractional basis (and not on a pecuniary basis);
· if the terms of the new (divided) trusts provide, in the aggregate, for the same succession of interests of beneficiaries as in the original trust; and
· if the original trust has an inclusion ratio other than one or zero (It is then divided into two trusts, one of which has an inclusion ratio of one and the other of which has an inclusion ratio of zero). 
The qualified severance rule may be used in conjunction with the unnatural order of death election under IRC § 2632(d), which is discussed above. For example, an irrevocable life insurance trust (ILIT) providing an income interest to the transferor’s spouse with remainder to the transferor’s two children may now be divided. This, together with the unnatural order of death election, could allow the ILIT to be divided into two parts, and then the transferor’s GST tax exemption could be allocated to the part that the deceased child’s descendants succeed to, if one of the transferor’s children were to predecease the transferor after the establishment of the ILIT.
The 2001 Tax Act provides that the value of property, for purposes of determining the inclusion ratio (and, thereby, the rate of GST tax imposed on taxable events) in connection with timely and automatic allocations of GST tax exemption, is the value finally determined for gift or estate tax purposes. IRC §§ 2642(b)(1)–(2). The value, for purposes of an allocation that was made at the end of an ETIP, is its estate or gift tax value at the end of the ETIP. 
Caution: This new rule is effective for transfers made after December 31, 2000, but will be automatically repealed when the 2001 Tax Act sunsets on December 31, 2010.
The 2001 Tax Act directs the Internal Revenue Service (IRS) to grant extensions of time to allocate the GST tax exemption and to grant exceptions to the filing deadlines, considering all relevant circumstances, including evidence of intent in the trust instrument or instrument of transfer for it to be GST tax exempt. IRC § 2642(g)(1). If a time extension to make a GST tax exemption allocation is granted, the allocation will not be considered “late” under Treas. Reg. § 26.2642-2(a)(2) but rather “timely” under Treas. Reg. § 26.2642-2(a)(1); therefore, the applicable fraction and inclusion ratio will be determined by the date of the transfer, not by the date on which the allocation is actually made. Relief for filing a late, but timely, GST tax exemption will be available for:
· lifetime allocations of GST tax exemption under IRC §2642(b)(1);
· death-time allocations of GST tax exemptions under IRC §2642(b)(2);
· elections out of automatic allocations to direct and indirect skips under IRC §§ 2632(b)(3) and (c)(5)(A)(i); and
· elections into automatic allocations for trusts that are neither direct skips nor indirect skips, as is permitted under IRC § 2632(c)(5)(A)(ii).
Caution: This relief is available for requests pending on, or filed after, December 31, 2000, but will be automatically repealed when the 2001 Tax Act sunsets on December 31, 2010. 2001 Tax Act §§ 564(b)(1), 901.
The IRS issued preliminary guidance on this relief provision in IRS Notice 2001-50, 2001-2 CB 189, which is effective for relief requests pending on or filed after December 31, 2000. The notice states that taxpayers may seek an extension of time to make the above allocations and elections under the rules of Treas. Reg. § 301.9100-3. In general, under these rules, relief is granted if it is established to the satisfaction of the IRS that the taxpayer acted reasonably and in good faith and that the grant of relief will not prejudice the government’s interests. Taxpayers requesting relief should follow the procedures in Rev Proc 2001-3, §5.02, 2001-1 I RB 111.
