Tag: grantor

Generational Skip Trust

Posted on by Peter Harper

Generational Skip Trust

With previous discussions of estate planning and grantor trust, let’s examine another common practice within financial planning: generation-skipping trust.

What is a Generation-Skipping Trust?

A generation-skipping trust is a trust where the settlor or grantor of the trust transfers assets to recipients who are two or more generations younger than them. Therefore, the settlor can bypass a generation when leaving assets to their heirs and eliminate one round of estate tax.

How a Generation-Skipping Trust Works

A generation-skipping trust allows the grantor to leave an inheritance (either in the form of money or assets) to his grandchild, great-niece, great-nephew, or any other natural person who is at least 37.5 years younger than the grantor. The trust’s beneficiaries cannot, however, be the spouse or ex-spouse of the grantor.

The trust created will also be regarded as irrevocable, meaning that the trust cannot be changed or revoked. The fact that the trust will be irrevocable does not mean that the grantor relinquishes all of their power and can still insert provisions that allow them to determine how the assets are distributed and how the estate is invested.

The tax on generation-skipping trusts is also separate from estate and gift tax. 

No regulations prevent the grantor’s children (the skip person) from participating in the income earned on the assets held in the trust as long as the original assets are not distributed. 

Who Needs a Generation-Skipping Trust?

A generational skipping trust may only be suitable for some. It should be noted that it should last the lifetime federal GST exemption of $12.06 million per individual (this increases to $24.12 million for a couple). If this is possible, the grantor may be subject to GST and estate taxes.

As the skipped generation will only be able to benefit from the income earned and generated from the trust assets, it may not be suitable for smaller estates where the assets need to pass directly to the next generation (children/spouses).  

Who Gets the Income from a Generation-Skipping Trust?

The income generated and earned from assets held in the trust can be paid to the children/spouse of the grantor as long as the assets are not physically distributed to them. The income will be taxed accordingly; however, the assets will be kept separate from their own estate.

Passing Assets to Grandchildren Through a Generation-Skipping Trust

A grandparent can ensure that assets and inheritance can be passed to grandchildren by forming a generation-skipping trust during the grantor’s lifetime or by transferring the assets directly to the grandchildren in the grandparent’s wills. 

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How to Create a Generation-Skipping Trust

Creating a generation-skipping trust is complicated, and the exact details of the trust will depend on the specific goals of the grantor. Two transferring strategies are available to grantors, and these are as follows:

Generation-Skipping Transfers:

Assets are placed in a trust using the GST exemption. The trust can then pay any income earned from the assets in the trust to the skip person and/or skipped generation (children/spouses), while the remaining assets in the trust pass outside of the grantor’s estate to future generations after the death of your child/spouse.

Direct Generation Skip

The grantor will bypass their own children and give the assets qualifying for the GST exemption amount directly to your grandchildren or place them in a trust for their benefit or the benefit of future generations.

Generation-Skipping Trusts & Taxes

Much like other financial trusts, a generation-skipping trust will often have taxes attached to it. Who, what, and how are listed as:

Who Has to Pay Estate Taxes?

Estate taxes are owed on any estate exceeding the federal estate tax exemption of $12.06 million. This lifetime exemption changes annually to adjust for inflation (it should be noted that should Congress not intervene, the exemption amount will revert to a $5 million baseline, adjusted for inflation, in 2026). In some states, the estate tax exemption is the same as the federal exemption; in others, this may be less than $1 million.

Gift Tax

An individual is allowed to give gifts during their lifetime without paying taxes as long as the value of the gifts does not exceed your lifetime exclusion which is the same as your estate tax exemption.

There is an annual gift exclusion of $15,000.00. However, should you grant a gift worth more than the annual exclusion, your lifetime exclusion decreases by the excess value of the gift.

Generation-Skipping Transfer Tax

The GST tax applies when someone gives direct gifts of money or other assets to someone at least 37.5 years younger than them. A flat tax rate of 40% on the transfer value exceeds the GST exemption, and GST tax can also be referred to as GSTT or simply as a transfer tax.

Benefits of Generation Skipping Trusts

The following three most common benefits are:

  • GST is a great planning tool for larger estates as you can ensure that your family legacy is maintained for at least two generations. It enables your own children to benefit and ensures that your grandchildren will also be supported.
  • GST allows the grantor to skip a round of federal estate taxes, as the federal estate taxes will only be assessed when the property is distributed to the beneficiaries of the trust. Should the assets be passed to the children of the grantor, the family legacy would have been subjected to tax twice.
  • GST assets are not included in your child’s estate, which effectively protects their estate. They can also retain complete control of their own trust during their lifetime.