In Rev Proc 2004-46, 2004-31 IRB 141 (July 29, 2004), the IRS issued additional guidance for relief concerning certain inter vivos gifts to trusts made on or before December 31, 2002, and qualified for the gift tax annual exclusion. This revenue procedure provides a simplified alternate method (which is also less expensive, since no user fee is charged for requests filed under this revenue procedure) to obtain an extension of time to make a late allocation of GST tax exemption. As a result of this revenue procedure, there will be no need to obtain a private letter ruling if 15 conditions are satisfied. Relief under the revenue procedure is available if:
· on or before December 31, 2000, the taxpayer made or was deemed to have made a transfer by gift to a trust from which a GST may be made;
· at the time the taxpayer files the request for relief under the revenue procedure, no taxable distributions have been made and no taxable terminations have occurred;
· the transfer to the trust qualified for the gift tax annual exclusion under IRC § 2503(b), and the amount of the transfer, when added to the value of all other gifts by the transferor to that donee in the same year, was equal to or less than the amount of the applicable annual exclusion amount under IRC § 2503(b) for the year of the transfer;
GST tax exemption was allocated to the transfer, whether or not a
· at the time the taxpayer files a request for relief under the revenue procedure, the taxpayer has unused GST tax exemption available to allocate to the transfer;
· the taxpayer files a U.S. gift tax return for the year of the transfer to the trust, regardless of whether a Form 709 had been previously filed for that year, and states at the top of the gift tax return that it is being “FILED PURSUANT TO REV. PROC. 2004-46”;
· the taxpayer reports on the gift tax return the value of the transferred property as of the date of the transfer;
· the taxpayer allocates GST tax exemption to the trust by attaching a statement to the gift tax return entitled “Notice of Allocation”;  and
· the U.S. gift tax return is filed on or before the date prescribed for filing the taxpayer’s federal estate tax return for the his or her estate (determined with regard to any extensions actually obtained), regardless of whether an estate tax return is required to be filed. If the IRS grants the relief, the transferor’s GST tax exemption will be allocated effective on the date of the inter vivos transfer. A grant of relief does not, however, preclude a subsequent determination by the IRS that the transfer is subject to an ETIP under IRC § 2642(f).
The 2001 Tax Act provides that substantial compliance with the statutory and regulatory requirements for allocating the GST tax exemption under IRC § 2632 is sufficient to establish that this exemption was allocated to a particular transfer or trust. IRC § 2642(g)(2). A taxpayer who demonstrates an intent to have an inclusion ratio of zero with respect to a particular transfer or trust is deemed to have allocated to the transfer or trust sufficient GST tax exemption to produce the lowest possible inclusion ratio. The IRS is directed to consider all relevant circumstances to determine whether there has been substantial compliance, including evidence of intent in the trust instrument or instrument of transfer and any other factors as the secretary of the treasury deems appropriate. Drafters may want to consider adding an introductory clause to trusts that are intended to be GST tax exempt. In light of the new automatic GST tax exemption allocation rules for new lifetime transfers under IRC § 2632(c), the substantial compliance rules or extension-of-time rules could be best used for GST transfers occurring some time after the transferor’s death. IRC § 2642(g)(2).
Caution: The new rule applies to transfers made after December 31, 2000, and will be automatically repealed when the 2001 Tax Act sunsets on December 31, 2010. 2001 Tax Act § 901.
The 2001 Tax Act provides for automatic allocation of a transferor’s GST tax exemption to certain lifetime transfers that are not direct skips but that are made to an inter vivos trust (such as an ILIT) that subsequently could have a GST with respect to the transferor (indirect skips). Such a trust is referred to as a GST trust under IRC § 2632(c)(3)(B). The rule applies to inter vivos transfers made after December 31, 2000, and to ETIPs ending after December 31, 2000. IRC § 2632(c). This new rule is in addition to the pre-2001 Tax Act automatic GST tax exemption allocation rules concerning lifetime direct skips under IRC § 2632(b). Thus, as a result of the new law, both lifetime direct skips and lifetime indirect skips are subject to the automatic GST tax exemption allocation rules. 
Practice Point: Trusts that were initially designed to not be GST trusts (including many typical ILITs in which the surviving spouse has a life estate if he or she survives the insured spouse) may, as a result of the new law, be classified as GST trusts. GST tax exemptions will automatically be allocated to transfers made to these trusts. Consequently, taxpayers should consider making a one-time election to permanently opt in or out of GST trust status and the GST automatic allocation rules. See below for a discussion of how to opt in or out of the GST automatic allocation rules. See, below for a sample form of memo an attorney may send to clients who have irrevocable life insurance trusts.
Caution: The new automatic allocation rule to indirect skips applies to transfers made after December 31, 2000, and will be automatically repealed when the 2001 Tax Act sunsets on December 31, 2010. 2001 Tax Act § 901.
In 2003, the IRS revised IRS Form 709 (United States Gift [and Generation-Skipping Transfer] Tax Return) to incorporate the revisions in the GST tax rules promulgated by the 2001 Tax Act; in particular, the automatic GST allocation rules (discussed in the section above).
· Transfers to a trust that is a both a nonskip person and not a “GST Trust” (as defined in IRC § 2632(c)(3)(B)) are reported on Part 1 of Schedule A, and a Notice of GST Tax Exemption Allocation must be attached to the Form 709.
· Direct skips (including transfers to a trust that is a skip person) are reported on Part 2 of Schedule A. Allocation of GST tax exemption for direct skips reported on Part 2 of Schedule A are made on line 4 of Part 2 of Schedule C.
· A new Part 3 (Indirect Skips) has been added to Schedule A of Form 709, which is to be used to report gifts to trusts that are currently subject only to the gift tax, but may later be subject to the GST tax, i.e., a GST trust. Only those gifts defined as indirect skips in IRC § 2632(c)(3)(A) (or those gifts that the donor wants to be treated as indirect skips) are to be listed in Part 3 of Schedule A. In addition, if a donor wants to treat gifts to a non-GST for purposes of the GST automatic allocations rules, the donor must attach an explanation to the Form 709.
· A new line 5 has been added to Part 2 of Schedule C of Form 709 for use in reporting the allocation of GST tax exemption to indirect skip transfers reported on Part 3 of Schedule A.
· Column C in Parts 2 and 3 of Schedule A of Form 709 is now used to elect out of the GST automatic allocation rules of IRC §§ 2632(b) (concerning direct skips) and (c) (concerning indirect skips to a GST trust), and an explanation must be attached to the Form 709.
· As stated above, if a donor does not want to have the GST automatic allocation rules apply to both the current transfer and all future transfers or, if the donor wants to treat a non-GST trust as a GST trust for purposes of the GST automatic allocations rules, the donor must attach an explanation to the Form 709. On June 29, 2005, the IRS issued final regulations concerning the electing in and out of the GST automatic allocation rules concerning indirect skips and GST trusts (discussed above). Treasury Decision 9208 (6/29/2005). The final regulations provide guidance on how to (1) elect out of the GST automatic allocation rules for both a current transfer and any future transfers to a GST trust, and how to terminate that election (Treas Reg § 26.2632-1(b)(2)(iii)); and (2) elect to treat a non-GST trust as a GST trust and have the GST automatic allocation rules apply to both current and future transfers to that trust and terminate that election (Treas Reg § 26.2632-1(b)(3)).
for IRS Form 709 also state that IRS Form 709-
The IRS has issued Form 8892, Payment of Gift/GST Tax and/or Application for Extension of Time to File Form 709, to request an extension of time to file IRS Form 709 (and paying any applicable gift or GST taxes). Form 8892 should be used when (1) the taxpayer owes gift or GST tax and has requested an initial extension to file his or her individual income tax return pursuant to IRS Form 4868, (2) the taxpayer has already obtained an initial four month extension to file Form 709 pursuant to IRS Form 4868 and the taxpayer needs an additional extension of time only for his or her Form 709 (and not for his or her individual income tax return), or (3) the taxpayer needs an initial extension of time only for his or her Form 709 (and not for his or her individual income tax return).
The reverse QTIP election allows the decedent, rather than the surviving spouse, to be treated, for GST tax purposes, as the transferor of property for which the QTIP election is made. IRC § 2652(a)(3). Since the reverse QTIP election is not available for an IRC § 2056(b)(5) general power of appointment trust, care must be taken to make sure that the QTIP trust does not give the surviving spouse any powers that rise to this general power of appointment trust level.