Drawbacks of Generation-Skipping Trusts

When considering a GST, the following drawbacks need to be considered:

  • GST was established to ensure that families cannot escape federal estate taxes over multiple generations. If the estate’s value exceeds the GST tax exemption, it will be subject to both GST and estate taxes at a rate of 40%.
  • Trusts may be powerful estate planning tools that allow families to minimize their estate’s exposure to probate. However, there is a very high administrative burden of running a trust. As trusts require a lot of thought, resources, and energy, it is best to work with an estate planning professional to assist with setting up a trust that will best suit your family’s needs.
  • With a large enough estate, your children may still benefit from the profits generated from the assets held in trust. Suppose there is a need to support your children financially. In that case, an evaluation needs to be done to ascertain that the income produced by the GST will be substantial enough to cover their expenses and lifestyle.

Can a Generation-Skipping Trust be Broken or Dissolved?

It may be possible to dissolve a generation-skipping trust as the trust is an irrevocable trust. This means the trust cannot be broken, modified, revoked, or dissolved; however, it may be possible to modify or terminate the trust judicially, depending on the State.

Can a Generation-Skipping Trust be Contested?

A GST can be contested; however, this cannot purely be done on the basis that an individual or family member does not agree to the terms. It will need to be proven that the trust is not legally valid for the contention to be valid. Here are some valid reasons for a GST to be contested:

Mental Incapacity

The grantor needs to be ‘sound of mind’ when the trust is created, meaning the grantor needs mental awareness of what they are doing. The trust can be invalid if it is possible to prove that they were not.

Undue Influence

If a third party coerced the grantor to create the trust or name a specific beneficiary/fiduciary, the validity of the trust can be challenged. The level of pressure the grantor faces must be so severe that their own free will must be overwhelmed.

Fraud or Forgery

If a trust document was obtained through fraud, it could be contested and thrown out. This can occur when the grantor is tricked into signing the trust when they are under the impression that they are signing another document.

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Who can Contest a Generation-Skipping Trust? 

A trust litigation attorney can be approached to contest the GST. The aggrieved party will submit a motion or oral application to a High Court.

Do I Need A Trust Litigation Attorney To Contest A Generation Skipping Trust?

Some states, such as California, do not require a trust litigation attorney to contest the validity of a GST. However, it would be most beneficial for the person challenging the trust to employ one. Other states do require a Trust litigation attorney to be appointed by the aggrieved party or family members to submit a motion or oral application to a High Court.

Is a GST Trust Revocable or Irrevocable?

A GST is an irrevocable trust; however, the grantor can still make decisions regarding the investments made in the trust and the distributions made from the trust.

Protect against the Generation-Skipping Transfer Tax

In order to protect against the GST Tax, it is crucial to consider the most tax-efficient planning tools. As the lifetime exemption applies to an individual, it is possible to put an estate plan in place which may allow each spouse to apply for their GST tax exemption either during their lifetime or at the time of their death when the trust is created.

Common Transfer Strategies for You to Discuss with Your Tax and Legal Advisors

Bring up options for GST as an irrevocable trust to your tax or legal advisor, as they will best recommend options that are unique to your case and circumstances. The same can be done for tools to protect against the GST tax discussed above.

How to Use a Lifetime Exemption from GST

Lifetime exemption from GST can be used during the grantor’s lifetime or at the time of their death when the assets are inherited outright by the next generation or transferred into the trust. During the lifetime of the grantor, all applicable transfers of wealth made are automatically applied to the lifetime GST exemption unless elected otherwise. Also taken into consideration is that it’s also possible to employ the annual gift tax exclusion to ensure that not too much of the GST exemption is used up during the course of the grantor’s lifetime. For transfers at death, the exemption may be allocated as directed in the will of the grantor or as directed by the executors if not explicitly mentioned in their wills.

 

Speak with an Asena consultant to learn more about your generational skip trust case.

–Jean-Dré Tombisa

–Peter Harper

IRC 677

Posted on by Peter Harper


To build upon our previous discussions on foreign grantor trusts, today’s topic concerns Section 677 of the Internal Revenue Code (IRC). Specifically, this section of the IRC discusses a foreign trust’s grantor’s ability to receive income from the trust. This topic is essential for anyone who owns assets in foreign trusts and is moving to the U.S. or facing a liquidity event. Furthermore, this topic is also necessary for those who wish to take steps to avoid having their trust activate a grantor trust status. 

IRC 677

What is IRC Section 677? Simply put, any rev. rul under it states that a grantor of a trust shall be recognized and treated in the role of the owner of any portion of a trust with an income that is distributed towards the grantor or their spouse, held, or has been accumulated for future distribution towards the grantor or their spouse. This also will apply to the payment of life insurance policies on the life of the grantor or their spouse.

Income for Benefit of Grantor

The grantor shall be recognized and treated as the owner if the income from the trust is or may, at the grantor’s discretion (or a nonadverse party), be:

  • Accumulated for future distribution towards the grantor or their spouse;
  • Distributed to the grantor or their spouse; or
  • Applied towards the life insurance payment on the life of the grantor or their spouse.

IRC Section 677 – General Rule

This section of the Internal Revenue Code and all rev. rul provides that the grantor of a trust will be granted ownership and taxation upon any portion of the trust whose income is at the discretion of the grantor, their spouse, or any nonadverse person without the consent or approval of an adverse party, either:

  • Accumulated for future distribution towards the grantor or their spouse
  • Distributed to the grantor or towards the grantor’s spouse
  • Applied to pay premiums on life insurance policies for the grantor or their spouse
  • Applied or distributed in order to support or put towards maintenance of beneficiaries whom the grantor or their spouse is legally obligated to support or maintain

Definitions Relevant to Section 677

Various definitions relevant to this section of the code are basic yet essential to explain.

What is Income?

For the purposes of this subpart, under any rev. rul under Internal Revenue Code 677, income refers to taxable income (and not fiduciary accounting income), such as ordinary income or capital gains income. 

Who is a Spouse?

For the purposes of this subpart, a person is considered the spouse of a grantor solely during the period of the marriage to the grantor. Therefore, if the grantor and the spouse divorce, the grantor would cease to be taxed as the trust’s owner for income distributions or accumulations that benefit the former spouse.

Who is an Adverse Party?

For the purposes of this subpart, an adverse party can be defined as someone who holds a substantial beneficial interest in the trust and would be negatively affected by the exercise (or lack of exercise) of the power the person possesses concerning the trust.

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What is a Grantor Trust?

According to the IRS, grantor trust status is activated when the grantor retains control over the trust’s income and assets. 

What Grantor Trusts Are Used For

There are various reasons for an individual to set up a grantor trust, but the five most common reasons are: 

  • Asset protection and wealth preservation;
  • Credit protection;
  • Avoiding probate;
  • Reduce or eliminate estate taxes and gift tax; and 
  • To gain any possible tax benefits or tax deferral benefits.

Who is the Grantor?

Also known as the owner, settlor, or trustor, it is a general rule that this person contributes property (such as real estate or estate planning), other funds, or even a trust instrument such as life insurance to the trust. According to the grantor trust reg, the property and the grantor’s funds become part of the trust corpus (in other words, the trust assets). It is crucial to note that a trust can have more than one grantor. If more than one taxpayer had funded a grantor trust, they will each be treated as a grantor in proportion to the cash or property’s value they transferred to the trust, according to the terms of the trust. 

The grantor is someone who retains the power to direct or control the trust’s income or assets, including estate planning under the trust. This is crucial to understand, especially when dealing with a foreign trust and the income tax treatment surrounding this trust instrument. Pulling from one of our previous articles, the grantor can also be any taxpayer who creates a trust and either directly or indirectly contributes a gratuitous transfer of property towards a trust. If someone creates or funds a trust on behalf of another, they are treated as the trust’s grantors. 

Income for Benefit of Grantor

The grantor shall be treated as owner if the income from their trust is or may, at the discretion of the grantor, be:

  • Distributed towards the grantor or to the grantor’s spouse, not in a fiduciary manner;
  • Accumulated for future distribution towards the grantor or their spouse; or
  • Applied towards the insurance policies’ payment on the life of the grantor or their spouse.
Constructive Distribution

Under Section 677, the grantor shall be recognized and treated in the role of the owner of any portion of a trust if they retain interest. And, without the approval/consent of an adverse party, the grantor can be enabled to have their income from the portion of the trust distributed to themselves at some time, either actually or constructively. The grantor shall also be treated as the owner if they have granted or retained any interest which might be distributed to the spouse (whether actually or constructively). Again, this action can be done without the approval or consent of an adverse party to enable their spouse to have the income from the portion at any time, even if it is not within the grantor’s lifetime. In this case, constructive distribution includes payment on behalf of the grantor or their spouse to another in obedience to their direction and payment of premiums upon life insurance policies on the grantor’s life or their spouse’s life.