Time for Making the Reverse QTIP Election
Generally speaking, a reverse QTIP election for a decedent transferor must be made on the last timely filed estate tax return (including extensions) or, if no timely return is filed, on the first late return. Treas. Reg. § 20.2056(b)-7(b)(4)(i).
Extension of Time to Make a Late Reverse QTIP Election
A discretionary extension of time to make a reverse QTIP election is available under Treas. Reg. § 301.9100-1, but the extension of time is not available to modify automatic allocation of the GST tax exemption. Treas. Reg. § 26.2632-1(d). However, Rev Proc 2004-47, 2004-32 IRB 169 (Aug 5, 2004), provides a simplified alternate method (which is less expensive—no user fee is charged for requests filed under this revenue procedure) for making a late testamentary reverse QTIP election for a deceased transferor. This alternate method, which became effective August 9, 2004, may be used in lieu of the private letter ruling process, if the requirements of the revenue procedure are met.  If the IRS grants the relief, the deceased transferor’s unused GST tax exemption will be automatically allocated to the reverse QTIP trust (or reverse QTIP property, as the case may be) effective on the decedent’s date of death and at the property’s value as finally determined for federal estate tax purposes. A grant of relief (1) does not extend the time to make an allocation of any remaining GST tax exemption, (2) does not include or grant permission to retroactively allocate the decedent’s remaining GST tax exemption, and (3) does not include or grant permission to make a late severance of a trust included in the decedent’s gross estate into two or more trusts (such as the severance of a single QTIP trust into a reverse QTIP trust and a nonreverse QTIP trust).
Practice Point: A reverse QTIP election is effective as to the whole QTIP trust in question. A partial reverse QTIP election (as to part of a QTIP trust) is not permitted. Treas. Reg. § 26.2654-1(b)(1). Therefore, if the deceased transferor’s unused GST tax exemption amount is less than the single QTIP trust, it will be necessary for the single QTIP trust to first be divided (severed) into a reverse QTIP trust and a non-reverse QTIP trust prior to the allocation of the deceased transferor’s GST tax exemption. Because the revenue procedure does not authorize a late severance of the QTIP trust, it may be possible to make a qualified severance of the QTIP trust prior to requesting a late reverse QTIP election under the revenue procedure. A qualified severance of a trust may be made at any time. IRC § 2642(a)(3)(C). See above.
The predeceased parent rule provides that if a skip person’s ancestor, who is a descendant of the transferor (for GST tax purposes), predeceases the transferor, the skip person moves up in generation assignments (vis-a-vis the transferor). Furthermore, if a beneficiary who is a descendant of the transferor (for GST tax purposes) dies within 90 days after the date of a GST transfer that occurs because of the death of the transferor, the beneficiary is treated as having predeceased the transferor, and the deceased beneficiary’s child will move up a generation assignment (visa-vis the transferor) and be placed in the same generation assignment held by his or her (now deceased) parent vis-a-vis the transferor. IRC § 2651(e); Treas. Reg. §26.2651-1(a)(2)(iii).
This survivorship rule expands the “predeceased parent rule” of IRC § 2651(e), by allowing a grandchild to move up into his parent’s generation for GST tax purposes if the parent dies within 90 days of a transferor. Expanded by the Tax Reform Act of 1997 (TRA 1997), the “predeceased parent rule” now applies to taxable terminations, taxable distributions, and direct skips and, under certain circumstances, includes grandnieces and grandnephews as permissible skip persons. On July 18, 2005, the IRS issued amendments to the final regulations concerning the predeceased parent rule under IRC § 2651(e). Treasury Decision 9214 (7/18/2005). See Treas. Reg. §§ 26.2612-1, 26.2651-1, .2651-2, 2651-3. The. amendments to the final regulations discuss the 90-day survival rule, how to determine the date of a transfer for applying the predeceased parent rule, and when certain adopted individuals (and their spouses and descendants) are to be reassigned to a different generation for GST purposes.