Discharge of Legal Obligation of Grantor or His Spouse

The grantor shall be recognized and treated as owner of the trust if that trust income is or able to be applied towards the discharge of a legal obligation belonging to the grantor or the grantor’s spouse.  

Exception for Certain Discretionary Rights Affecting Income

A grantor should not be recognized or treated as the owner of a trust when a discretionary right can only impact the income’s beneficial enjoyment of a trust that is received after a period of time during which the grantor would not be recognized or treated as an owner if the power were a reversionary interest. 

Accumulation of Income

The grantor shall be recognized and treated as owner of a trust if any income has been accumulated for future distribution towards the grantor or their spouse without the consent of an adverse party. The grantor will be taxed in the current year, even if they must wait for an extended amount before accessing the accumulated income. Suppose that income is accumulated as a tax liability for future distribution towards the grantor or their spouse during any taxable year. In that case, the grantor shall be considered the owner for that taxable year.

Income Distributed to or on Behalf of the Grantor or Grantor’s Spouse

Section 677 applies when the grantor or their spouse is entitled to or can demand trust income. Further, it also applies when a nonadverse trustee has the discretion to distribute trust income to either the grantor or their spouse without the consent of an adverse party. Therefore, even the mere possibility that the grantor or their spouse will receive income is sufficient to trigger the application of Section 677. For income tax purposes, the grantor shall be taxed on all income that could be distributed, even if it is not distributed. 

Income Accumulated for Future Distribution to Grantor or Grantor’s Spouse

According to the grantor trust reg, a grantor is recognized and treated as owner of a trust whose income is or may be at the discretion of the grantor, their spouse, or a nonadverse party, currently accumulated for future distribution towards the grantor or their spouse, even without an adverse party’s consent. Therefore, this income would be taxable to the grantor in this scenario. 

Deferred Right to Distribution or Accumulations

Section 677 does not result in a grantor being taxed on a trust’s income when a discretionary power to apply the income of the trust for the grantor or their spouse’s benefit may occur only after a period of time that would not cause the grantor to be treated as an owner if the discretionary power were what is called a reversionary interest. 

Income Applied to Pay Premiums on Life Insurance Policies on the Life of the Grantor or Grantor’s Spouse

For income tax purposes, the grantor is taxed on any taxable income (and not fiduciary income) used to pay premiums on life insurance policies on the life of the grantor or their spouse. 

Income Applied or Distributed in Satisfaction of the Grantor’s or Grantor’s Spouse’s Legal

For possible income tax purposes, the income of a trust is not taxable to the grantor merely because trust income may be distributed or applied for the support or maintenance of a trust beneficiary whom the grantor or their spouse is legally obligated to support or maintain. The discretion of another person or the grantor acting as trustee must be applied in this scenario.

Obligation of Support for a Trust Beneficiary

With the statement above, however, any trust income distributed or used to satisfy the grantor’s or their spouse’s legal obligation of support for beneficiaries will cause the grantor to be taxed on such income. 

Divestiture of Powers Triggering Section 677

Suppose the grantor and/or their spouse have any interest in a trust that triggers the grantor trust status. In that case, they may be able to evade the application of Section 677 if they divest themselves of every interest that could cause the grantor to be taxed under Section 677. 

Taxable Portion Under Section 677

A grantor with only an income interest in the trust is taxed on ordinary items of income, and a grantor with only an interest in the trust’s principal is taxed on capital gains items.

Estate, Gift, and Generation Skipping Transfer Tax Implications of Section 677

The three most common transfer taxes under this section of the code (gift tax, estate tax, and generation skipping tax) under IRC 677 usually depend on the existing status of a person involved with the trust. For instance, the federal estate tax can be applied to the transfer of property or other kinds of items of income upon or following death. The gift tax also applies to transfers made only if a person is still living. Additionally, the generation skipping transfer tax is a supplemental tax on a transfer of a trust property or other items of income that skips a generation. However, intention and power under this section of the code over that transfer may impact if one of these taxes is imposed for your case. For example, a gift tax can only be imposed if complete dominion, including interest, over the gift, as the gift will be recognized as a trust property, thus triggering the gift tax.

How is an Irrevocable Grantor Trust Taxed?