Although the GST tax is scheduled to be repealed in 2010, the nation’s current fiscal crisis, the trade deficit, the war on terrorism, and the looming Social Security and Medicare crisis all combine to provide additional uncertainty about the likelihood of a permanent repeal of this tax. Therefore practitioners still need to consider the impact the GST tax may have on a client’s estate plan. The GST tax may be well alive in 2011, and planning today will help to minimize the tax.
1. A testamentary trust (whether established under a will or under a decedent’s previously revocable living trust), established by a person who dies in 2010 when there is no federal estate tax or GST tax, should be able (theoretically) to make subsequent distributions to skip persons that are not subject to GST tax, since there will be no transferor under IRC § 2652(a)(1) with respect to the testamentary trust. An inter vivos trust established in 2010 when the GST tax will not be in effect, however, will probably see its subsequent distributions to skip persons be subjected to GST tax, since there will be a transferor when the trust is established, due to the gift tax being in effect in 2010. How does a transferor allocate the GST tax exemption to such a trust? Would he or she use a prospective protective election? Will the late allocation rules apply? Will the automatic allocation rules apply? These questions remain unanswered at the moment.
2. See Sebastian V. Grassi, Coping with the Proposed GST Tax Qualified-Severance Regulations (with Drafting Examples), Prac Tax Law, Winter 2005, at 21, for a more detailed discussion of the qualified severance rule and its proposed regulations.
3. Allocation of GST tax exemption is not effective until the close of the ETIP. IRC § 2642(f). An ETIP is the period during which the trust property would be included in the gross estate of the transferor or the transferor’s spouse if either were to die. Treas Reg § 26.2632-1(c)(2).
4. The notice of allocation must contain the following
information: (1) a clear identification of the trust, including the trust’s
taxpayer identification number, as defined in IRC § 6109 and the regulations
under it, when applicable; (2)the value of the property transferred as of the
date of the transfer (adjusted to account for split gifts, if any); (3) the
amount of the taxpayer’s unused GST exemption at the time the notice of
allocation is filed (a taxpayer must have unused GST exemption at the time the
notice of allocation is filed); (4) the amount of GST exemption allocated to
the transfer; (5) the inclusion ratio of the trust after the allocation; and
(6) a statement that all of the nine requirements (discussed above) of § 3.01
of Rev Proc 2004-46 have been met. The
5. See §4.22 of Grassi, A Practical Guide to Drafting Irrevocable Life Insurance Trusts (ALI-ABA, Philadelphia, PA 2003) (800) 253-6397, www. ali aba.org/aliaba/BK28.asp. for a detailed discussion (with examples) of the new GST tax exemption allocation rules.
6. Relief is available under Rev Proc 2004-47, if, on
the date of the filing of the request for relief, the following requirements
are met: (1) a valid QTIP election under IRC § 2056(b)(7) was made for the
property or trust on the federal estate tax return filed for the decedent’s
estate; (2) the reverse QTIP election was not made on the estate tax return as
filed because the taxpayer relied on the advice and counsel of a qualified tax
professional and that qualified tax professional failed to advise the taxpayer
of the need, advisability, or proper method to make a reverse QTIP election;
(3) the decedent has a sufficient amount of unused GST tax exemption, after the
automatic allocation of the GST tax exemption under IRC § 2632(e) and Treas Reg
§ 26.2632-1(d)(2), to result in a zero inclusion ratio for the reverse QTIP
trust or property; (4) the decedent’s estate is not eligible under Treas Reg §
301.9100-2(b) for an automatic six-month extension to file the decedent’s
estate tax return; (5) the surviving spouse has not made a lifetime disposition
of all or any part of the qualifying income interest for life in the QTIP trust
or property; (6) the surviving spouse is alive or no more than six months have
passed since the death of the surviving spouse; (7) the decedent’s estate files
with the IRS a request for an extension of time to make a reverse QTIP election
and the request has a cover sheet that states at the top of the document,
Request for Extension Filed Pursuant To Rev Proc 2004-47; (8) the following
items are attached to the request for relief: (a) copies of Parts 1 through 5
and Schedule M of the decedent’s estate tax return as filed with the IRS; (b) a
properly completed Schedule R, which is required to make a reverse QTIP election;
(c) a statement describing why the reverse QTIP election was not made on the
decedent’s estate tax return as filed; (d) a statement affirming that all of
the requirements in items (1 )–(6) have been met; (e) a dated declaration,
signed by the executor of the decedent’s estate, stating, “Under penalties of
perjury, I declare that, to the best of my knowledge and belief, the facts
presented in support of this election are true, correct, and complete. In
addition, all attachments provided in support of this request for relief are
true and correct copies of the original documents”; and (f) a signed statement
from the qualified tax professional on whom the taxpayer relied when preparing
the decedent’s original estate tax return. The statement should establish the
tax professional’s qualifications as a qualified tax professional and must
include a dated declaration stating, “Under penalties of perjury, I declare
that, to the best of my knowledge and belief, the facts presented in support of
this request for relief are true, correct, and complete.” The request for
relief is to be sent to the
under the revenue procedure is not available if (1) the transfer is to an inter
vivos QTIP trust or (2) the surviving spouse is not a
Sebastian V. Grassi, Jr. Listed in The Best Lawyers in
TO: [Clients with Irrevocable Life Insurance Trusts]
FROM: [Name of Advisor]
RE: Irrevocable Life Insurance Trusts and Final IRS Regulations Concerning Automatic Allocation of Generation Skipping Tax Exemption
Why the Memo
You are receiving this memorandum because our records indicate that you have an irrevocable life insurance trust (“ILIT”), and may be affected by a recent change in the tax laws, as discussed below.
Changes in the Tax Laws.
In May of 2001 Congress enacted the 2001 Tax Act at record breaking speed, with little or no input from the estate tax bar, and no advance warning. Some of the provisions of the 2001 Tax Act are very favorable to taxpayers, but some provisions are less favorable. One provision in particular, the GST tax exemption automatic allocation rule (discussed below), is generally not favorable to persons who have established ILITs.
Primary Purpose of an ILIT.
The primary purpose of an ILIT is to provide life insurance benefits to the insured’s immediate family, and to assist the insured’s estate in paying any death taxes that may be owed. If all goes well, the ILIT’s receipt of the life insurance benefits are income tax free and death tax free.
When an insured creates a “typical” ILIT for the primary benefit of his or her surviving spouse (assuming the insured is married, and the spouse’s life is not insured by the ILIT under a 1st or 2nd to die life insurance policy) and/or children, the insured is generally not concerned about the grandchildren’s inheritance under the ILIT since it is expected that after the death of the surviving spouse, the children will receive all of the money in the ILIT when they reach a specified age. Thus, the “typical” ILIT is not designed to provided a primary inheritance to the insured’s grandchildren - although in some instances grandchildren may receive an inheritance from an ILIT if their parent (the insured’s child) dies before attaining a specific age.
Special Tax on Gifts and Inheritances Left to Grandchildren.
Since 1986, there has been a special tax on gifts and inheritances left to grandchildren by their grandparents. This tax is in addition to the federal gift tax and federal estate tax. This special tax is called the Generation Skipping Transfer Tax (“GST Tax”). The tax is imposed at the highest federal estate tax rate. The tax is designed to discourage grandparents from gifting or leaving a sizeable inheritance to grandchildren. By leaving money to grandchildren, the grandparent has “skipped” over a generation - the children’s generation, and the IRS has lost the opportunity to impose a federal estate tax on that money when the children die. Hence the name, Generation Skipping Transfer Tax - it is a tax imposed for skipping over an intervening generation (the children), and is designed to insure that the IRS gets to tax the “skipped” over gift or inheritance received by the grandchild. Fortunately, every individual has a $1,000,000 GST tax exemption (indexed for inflation) (“GST tax exemption”). This means that a grandparent can make a gift and/or leave an inheritance to his or her grandchildren and not have to pay the GST tax, provided the gift/inheritance does not exceed the grandparent’s then available unused GST tax exemption amount. A person’s GST tax exemption amount can be used up (“allocated”) during their lifetime by making gifts to grandchildren, or it can be allocated when the grandparent dies and leaves an inheritance to his or her grandchildren.