An irrevocable trust can trigger grantor trust status if the trust fulfills any one of the following requirements as set out in Internal Revenue Code § 673-679:

  • The Grantor Maintains A Reversionary Interest
    • If a grantor holds a ‘reversionary interest’ within a trust greater than 5% of the trust income or principal, the trust may trigger the grantor trust status in terms of IRC § 673m.
  • The Grantor Has The Power To Control Beneficial Enjoyment
    • If a grantor can control the ‘beneficial enjoyment’ of trust assets or income, the trust may trigger the grantor trust status in terms of IRC § 674.
  • The Grantor Maintains Administrative Control
    • If the grantor can maintain administrative control over their trust that is able to be exercised for their own benefit, the trust may trigger the grantor trust status in IRC § 675.
  • The Grantor Maintains Revocation Powers
    • If the trust allows the grantor to revoke any portion of the trust, followed by reclaiming or taking back the trust assets, the trust may trigger the grantor trust status in terms of IRC § 676.
  • The Trust Distributes Income To The Grantor
    • If the trust distributes any income towards the grantor, the trust can, in terms of IRC § 677(a), trigger the grantor trust status.

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Is an ILIT a Grantor Trust?

An ILIT, also known at length as an irrevocable life insurance trust, is an optional irrevocable trust that contains provisions designed to facilitate the ownership over one or more life insurance policies. In other words, an ILIT is a trust designed primarily to hold life insurance. Because it is irrevocable, the grantor cannot change or terminate it. It is important to note that in this scenario, the ILIT is both the owner and beneficiary of the life insurance policy and that it insures the grantor’s life. But to answer the question in this section, an ILIT is not necessarily a grantor trust. For a trust to trigger grantor trust status, specific provisions or powers that can lead the grantor of the trust to be recognized and treated as the owner over the trust’s assets under reg have to be in place. An ILIT is also subject under Grantor Trust Rule §677(a)(3) if the income of the trust may be applied towards the premium payments on policies that insure the grantor’s life (or the grantor’s spouse’s life). Again, for income tax purposes, the grantor will need to report all income of the ILIT towards the grantor’s income tax return. That way, the ILIT will use the grantor’s Social Security number as its primary tax identification number. This grantor trust option is usually referred to as an Intentionally Defective Grantor Trust (IDGT”).

What Makes an Insurance Trust a Grantor Trust?

The grantor will be treated as the trust’s owner if its income is, or in the owner’s direction, distributed to the owner or the grantor’s spouse. It will also accumulate for any future distribution to the grantor or their spouse or to be applied to payment of insurance policies on either the life of the grantor or their spouse.

Can a Non-Grantor Trust Own Life Insurance?

Yes, for instance, through private placement life insurance or PPLI. PPLI provides the ability for a foreign non-grantor trust to make investments into assets deemed to generate U.S.-sourced income and avoid U.S. taxation to the non-grantor trust.

An increasingly utilized technique to either eliminate or reduce U.S. income taxation towards U.S.-sourced income-generating assets to the foreign non-grantor trust is all for the trust to be making those investments inside a U.S. tax-compliant PPLI contract.

Inside a PPLI transaction, the insurance company will become the underlying beneficial owner over the assets in exchange for a policy whose value is tied to the asset’s value as held by the insurance company. Therefore, the trust would have ownership over a U.S. tax-compliant life insurance policy that includes a tax deferral on the build-up of cash value. It will not own the income tax-generating U.S.-sourced income assets, as those assets would be considered to be owned by the insurance company.

If the U.S.-sourced income-generating assets are held until the insured’s death within a PPLI policy, the death benefit is tax-free by the trust. In effect, having the U.S.-sourced income-generating assets that are held along with the policy should permit all the growth within the assets to escape U.S. income taxation while also being held and then sold at the insured’s death as they are changed into a death benefit.

However, once the current taxable year’s distribution exceeds the trust’s distributable net income, it is treated under reg as being paid from prior years’ undistributed income (also known as an accumulation distribution). This throwback to an accumulated distribution is taxed at the highest income tax rate that would have been applied if the income had been distributed to the beneficiaries in the year it was received. To make matters worse, any accumulated long-term capital gain loses its favorable character and is taxed at the higher ordinary income tax rate for a higher total tax liability. Further, the beneficiaries are also subject to a non-deductible interest charge on the accumulation distribution based on how long the trust retained it.

 

Speak with one of our specialists to learn more about IRC 677 and how it can help your case.

Arin Vahanian

Peter Harper