Allocation of GST Tax Exemption to ILITs.
Unless an ILIT is specifically designed from the onset to benefit the insured’s grandchildren or to serve a long term trust for the benefit of multiple generations of the insured’s descendants (such as children, grandchildren, great grandchildren, etc.), insureds generally do not allocate their GST tax exemption to the annual premiums payments or gifts made to the ILIT. This is because, in many instances, it may be wasteful to allocate GST tax exemption to a trust that may never leave any money to the grandchildren. However, because of the possibility that a grandchild could receive some money from the ILIT if the grandchild’s parent (i.e., the insured’s child) dies before receiving all of his or her inheritance under the ILIT, attorneys typically add special provisions in an ILIT that attempt to avoid or minimize the GST tax. These provisions may result in the payment of a federal estate tax on money received by the grandchildren from the ILIT - but since the federal estate tax rate is a graduated rate (similar to the graduated income tax rate), the federal estate tax will almost always be less than the GST tax (which, as previously mentioned, is imposed at the highest federal estate tax rate).
How the New Tax Law Affects Your GST Tax Exemption.
Prior to the 2001 Tax Act, an insured had to make an affirmative decision to allocate his or her GST tax exemption to an ILIT, and had to file a Notice to Allocate GST Tax Exemption with the IRS. If the insured “did nothing” (i.e., did not file the Notice), the IRS did not allocate any GST tax exemption to the ILIT premium payments, etc. Thus, the insured was in control of how and when his or her GST tax exemption would be allocated, if at all, to the ILIT. However, when the 2001 Tax Act went into effect, Congress and President Bush decided that the IRS (and not the insured) should generally determine when a person’s GST tax exemption should be allocated to an ILIT; and a set of very complicated rules was enacted. The new rules favor (and mandate) the automatic allocation of GST tax exemption to an ILIT. There are certain limited exceptions, but most ILITs do not meet these exceptions. Although these new rules are meant to be helpful to taxpayers, they are in fact very complicated, unrealistic concerning their limited exceptions, and difficult and expensive for taxpayers to comply with. (So much for “tax reform”.)
What Does This Mean to You?
Just recently, the IRS (finally) issued some guidance on the new 2001 Tax Act rules concerning the automatic allocation of an insured’s GST tax exemption to premium payments and gifts made to an ILIT. It was hoped that the “new and gentler” IRS would permit taxpayers to retroactively “just say no” to the new 2001 Tax Act rules concerning the automatic allocation of GST tax exemption to ILITs, but that is not the case. Instead, the IRS held steadfast and has stated, in effect, “what’s done is done,” and only going forward can a taxpayer, such as an insured who has established an ILIT, make an election to either: (1) “opt out” of the new GST tax exemption allocation rules (and thus decide for themselves as to how and when they want to allocate their GST tax exemption to an ILIT), or (2) permanently “opt in” to the new rules, particularly if they are uncertain as to whether or not their ILIT comes within one of the limited exceptions. Regrettably, the IRS has not issued any guidance on the limited exceptions. Because of this, tax advisors are alerting their clients concerning the “opt in” and “opt out” issues, and informing them of the uncertainty created by the new rules, and lack of IRS guidance.
What Should You Do?
If you want to make sure that any inheritance your grandchildren or great-grandchildren may receive from your ILIT is not subject to the confiscatory GST tax, or if you want to stop the IRS from automatically allocating your GST tax exemption to your ILIT premiums and gifts, you need to do the following:
1) Have your tax advisor review your ILIT to see if it comes within one of the limited exceptions to the automatic allocation of your GST tax exemption - as previously mentioned, most do not. If the ILIT does come within an exception, then no GST exemption has been automatically allocated to the ILIT by the IRS under the new 2001Tax Act rule, and you will have to do one of the following:
(A) Affirmatively allocate your GST tax exemption to the ILIT in order to avoid the imposition of a federal estate tax or GST tax on an inheritance a grandchild or great-grandchild may receive from the ILIT as a result of their parent dying prematurely. This will require the filing of a notice with the IRS along with a U.S. Gift Tax Return (IRS Form 709); and it may also require you, through your tax advisor, to make what is commonly known as a “late” allocation of your GST tax exemption.  This option results in your “opting in” to the automatic GST tax exemption allocation rules. GENERALLY, THIS IS THE SAFEST AND MOST CAUTIOUS WAY TO PROCEED UNDER THE CIRCUMSTANCES.
(B) File a notice with the IRS along with a U.S. Gift Tax Return (IRS Form 709) informing the IRS that you do not want your GST tax exemption to ever be automatically allocated to your ILIT. This option results in your “opting out” of the automatic GST tax exemption allocation rules.
2) Have your tax advisor review your ILIT to see if it falls outside the limited exceptions to the automatic allocation of your GST tax exemption - most ILITs do, unless they were designed from the onset to be “generation skipping ILITs.” If the ILIT does fall outside of the limited exceptions, this means that the IRS has been automatically allocating your GST tax exemption to your ILIT premium payments and gifts since the enactment of the 2001 Tax Act, and you will have to do one the following:
(A) Continue to permit the IRS to automatically allocate your GST tax exemption to premium payments and gifts you make to your ILIT (even though your grandchildren may never receive one dollar from the ILIT). This will require the filing of a notice to the IRS along with a U.S. Gift Tax Return (IRS Form 709); and it may also require you, through your tax advisor, to make what is commonly known to as a “late” allocation of your GST tax exemption.  This option results in your “opting in” to the automatic GST tax exemption allocation rules. You must opt in via the special notice since the rules for the automatic allocation of your GST tax exemption to your ILIT may not be applied consistently each year - this is one of the flaws in the new law. GENERALLY, THIS IS THE SAFEST AND MOST CAUTIOUS WAY TO PROCEED UNDER THE CIRCUMSTANCES.
(B) Stop the IRS from continuing to automatically allocate your GST tax exemption to premium payments and gifts you make to your ILIT. This will require you, through your tax advisor, to file a special notice with the IRS along with a US Gift Tax Return.  This option results in your “opting out” of the automatic GST tax exemption allocation rules.
The Bottom Line.
The IRS is “forcing” you to make a decision concerning the allocation of your GST tax exemption, and for you to inform it of the decision. Therefore it is imperative that you show this memo to your tax advisor so that he or she can help you in your making an appropriate decision.
We Can Assist You.
If you would like our firm to arrange for a review your ILIT, and make a recommendation concerning your options, please contact me at [ phone # of Advisor].
Doing nothing may result in serious tax consequences to your estate and to your family.
 See, Treasury Regulation section 26.2632-1(b)(3) (as redesignated by T. D. 9209 (6/27/2005)).
 See, Treasury Regulation section 26.2632-1(b)(2)(iii)(as re-designated per T. D. 9209 (6/27/05)).
 See, Treasury Regulation section 26.2632-1(b)(3)(as re-designated per T. D. 9209 (6/27/05)).
 See, Treasury Regulation section 26.2632-1(b)(2)(iii)(as re-designated per T. D. 9209 (6/27/05)).
Copyright © 2005 Sebastian V. Grassi, Jr.
For a discussion of the GST exemption as a prospecting tool see the Current Comment::
For a discussion of the Insurance Funded GST-exempt irrevocable life insurance trust see: