GENERATION SKIPPING TRANSFER TAX (GSTT) PLANNING

GENERATION SKIPPING TRANSFER TAX (GSTT) PLANNING First Run Broadcast: September 22, 2011 Live Replay: December 22, 2011 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) The Generation Skipping Transfer (GST) tax has been reinstated for tax year 2012 and beyond, but with certain changes that open new planning opportunities. This program will provide you with an overview of the complex framework of the GST tax and an in-depth discussion of advanced planning opportunities after the restoration of the tax and ahead of the forthcoming sunset of certain safe harbors. Among other topics, this program will cover planning opportunities for the larger GST exemption under the Tax Reform Act of 2010, advanced planning techniques including the use of dynasty trusts and HEET Trusts, and avoiding pitfalls on reporting on Form 709. The program will also discuss what practitioners can do in anticipation of the sunset of certain safe harbors in 2013. Quick overview of the GST tax generally Planning to use the new larger GST exemption under TRA 2010 Advanced planning issues, including the use of dynasty trusts and the sophisticated "HEET" Trusts What to do about the sunset of GST tax safe harbor rules that will occur on January 1, 2013 Avoiding pitfalls in reporting on Form 709 Speakers: Daniel L. Daniels is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP, where his practice focuses on representing business owners, corporate executives and other wealthy individuals and their families. A Fellow of the American College of Trust and Estate Counsel, he is listed in The Best Lawyers in America, and has been named by Worth magazine as one of the Top 100 Lawyers in the United States representing affluent individuals. Mr. Daniels is co-author of a monthly column in Trusts and Estates magazine. Mr. Daniels received his A.B., summa cum laude, from Dartmouth College and received his J.D., with honors, from Harvard Law School.

PROFESSIONAL EDUCATION BROADCAST NETWORK Speaker Contact Information Generation Skipping Transfer Tax Planning Daniel L. Daniels Wiggin & Dana, LLP - Stamford (o) 203-363-7665 ddaniels@wiggin.com David T. Leibell Wiggin & Dana, LLP - Stamford, Connecticutt (o) (203) 363-7623 dleibell@wiggin.com

Fundamental GST Planning, With Special Attention to the Tax Relief Act of 2010 By Dan Daniels and David Leibell Wiggin and Dana LLP 2011 Wiggin and Dana

Agenda Review of the GST Tax Overview of TRA 2010 and its GST Provisions Impact on 2010 GST Planning Impact on 2011 and 2012 GST Planning Impact on Post-2012 GST Planning 2011 Wiggin and Dana 2

Introduction to the GST Tax Purpose of Tax Need to learn GST vocabulary Skip person and non-skip person Taxable Termination Direct Skip Taxable Distribution Tax Rate Inclusion ratio GST exemption 2011 Wiggin and Dana 3

Name That Transfer T makes a gift of property to his grandchild, GC T transfers property to a trust to pay income his child, C, for life, with the remainder to pass to C s children T makes a gift to a sprinkle trust for the benefit of his children and grandchildren Trustee of that trust makes distributions to grandchildren 2011 Wiggin and Dana 4

Name that Transfer - Bonus Questions (Hint: Know the transferor move down rule) T makes a gift to a sprinkle trust for the benefit of his grandchildren and great grandchildren Trustee later makes a distribution from the trust to a grandchild Trustee later makes a distribution from the trust to a great grandchild 2011 Wiggin and Dana 5

In general Transferor Transferor is decedent for property transferred at death Transferor is donor for property transferred by gift Why do we care who is the transferor? Only the transferor can allocate GST exemption Identity of transferor provides starting point for determining whether a transferee is a skip person or not Identity of transferor can change over time Transferor is person who transfers property and with respect to whom the property was most recently subject to estate or gift tax 2011 Wiggin and Dana 6

Interest Why do we care about the term interest? Integral part of the definition of certain generation skipping events A taxable termination occurs when there is A termination of an interest in property held in trust Unless immediately thereafter a non-skip person has an interest in the property A transfer to a trust will be not be a direct skip as long as a nonskip person has an interest in the trust 2011 Wiggin and Dana 7

Interest Special Rule for Charities A charity may have an interest in a trust for GST tax purposes in two situations: Charity has a present non-discretionary right to receive income or principal from the trust Charity is the remainderman of a CRAT, CRUT or pooled income fund Example: T transfers property to a CRT to pay a unitrust percentage to GC for life, remainder to charity. T s transfer is not a direct skip. Distributions to GC are taxable distributions. 2011 Wiggin and Dana 8

Skip Person/Non-Skip Person A skip person may be a natural person or a trust A natural person is a skip person if she is assigned to the second or lower generation below the transferor A trust is a skip person if either: all interests in the trust are held by skip persons; or no person holds an interest in the trust and at no time after the transfer may a distribution be made to a non-skip person A non-skip person is a natural person or trust that is not a skip 2011 Wiggin and Dana 9

Skip Person Quiz T creates a trust naming his grandchild, GC, as the only permissible income and principal beneficiary, remainder to great-grandchildren T creates a trust for GC. Trustee directed to accumulate income until GC is 21 then pay income to GC for life, remainder to GGC T creates a sprinkle trust for C and GC for the life of C, remainder to GC T creates a trust to pay all income to GC, remainder to C 2011 Wiggin and Dana 10

Skip Person Quiz Advanced Questions T creates a CRT to pay an annuity interest to GC, remainder to charity T creates a sprinkle trust for C and his five GCs for the life of C, remainder to GC; Crummey rights are given to all six beneficiaries 2011 Wiggin and Dana 11

Inclusion Ratio What is it? Essentially, the proportion of the trust that is subject to GST tax More correctly, it s a factor in determining the GST Tax Rate Tax rate = (Top Estate Tax Rate) X Inclusion Ratio 2011 Wiggin and Dana 12

Determining Inclusion Ratio Inclusion ratio equals 1 - applicable fraction Applicable Fraction Amount of GST Exemption allocated/value of property in the trust 2011 Wiggin and Dana 13

Inclusion Ratio Example T transfers $100,000 to trust T allocates $40,000 of GST Exemption Applicable fraction equals $40,000/$100,000, or.40 Inclusion ratio equals 1 -.40, or.60 Tax rate equals.60 x 35% = 21% 2011 Wiggin and Dana 14

GOAL IS AN INCLUSION RATIO OF EITHER ZERO OR ONE Mixed inclusion ratio wastes GST exemption when distributions from a trust are made to children Mixed inclusion ratio causes unnecessary GST tax when distributions from a trust are made to grandchildren A trust with a zero inclusion ratio will be invested differently from a trust with a one inclusion ratio 2011 Wiggin and Dana 15

Achieving a Zero Inclusion Ratio Allocate GST exemption to each transfer to the trust Timely allocation permits use of date-of-gift value for purposes of allocation Late allocation requires use of values as of date return is filed Special first of the month rule Planning pointers: Be sure trust agreement includes power for trustee to split into zero and one inclusion ratio trusts Use intentional late allocation for life insurance in trust? 2011 Wiggin and Dana 16

Automatic Allocation Rules Lifetime Direct Skips Automatic Allocation at Death Rules on Automatic Allocation to Indirect Skips (Repealed as of 1/1/2013) An Indirect Skip is a transfer that is not a direct skip which is made to a GST Trust A GST Trust is any trust that could have a taxable termination or taxable distribution unless one of six exceptions applies 2011 Wiggin and Dana 17

2010 Tax Relief Act, In General Increase in estate, gift and GST exemptions and decrease in tax rates for 2010, 2011 and 2012 $5,000,000 exemptions 35% rate Exemption indexed for inflation from 2010, starting in 2012 2010 Tax Act sunsets in 2013 $1,000,000 estate, gift and GST exemptions Note that the GST exemption will be indexed for inflation 55% rate Estates of decedents who died in 2010 (even after enactment) had the option to elect out of the estate tax and into carryover basis 2011 Wiggin and Dana 18

Portability 2011 and 2012 estate and gift tax exemptions are portable between married couples The Executor of a deceased spouse may transfer any unused estate tax exemption to the surviving spouse Portability of GST Exemptions is NOT available 2011 Wiggin and Dana 19

Extended Deadlines for 2010 Estates Estate tax return and payment due nine months after date of enactment (December 17, 2010) Special due date applies for decedents dying from January 1 to December 16, 2010 Note that nine months from December 17, 2010 is September 17, 2011, which is a Saturday, so that the actual due date was September 19, 2011. Deadline for filing returns reporting generation skipping transfers similarly extended Deadline for disclaimers similarly extended 2011 Wiggin and Dana 20

2010 Tax Relief GST Provisions 2010 Rules: 0% GST tax rate $5 million GST exemption Helpful provisions of EGTRRA 2001 (automatic allocation rules, qualified severance rules, 9100 relief) still available 2011 and 2012 Rules: 35% GST tax rate $5 million GST exemption Helpful provisions of EGTRRA 2001 still available 2013 and Thereafter Rules: 55% GST tax rate $1 million GST exemption (indexed for inflation) Helpful provisions of EGTRRA 2001 eliminated 2011 Wiggin and Dana 21

GST Opportunities for 2011 and 2012 Unprecedented opportunity to use $5 million of GST exemption Window may close in 2013 Consider funding new trusts Consider reciprocal trust issues Consider allocating exemption to old trusts that were too large to fully shelter from GST tax in prior years Take advantage of the helpful EGTRRA 2001 provisions while they last Qualified severance rules 9100 relief Warn clients of possible expiration of automatic allocation rules for indirect skip transfers 2011 Wiggin and Dana 22

The Federal Generation Skipping Transfer Tax: An Brief Overview, with Particular Attention to Issues Raised by the 2010 Tax Relief Act by Daniel L. Daniels and David T. Leibell Wiggin and Dana LLP 30 Milbank Avenue Greenwich, CT 06830 (203) 363-7600 ddaniels@wiggin.com www.wiggin.com 1\310\2568059.1

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I. OVERVIEW FEDERAL GENERATION SKIPPING TRANSFER TAX A. Purpose of the Tax The purpose of the federal generation-skipping transfer tax ( GST Tax ) is to ensure that property is subject to US transfer tax at each generational level. B. Quick Review of GST Tax Vocabulary The GST Tax employs a dizzying number of defined terms. For purposes of an introduction to the tax, the most important of these terms are taxable termination, taxable distribution, direct skip, skip person, non-skip person, transferor and inclusion ratio. 1. Skip Person; Non-Skip Person. A skip person is a person assigned to the second generation or more below the transferor, e.g., a grandchild. A non-skip person is any person who is not a skip person. 2. Taxable Termination, Taxable Distribution and Direct Skip. These terms refer to the three types of transfers to which the GST Tax applies. Although the definitions of these terms contained in the Code are predictably opaque, they are fairly easily understood by example. (a) Taxable Termination. The Code defines a taxable termination as the termination of an interest in property held in trust unless immediately thereafter a non-skip person has an interest in the property or unless thereafter no distributions may be made to a skip person. IRC 2612(a). Example: T creates a lifetime trust for C, remainder to GC. A taxable termination occurs on C s death. (b) Taxable Distribution. A taxable distribution is any distribution from a trust to a skip person other than a taxable termination or a direct skip. IRC 2612(b). Example: T creates a sprinkle trust for the benefit of C and GC for the life of C, remainder to GC. Any distribution to GC during C s life is a taxable distribution. At C s death, there is a taxable termination. If the trust continues for GC after C s death, further distributions from the trust to GC are not taxable distributions. (c) Direct Skip. A direct skip is a transfer subject to estate or gift tax of an interest in property to a skip person. IRC 2612(c). Example: T transfers $100,000 outright to GC. It is important to note that for taxable terminations and taxable distributions, the GST Tax is imposed on a tax inclusive basis, similar to the estate tax, in that the taxable amount includes the GST Tax itself. For direct skips, on the other hand, the tax is imposed only on the amount actually received, similar to the gift tax. However, any GST Tax paid by the donor upon a direct skip is treated as an additional taxable gift.

2 3. Inclusion Ratio. The GST Tax rate is the top estate and gift tax rate then in effect multiplied by the inclusion ratio, if any. IRC 2641. The inclusion ratio is a fraction representing, in essence, the excess value of the property transferred over the amount of the transferor s generation-skipping tax exemption ( GST Exemption ) applied to the transfer. Example: T transfers $1,000,000 to a trust for C, remainder to GC. At the time of the gift, T allocates $1,000,000 of his GST Exemption to the trust. Therefore, the trust has an inclusion ratio of zero. Although there will be a taxable termination at C s death, no GST Tax would be imposed because the trust has a zero inclusion ratio. If in the above example T had allocated only $600,000 of his GST Exemption to the $1,000,000 transfer, the trust s inclusion ratio would have been 0.4 (i.e., the difference between the amount of the transfer [$1,000,000] and the amount of GST Exemption applied [$600,000], divided by the total value of the transfer [$1,000,000], equals $400,000/$1,000,000 equals 0.4). Accordingly, assuming a top rate of 35%, the tax rate applied at the time of the taxable termination would be 35% x 0.4). II. BASIC DEFINED TERMS: TRANSFEROR, INTEREST, SKIP PERSON, NON-SKIP PERSON, AND TRUST A. Transferor 1. In general. In general, the transferor of property for GST Tax purposes is (a) the decedent as to any property subject to the federal estate tax and (b) the donor as to any property subject to the federal gift tax. IRC 2652(a)(1). However, if property is the subject of a QTIP election under IRC 2056 or 2523, the transferor s spouse is deemed to be the transferor of the property for GST Tax purposes unless a special reverse QTIP election is made. The identity of the transferor is important in determining (and planning for) whose GST Exemption is used and in determining generation assignments. 2. Change in Transferor Upon a Chapter 11 or 12 Event. The transferor is the person who transfers property and with respect to whom the property was most recently subject to federal estate or gift tax. IRC 2652(a)(1); Treas. Regs. 26.2652-1(a)(1) 1. Therefore, the identity of the transferor can change over time. Example: T transfers property to a trust for C in which C has an unlimited right of withdrawal after attaining age 30. If C dies prior to age 30, remainder to GC. At the date of the transfer, T is the GST transferor. If C dies prior to age 30, T remains the GST transferor. If C dies after age 30, C becomes the transferor because the property is includible in C s estate at that time for federal estate tax purposes. 1 The inclusion of an insurance trust included in the transferor s estate by reason of IRC 2035 does not result in a new transfer for GST purposes nor does it change the trust s inclusion ratio. See Treas. Regs. 26.2652-4(a)(3).

3 3. Transferor Move-Down Rule. Under IRC 2653(a), if property continues to be held in a trust after a generation skipping transfer, the transferor is treated as having been moved down to the first generation above the highest generation of trust beneficiaries. Example: T has used all of his GST exemption. She transfers $1,000,000 to a trust for the benefit of her grandchildren and more remote descendants. T s transfer is a direct skip resulting in GST tax. Distributions to T s grandchildren from the trust will not be treated as taxable distributions because they are no longer skip persons with respect to T. However, the a distribution to a great grandchild would be a taxable distribution. Similarly, the death of all of T s grandchildren, leaving only great grandchildren as trust beneficiaries, would be a taxable termination. 4. Gift Splitting. Gift splitting between husband and wife causes each to be the GST transferor of one-half of the property. IRC 2513, 2652(a)(2). 5. Reverse QTIP Election. Recall that the GST transferor changes each time property is subject to estate or gift tax. Accordingly, if H leaves property in a QTIP trust for W, H is the transferor of the property at his death, but W becomes the transferor at her death because the property is includible in her estate. With respect to QTIP property only, the creator of the QTIP trust may elect to treat the trust as if no QTIP election had been made for purposes of determining the GST transferor. IRC 2652(a)(3). In other words, in the example above, H s executor could elect to have H treated as the transferor of the QTIP trust for GST purposes notwithstanding the fact that the QTIP property later will be included in W s estate. This election is commonly referred to as the reverse QTIP election. The election must be made over the entire QTIP trust. Treas. Regs. 26.2652-2(a). Planning pointer: Properly drafted QTIP trusts should always allow for a division into QTIP and reverse QTIP shares to avoid creating a trust which is only partially GST-Exempt. 2 B. Interest 1. In general. It is important to know who has an interest in a trust for GST Tax purposes because: (1) no taxable termination can occur as long as a non-skip person has an interest in the trust; and (2) a trust will not be a skip person for purposes of determining whether a direct skip has occurred as long as a non-skip person has an interest in the trust. In general, a person has an interest in trust property for GST Tax purposes if the person has a present right to receive income or principal from the trust. 2 Under a transition rule, if a reverse QTIP election was made with respect to a trust prior to December 27, 1995, the transferor (or his executor) may elect to treat the trust as two trusts, one with a zero inclusion ratio and one with a one inclusion ratio. The reverse QTIP election is treated as applying only to the trust with the zero inclusion ratio. In order to be eligible for this transition rule, a statement must be attached to a copy of the return on which the reverse QTIP election was made (i) indicating that an election is being made to treat the trust as two separate trusts and (ii) identifying the values of the two separate trusts. The statement must have been filed at the IRS office where the return was filed before June 24, 1996.

4 IRC 2652(c)(1)(A). In addition, a person has an interest in the trust if the person is not a charity and is a permissible current recipient of the trust income or principal. IRC 2652(c)(1)(B). Generally, a future interest is not an interest for GST Tax purposes except for certain future interests in charities, as discussed below. 2. Charities. Special rules apply to determine whether a charity has an interest in a trust for GST Tax purposes. A charity may have an interest in a trust for GST Tax purposes in two situations: (a) Charity has a present nondiscretionary right to receive income or principal from the trust. IRC 2652(c)(1)(A). Example: Charitable lead trust or a nonqualified charitable income trust. (b) Charity is the remainderman of a CRAT, CRUT or pooled income fund. Example: T creates a CRUT to pay a unitrust amount of 8% per year to GC, remainder to charity. The initial transfer to the trust is not a direct skip because the trust is not a skip person. However, the annual unitrust payments to GC will be taxable distributions. 3. Future interests are not interests for GST Tax purposes. IRC 2652(c)(1)(C). (Except the interest of a charity as remainderman of a CRAT, CRUT or pooled income fund.) 4. Interests inserted in the trust primarily to avoid tax will be disregarded. IRC 2656(c)(2). 5. Support Obligations. Suppose T creates a trust for the benefit of GC, a minor. Trust principal can be used to discharge C s support obligation to GC. Before the final regulations were issued, there was a concern that C has an interest in the trust for GST Tax purposes, with the result that T s transfer to the trust is not a direct skip and no tax will be assessed until C s support obligation ceases. However, the final regulations clarify that an individual does not have an "interest" in a trust for GST Tax purposes merely because a support obligation of that individual may be satisfied by a distribution that is either within the discretion of a fiduciary or pursuant to a Uniform Gifts to Minors Act or equivalent statute. Treas. Regs. 26.2612-1(e)(2)(i). 6. Interest under a power of appointment. Suppose T creates a trust of which GC is the only permissible income and principal beneficiary but GC has a power to appoint the trust property among T s other descendants. Do the possible takers under the power of appointment have interests in the trust for GST Tax purposes? If the power of appointment is exercisable inter vivos, the answer may be yes. Possible takers under a testamentary power of appointment would not have an interest until the power was actually exercised. In Estate of Eleanor R. Gerson v. Comm., 507 F.3d 435 (November 9, 2007), the Sixth Circuit affirmed a Tax Court decision upholding regulations that treat as a separate taxable generation-skipping transfer the post-september 25, 1985, exercise of a general power of appointment created under a trust that was irrevocable on September 25, 1985. This has created a 2-2 split among the circuits on the grandfathering

5 issue as it applies to the exercise of general powers of appointment contained in grandfathered trusts. The 8th and 9th Circuits hold that the grandfathering rule is unambiguous and protects the taxpayer; the 2nd and 6th Circuits side with the government. On May 27, 2008, the U.S. Supreme Court declined to review the Sixth Circuit decision, which is now identified as Kleinman v. Commissioner, U.S., No. 07-1064, cert. denied May 27, 2008. C. Skip Person; Non-Skip Person. 1. Skip Person. (a) In general. A skip person may be either a natural person or a trust. A natural person is a skip person if assigned to the second or more remote generation below the transferor. A trust is a skip person if either (a) all interests in the trust are held by skip persons or (b) no person holds an interest (for GST Tax purposes) in the trust and at no time after the transfer may a distribution be made to a non-skip person. (b) Examples. 1. T creates a trust of which his grandchild, GC, is the only permissible income and principal beneficiary, remainder to T s great-grandchildren. The trust is a skip person. 2. T creates a trust for GC in which the Trustee is directed to accumulate the income until age 21 and, thereafter, to pay the income to GC, remainder to GGC. At the time the trust is created, GC is age 20. The trust is a skip person because at the time of the transfer no person holds an interest in the trust for GST Tax purposes and at no time after the transfer may a distribution be made to a non-skip person. 3. Same as the trust in example (2), except that on GC s death, the trust property passes to GC s then living descendants or, if none, to T s then living descendants. The trust will not be treated as a skip person if the probability that a distribution may be made to a non-skip person (i.e., if GC dies without descendants) is 5% or more. See Treas. Regs. 26.2612-1(d)(2)(ii). 2. Non-Skip Person. (a) In general. A non-skip person is a person or trust which is not a skip person, that is, either (1) a natural person who is not assigned to the second or more remote generation below the transferor or (2) a trust in which either (A) not all of the interests are held by skip persons or (B) no person holds an interest but in which a distribution may be made to a non-skip person. (b) Examples.

6 1. T creates a sprinkle accumulation trust for C and C s descendants for the life of C, remainder to GC. The trust is not a skip person because not all interests in the trust are held by skip persons. 2. T creates a trust for C in which the Trustee is directed to accumulate the income until C attains age 30. At age 30, the entire trust principal is to be distributed to C. If C dies before attaining age 30, remainder to GC. The trust is a non-skip person because no person hold an interest in the trust at the time of the transfer but a distribution may be made to a non-skip person, C, if C survives to age 30. 3. T creates a trust to pay all income to GC, remainder to C. The trust is a skip person because C s remainder is not an interest for GST Tax purposes. 4. Same as example (3), except the remainderman is X Charity. The trust is a skip person because X Charity s remainder interest is not an interest for GST Tax purposes. 5. Same as example (4), except that GC s interest is a qualified annuity or unitrust interest. Under a special rule applicable to CRATs, CRUTs and pooled income funds, X Charity s remainder interest is a GST Tax interest and, therefore, the trust is a non-skip person. However, the annuity or unitrust distributions to GC will be treated as taxable distributions for GST Tax purposes. 3. Crummey Trusts. Suppose T establishes a trust for the benefit of his children and grandchildren in which he gives simple Crummey withdrawal rights to each of five grandchildren. An early Technical Advice Memorandum held that T s transfers to the trust constituted direct skips to the grandchildren holding Crummey withdrawal powers. TAM 8901004. However, the regulations clarify that (a) a transfer to a trust subject to a right of withdrawal is treated as a transfer to the trust and not as a transfer to the holders of the withdrawal rights and (b) a transfer to a trust is only a direct skip if all interests in the trust are held by skip persons. Treas. Regs. 26.2612-1(f), Example 3. D. Trust 1. In general. The regulations provide that a trust includes any arrangement (other than an estate) that has substantially the same effect as a trust. Treas. Regs. 26.2652-1(b)(1). Therefore, a trust can include not only the traditional trust agreement but also arrangements involving life estates and remainders, estates for years and insurance and annuity contracts if the identity of the transferee is contingent upon the occurrence of an event. Id. 2. Example. T transfers cash to an UGMA or UTMA account in the name of T's child, C, as custodian for T's grandchild, GC, a minor. The transfer is treated as a transfer to a trust. Treas. Regs. 26.2652-1(b)(2), Example 1. The transfer should constitute a direct skip even if C may use the funds to defray a support obligation. See Treas. Regs. 26.2612-1(e)(2)(i). III. GENERATION ASSIGNMENT

7 A. Purpose Generation assignments determine whether an individual is a skip person or a non-skip person. In turn, the determination of whether an individual is a skip person or a non-skip person determines whether there is a generation-skipping taxable transfer. B. Generation Assignment is based either on family relationship or age 1. Family Relationship. (a) A descendant of a grandparent is assigned to a generation by comparing the number of generations between the descendant and the grandparent and the number of generations between the transferor and the grandparent. IRC 2651(b)(1). (b) A present or former spouse of the transferor is assigned to the same generation as the transferor, regardless of the disparity between their ages. IRC 2651(c)(1). (c) A descendant of a grandparent of a spouse or a former spouse of the transferor is assigned to a generation by comparing the number of generations between the spouse and the grandparent with the number of generations between the descendant and the grandparent. IRC 2651(b)(2). (d) A present or former spouse of a descendant of a either a grandparent or a spouse of a grandparent is assigned to the same generation as the same generation as the descendant. IRC 2651(c)(2). (e) A legally adopted person is treated as a blood relative of the adopting parent. IRC 2651(b)(3)(A). (f) If an individual can be assigned to more than one generation under the above rules, he will be assigned to the youngest generation. IRC 2651(e)(1). 2. Age. Persons not assigned to a generation by family relationship are assigned based on age relative to the transferor. IRC 2651(d). (a) Any person not more than 12-1/2 years younger than the transferor is assigned to the transferor s generation. IRC 2651(d)(1). (b) Any person more than 12-1/2 years younger but not more than 37-1/2 years younger is assigned to the first generation below the transferor. IRC 2651(d)(2). (c) Any person more than 37-1/2 years younger than the transferor is assigned to a second or succeeding generation below the transferor and, therefore, will be a skip person relative to the transferor. IRC 2651(d)(3). 3. Charities. Charities and governmental entities are assigned to the transferor s generation. IRC 2651(e)(3).

8 4. Chart Summarizing Generational Assignments. Generation Assignment Family Relationship Age Transferor's Generation Transferor; his Spouse; his Siblings and Their Spouses; and his Spouse's Siblings and Their Spouses; Charities and Governmental Entities One Generation Below the Transferor Two or More Generations Below the Transferor Transferor's and spouse's children, nephews, nieces and their spouses Transferor's and spouse's grandchildren, grandnephews, grandnieces and their spouses and more remote descendants and collaterals and their spouses Unrelated person who is not more than 12-1/2 years younger than the transferor Unrelated person who is more than 12-1/2 years younger but not more than 37-1/2 years younger than the transferor Unrelated person who is more than 37-1/2 years younger than the transferor. IV. TAXABLE TRANSFERS A. Taxable Terminations 1. In general. A taxable termination occurs when there is a termination of an interest in property held in trust unless: 1. immediately thereafter a non-skip person has an interest in the trust; or 2. no distribution 3 may thereafter be made to a skip person; or 3. a transfer subject to the federal estate or gift tax occurs at the time of the termination, with the result that there is a new transferor for the trust. IRC 2612(a)(1); Treas. Regs. 26.2612-1(b)(1). 2. Examples. 3 Other than a distribution the probability of which occurring is so remote as to be negligible, i.e., if there is less than a 5% probability that the distribution will occur.

9 (a) T creates a trust to pay the income to C for life, remainder to GC. C s death is a taxable termination. See Treas. Regs. 26.2612-1(f), Examples 4, 8 and 11. (b) T creates a trust to sprinkle income and principal among C, GC and GGC. Upon the death of C, the remaining trust property is to be distributed to GGC. Therefore, at C's death, both C's interest and GC's interest terminate. Before the final regulations were issued, it was unclear whether one or two taxable terminations occurred in this scenario. The final regulations clarify that only one taxable termination occurs. Treas. Regs. 26.2612-1(f), Example 10. B. Taxable Distributions A taxable distribution is any distribution from a trust to a skip person other than a taxable termination or a direct skip. IRC 2612(b). Example: T creates a trust in which the trustee is authorized to sprinkle the income and principal among C and GC. Any distribution of income or principal to GC during C's lifetime is a taxable distribution. 4 Treas. Regs. 26.2612-1(f), Example 12. (The distribution to GC at C's death would be a taxable termination.) C. Direct Skips A direct skip is a transfer to a skip person of property subject to the estate or gift tax. IRC 2612(c). Example 1: T gifts $1,000,000 to GC. The transfer is a direct skip subject to both gift and GST Tax. Example 2: T gifts $1,000,000 to a trust in which GC holds the only present interest. The transfer is a direct skip subject to both gift and GST Tax. D. Predeceased Ancestor Exception 1. Pre-1998 Law Prior to the Taxpayer Relief Act of 1997, under IRC 2612(c)(2), if a child of the transferor or of the transferor's spouse predeceases the transferor, that child s descendants are moved up one generation for purposes of determining whether a direct skip has occurred. In addition, under the final regulations, a parent will be deemed to have predeceased the transfer in question if the parent does not survive the transfer by more than 90 days and either local law or the governing instrument provides that the parent shall be deemed to have predeceased. Treas. Regs. 26.2612-1(a)(2). 4 If the distribution is from income, an income tax deduction is available for the GST Tax paid. IRC 164(a)(4); 164(b)(4).

10 2. Post December 31, 1997 Law Under 511 of the Taxpayer Relief Act of 1997, old section 2612(c) was repealed. In its place was enacted 2651(e), which creates an expanded predeceased ancestor exception. Under the new law, effective for generation-skipping transfers made after December 31, 1997, the exception is available in the case of direct skips, taxable distributions and taxable terminations as long as the predeceased ancestor was dead at the time the transfer was first subject to estate or gift tax. In addition, the new law extends the benefits of the predeceased ancestor exception to grandnieces and grandnephews; provided, however, that this additional benefit is only available if the transferor had no living descendants at the time of the transfer. Example 1: T s daughter, C, predeceases T, leaving GC surviving. Under both the old and the new law, T s gift of $1,000,000 to GC will be treated as a taxable gift for gift tax purposes but will not be treated as a direct skip for GST Tax purposes. Example 2: T establishes an irrevocable trust providing for income to be paid to GC for 5 years. At the end of the 5 year period, the trust terminates and the trust is distributed to GC. T's child, C, who is GC's parent, was deceased at the time of the transfer to the trust. Therefore, under both the old and the new law, GC is treated as a child of T rather than a grandchild and the initial transfer to the trust is not a direct skip. In addition, under both the old and the new law, any distributions from the trust to GC will not be taxable distributions. Treas. Regs. 26.2612-1(f), Example 6. Example 3: Same facts as Example 2 above, except that T's spouse, S, is also an income beneficiary of the trust. Since S has an interest in the trust, the trust is not a skip person and the transfer is not a direct skip. Therefore, under old law, the predeceased parent exception does not apply. Upon the expiration of the 5 year term of the trust, a taxable termination occurs. Treas. Regs. 26.2612-1(f), Example 7. Under the new law, the distribution to GC at the end of the trust term will not be a taxable termination. Example 4: Reverse QTIP Problem: T's Will establishes a reverse QTIP Trust for the benefit of S, remainder to T's child, C, if C is then living, otherwise to T's grandchild, GC. T dies survived by S, C and GC. C later dies and then S dies, with the result that the remainder passes to GC. Even under the new law, the exception probably does not apply because C was not deceased at the time the trust was first subject to estate tax, i.e., T's death. Example 5: Collateral Heirs: T transfers $1,000,000 to his brother's grandchild, GN on January 1, 1998. T's brother is deceased. If T has no living descendants on January 1, 1998, the transfer is not a direct skip. If T does have living descendants on January 1, 1998, the transfer is a direct skip. E. GST Annual Exclusion/ GST Med-Ed Exclusion 1. GST Annual Exclusion.

11 (a) A direct skip to an individual that qualifies for the gift tax annual exclusion, while not technically exempt from the GST Tax, will have an inclusion ratio of zero, with the result that no GST Tax is imposed. IRC 2642(c). (b) A direct skip to a trust which qualifies for the gift tax annual exclusion will not have a zero inclusion ratio unless (i) the trust is exclusively for one beneficiary during that beneficiary s lifetime and (ii) the trust will be includible in the beneficiary s gross estate if he dies before termination of the trust. IRC 2642(c)(2). 2. GST Med-Ed Exclusion. (a) A direct skip transfer which qualifies for the gift tax exclusion for direct payments of certain medical or education expenses, while not technically exempt from the GST Tax, will have an inclusion ratio of zero, with the result that no GST Tax is imposed. IRC 2642(c)(3). (b) Likewise, a transfer from a trust is not a taxable distribution if it would qualify for the gift tax medical/education expense exclusion if made by an individual. IRC 2611(b)(1). i. Example 1: T creates a trust for the benefit of C and GC, remainder to GC. Direct payment to the provider by the Trustee for GC s medical or educational expenses would not be a taxable distribution from the trust. If the Trustee makes the payments to GC to be used for educational or medical expenses, the distributions would be taxable distributions. ii. Example 2: T creates a trust for the sole benefit of his five grandchildren, remainder to great-grandchildren. Although the Trustee s direct payment of educational or medical expenses would qualify for the GST med/ed exclusion, there would be no need to use the exclusion: Because the initial transfer to the trust would be a direct skip, subsequent distributions from the trust to grandchildren would not be taxable distributions. (Under the same principle, however, if distributions to great-grandchildren were permitted, these would be treated as taxable distributions.) F. Gallo Exclusion- Expired The Gallo exclusion provided that the GST Tax would not apply to direct skips prior to January 1, 1990, to a grandchild to the extent the aggregate transfers to that grandchild by the transferor did not exceed $2,000,000. V. GST EXEMPTION; INCLUSION RATIO A. In General 1. Each individual has an exemption from the GST Tax (the GST Exemption ). IRC 2631(a). Under EGTRRA 2001, as modified by the 2010 TRA, the GST Exemption is as shown in the following chart:

12 Year GST Rate GST Exemption at Death 2001 55% $675,000/ $1,060,000 2002 50% (and 5% surtax repealed) $1,000,000/ $1,060,000 2003 49% $1,120,000/ $1,060,000 2004 48% $1,500,000/ $1,500,000 QFOBD repealed 2005 47% $1,500,000/ $1,500,000 2006 46% $2,000,000/ $2,000,000 2007 45% $2,000,000/ $2,000,000 2008 45% $2,000,000/ $2,000,000 2009 45% $3,500,000/ $3,500,000 2010 0% $5,000,000 2011 35% $5,000,000 2012 35% $5,000,000 2013 55% $1,000,000/ 5 2. The exemption may be used for transfers during lifetime or at death. IRC 2632(a)(1). 3. Since only the transferor (or the transferor s Executor) can allocate the GST Exemption, once a new transferor is determined with respect to any property, any previous allocation of GST Exemption is lost. See IRC 2631(a). Example: T leaves $1,000,000 to a QTIP trust for S. At S s death, the property passes to a lifetime trust for T s child, C, remainder to GC. At S s death, the property is included in S s estate under IRC 2044 and S becomes the GST transferor of the property. IRC 2652(a)(1). Therefore, T s earlier allocation of GST Exemption to 5 Indexed for inflation. Estimated to be in excess of $1,340,000.

13 the trust is wasted. If S does not allocate her own GST Exemption to the trust, a GST Tax will be due at C s death. 6 4. In general, an allocation of GST Exemption may be made at any time before the due date (including extensions) of the transferor s estate tax return. IRC 2632(a)(1). 5. Valuation Rules. (a) For lifetime transfers subject to the gift tax, if an allocation of GST Exemption is made on a timely-file gift tax return, the value of the property for purposes of allocating the GST Exemption will relate back to its value at the time of the transfer. IRC 2642(b)(1); Treas. Regs. 26.2642-2(a)(1). (b) On the other hand, if the allocation is made on a late-filed gift tax return, the value of the property for purposes of allocating the GST Exemption will be its value on the date the return is filed. IRC 2642(b)(3); Treas. Regs. 26.2642-2(a)(2). Given that it is often impossible to know the value of the property at the precise time that the return is filed, the regulations provide some relief for late allocations to transfers in trust. Under this rule, the transferor may elect to value property in trust as of the first day of the month in which the gift tax return is filed. Treas. Regs. 26.2642-2(a)(2). The election is made by stating the following on the gift tax return on which the allocation of GST Exemption is made: (i) that the election is being made; (ii) the date on which the property was valued; and (iii) the fair market value of the trust assets on that valuation date. Id. This special rule for late allocations does not apply to life insurance held in a life insurance trust if the insured individual has died. Id. (c) In general, if GST Exemption is allocated to property included in the transferor's gross estate, the value of property is its value as finally determined for federal estate tax purposes. Treas. Regs. 26.2642-2(b). Special rules are provided for valuation of section 2032A special use valuation property, Treas. Regs. 26.2642-2(b)(1), and for pecuniary payments, Treas. Regs. 26.2642-2(b)(2) and (3). (d) An "intentional" late allocation of GST Exemption can be a useful, albeit risky, technique in the case of a GST-Exempt Trust holding relatively new life insurance. Example: T creates a second-to-die life insurance trust designed to last in perpetuity. Annual premiums on the $2 million policy in the trust are $40,000. If T makes timely allocations of GST Exemption to the trust for, say, 3 years, he will have allocated $120,000 of exemption. On the other hand, the value of the insurance policy at 6 Under the current version of Schedule R, it should no longer be possible to make this mistake. Schedule R provides that if GST Exemption is allocated to a QTIP trust, the reverse QTIP election is deemed to have been made, with the result that the surviving spouse cannot become the transferor of the trust and exemption is not wasted.

14 the end of 3 years is likely to be far less than $120,000, e.g., $100,000. T could "gamble" and wait to make a late allocation of GST Exemption to the trust at the end of the three year period, thereby using only $100,000 of exemption to cover the full value of the policy. Caveat: Beyond ensuring that T understands that this technique involves gambling on his life expectancy, T's lawyer should be careful to ensure that the entire allocation of GST Exemption is a late allocation. For example, suppose that T paid premiums as follows: 1/1/2005 $40,000 1/1/2006 $40,000 1/1/2007 $40,000 Assume that the value of the trust on 1/1/07 is $120,000 but that T makes an allocation of GST Exemption of $100,000 on April 1, 2007, intending it to be a late allocation and that the value of the trust at that time is $100,000. However, that allocation will be insufficient because it will be treated first as a timely allocation to the premium payment made on 1/1/07 and as a late allocation to the balance. This results in an inclusion ratio for the trust of 6.67%. The calculation of this inclusion ratio is set forth in the footnote below. 7 B. Automatic Allocation Rules In some cases, the transferor s GST Exemption will be allocated automatically to a transfer unless the transferor elects not to have the exemption allocated, as discussed below. 1. Lifetime Direct Skips. The transferor s GST Exemption is automatically allocated to any lifetime direct skip in an amount sufficient to exempt the transfer from the GST Tax (or, in the amount of the transferor s remaining GST Exemption if there is not enough exemption left to exempt the entire transfer from the GST Tax). IRC 7 Assume that the allocation of GST Exemption is made on April 1, 2007, and that the value of the trust at that time is $100,000. Assume, however, that the value of the trust at the time of the January 1, 2007, premium payment was $120,000. The first $40,000 of the allocation will be treated as timely. Therefore, immediately after that allocation, the trust has an applicable fraction of.333 ($40,000/$120,000) and an inclusion ratio of.667 (1-.333). The inclusion ratio for the trust as to the late allocation is determined in accordance with Treas. Regs. 26.2642-4(b), Example 2, as follows: The "non-tax" portion of the trust as of the late allocation date is the applicable fraction (.333) at that time multiplied by the value of the trust at that time ($100,000), or $33,300. The numerator of the new applicable fraction is the sum of the nontax portion ($33,300) plus the GST Exemption allocated late ($60,000) or $96,000. The denominator of the new applicable fraction is the value of the trust at the time of the late allocation ($100,000), resulting in an applicable fraction of.933 and an inclusion ratio of.067. Thus, 6.7% of the trust is still generation-skipping taxable.

15 2632(b)(1). The transferor may elect out of this automatic allocation on a timely file gift tax return. IRC 2632(b)(3); Treas. Regs. 26.2632-1(b)(1)(i). 2. Order of Automatic Allocation at Death. To the extent that the transferor s GST Exemption is not fully allocated by his Executor on a timely filed federal estate tax return (including extensions), the statute automatically and irrevocably allocates exemption in the following order of priority: First, to direct skips occurring at the transferor s death. IRC 2632(c)(1)(A). Second, pro rata to any trusts from which a taxable termination or taxable distribution may occur at or after the transferor s death. IRC 2632(c)(1)(B); Treas. Regs. 26.2632-1(d)(2). 3. Automatic Allocation to Indirect Skips. Effective for transfers after December 31, 2000, the law provides for automatic allocation of generation-skipping transfer tax exemption (GST exemption) to a new class of transfers labeled indirect skips. 8 An indirect skip is a transfer of property that is not a direct skip and which is made to a generation skipping transfer trust or GST trust. A GST Trust is a trust that could have a taxable termination or a taxable distribution, unless one of the following exceptions applies: (a) Exception 1: The trust instrument provides that more than 25% of the trust corpus must be distributed or may be withdrawn by one or more individuals who are non-skip persons (a) before the date that the individual attains age 46, (b) on or before one or more dates specified in the trust instrument that will occur before the date that such individual attains age 46, or (c) upon the occurrence of an event that, in accordance with regulations prescribed by the Treasury, may reasonably be expected to occur before the individual attains age 46. Master Example: T creates an irrevocable sprinkle trust for the benefit of his spouse, S, and children. The trust instrument provides that the trust shall terminate upon the death of the survivor of T and S, at which time any remaining trust principal will be distributed to separate, continuing trusts for each of T s descendants, per stirpes. The trust instrument provides that each descendant is entitled to withdraw 1/3 of his trust at age 30, an additional 1/3 at age 35 and the balance at 40. (Under normal circumstances, this trust will be distributed outright to children during their lifetimes and would not be intended as a GST vehicle). Analysis: The children s withdrawal rights do not come into being until the latter of (1) the death of the survivor of T and S and (2) the children s attaining age 40. The death of the survivor of T and S is an event which may occur after the 8 These automatic allocation rules are contained in EGTRRA 2001 and, pursuant to TRA 2010, will be repealed as of January 1, 2013 unless Congress changes the law.

16 children attain age 46; therefore, the trust instrument cannot be said to provide that more than 25% of the trust corpus shall be distributed to non-skip persons before they attain age 46. On the other hand, Exception 1 could shield the trust from deemed allocation if, under Treasury Regulations, the withdrawal ages set forth in the trust instrument are events that may reasonably be expected to occur before the individual attains age 46. Example A: T creates an irrevocable trust for his child, C, funded with annual exclusion gifts. The trust instrument provides that C has the right to withdraw 1/3 of the principal at age 35, an additional 1/3 at age 40 and the balance at age 45. The trust is not a GST trust and will not be subject to deemed allocation of T s GST exemption. Example B: T creates an irrevocable trust for his child, C, funded with annual exclusion gifts. The trust instrument provides that C has the right to withdraw 25% of the trust principal at age 45. The trust is a GST trust because C does not have the right to withdraw more than 25% of the trust before age 46. The trust will be subject to deemed allocation of T s GST exemption. (b) Exception 2: The trust instrument provides that more than 25% of the trust corpus must be distributed to or may be withdrawn by one or more individuals who are non-skip persons and who are living on the date of death of another person identified in the trust instrument who is more than 10 years older than such individuals. Master Example Analysis: The trust does not fall within the literal terms of Exception 2 because the trust property is not distributable to (or subject to withdrawal by) non-skip persons upon the death of the survivor of T and S. Rather, the trust property continues on in separate trusts. Example C: T creates an irrevocable sprinkle trust for the benefit of his spouse, S, and T s children. The trust instrument provides that the trust shall terminate upon the death of the survivor of T and S, at which time any remaining trust principal is to be distributed to T s children. T and S are both more than 10 years older than T s oldest child. The trust is not a GST trust and no automatic allocation of T s GST exemption will be made. Query whether the result would be the same if the trust provided for a distribution to T s then living descendants, per stirpes upon the death of the survivor of T and S rather than a distribution to T s children. In that event, because a distribution could be made to a grandchild if a child predeceased T and S, the trust might not comply with the statute s literal requirement that the trust instrument provide that more than 25% of the trust corpus must be distributed to non-skip persons upon the death of an individual more than 10 years older (c) Exception 3: The trust instrument provides that if one or more individuals who are non-skip persons die on or before a date or event described in Exception 1 or 2 above, more than 25% of the trust corpus either must be distributed to

17 the estate or estates of one or more of such individuals or is subject to a general power of appointment exercisable by one or more of such individuals. Master Example Analysis: Same issues as above. Example D: T creates an irrevocable trust for his child, C, funded with annual exclusion gifts. The trust instrument provides that C has the right to withdraw 1/3 of the principal at age 35, an additional 1/3 at age 40 and the balance at age 45. The trust instrument further provides that if C dies prior to withdrawing the entire principal of the trust, then the property subject to C s withdrawal rights is distributed as C shall appoint (including C s estate) or in default of appointment, to C s estate. The trust is not a GST trust and will not be subject to deemed allocation of T s GST exemption. (d) Exception 4: The trust is a trust any portion of which would be included in the estate of a non-skip person (other than the transferor) if such person died immediately after the transfer. Flush language indicates that withdrawal powers (e.g., Crummey powers?) will be ignored if limited to annual exclusion amount. Master Example Analysis: Depending on what is made of the flush language, this exception is likely inapplicable to the trust in the master example. Some commentators suggest that a hanging Crummey amount may inadvertently trigger this exception and avoid automatic allocation. Example E: T creates an irrevocable trust for the benefit of his child, C, to last for C s lifetime. Any trust principal remaining at C s death is subject to C s general power of appointment. The trust is not a GST trust. The result presumably would be the same if C possessed a general power of appointment over only a portion of the trust. (e) Exception 5: The trust is a charitable lead annuity trust, a charitable remainder annuity trust or a charitable remainder unitrust. (f) Exception 6: The trust is a charitable lead unitrust and is required to pay the remainder to a non-skip person if such person is alive at the termination of the lead interest. 4. An individual can elect out of the automatic allocation rules on a timely filed gift tax return for the year in which the election is to become effective. The optout can be with respect to any or all transfers made to a particular trust. Final Regulations on Election Out of GST Deemed Allocations, T.D. 9208, 70 Fed. Reg. 37258-02 (6/29/2005).

18 C. Retroactive Allocation of GST Exemption. IRC 2632(d), added by EGTRRA 2001 9, provides that generation-skipping transfer tax exemption can be allocated retroactively where there is an unnatural order of death. If a lineal descendant of the transferor predeceases the transferor, then the transferor can allocate unused GST exemption to any previous transfer on a chronological basis. For example, suppose a transferor creates a trust for the benefit of child until age 35 providing that if the child dies prior to age 35, any remaining trust property will be distributed to the child s children (the grandchildren of the transferor). If the child dies prior to age 35 and the transferor is still living, the transferor can allocate exemption to the trust to avoid a GST tax on the taxable termination that occurs at that time. The transferor is permitted to allocate based on the value of gifts made to the trust at the time the gifts were made. The retroactive allocation rule is applicable only if the beneficiary: i. Is a non-skip person; ii. Is a lineal descendant of the transferor s grandparent or a grandparent of the transferor s spouse; transferor; and iii. iv. Is a generation younger than the generation of the Dies before the transferor. D. Relief for Late Elections. 1. In general. Under prior law, the allocation of generation-skipping exemption must have been made on a timely filed gift tax return in order for the donor to be able to use the date-of-gift value for purposes of the allocation. If the allocation was made on a late-filed return, the donor generally was required to use the value as of the date of the allocation. There was no statutory relief for an inadvertent failure to allocate exemption on a timely filed return. Effective for requests for relief pending on or filed after December 31, 2000 EGTRRA 2001 authorizes the IRS to grant extensions of time to allocate generation-skipping exemption. If such an extension is granted, the donor is permitted to use the date-of-gift value rather than the value as of the date of the allocation. 10 2. Notice 2001-50. Notice 2001-50, 2001-34 IRB 189 (8/20/2001), confirms that the procedure for obtaining relief for a late GST allocation election will be similar to those used for 9100 relief under Reg. 301.9100-3. In general, the transferor must 9 10 Along with the rest of the GST changes made by EGTRRA 2001, pursuant to TRA 2010, this provision sunsets after December 31, 2012. This provision is contained in EGTRRA 2001 which, as modified by TRA 2010, will not apply after 2012.

19 show that he acted reasonably and in good faith under the circumstances. Reliance on advice of counsel generally counts as acting reasonably and in good faith. 3. REG-147775-06 (4/26/2008). Proposed regulations were issued under Reg. 2642(g) to further describe the circumstances and procedures under which an extension of time will be granted to individuals or estates who fail to make a timely allocation of their GST exemption. Notice 2001-50 will be made obsolete upon the adoption of the final regulations and relief will then only be available under the final regulations. E. Substantial Compliance Rule Extended to GST Exemption Allocations. Under pre-egtrra 2001 law, the substantial compliance rule did not apply to the allocation of GST exemption, meaning that, notwithstanding the donor s intent that exemption be allocated, a technical misstep in the mechanics of making the allocation could frustrate that intent. Effective for transfers after December 31, 2000, the new law provides that the substantial compliance doctrine will apply to allocations of generationskipping exemption. When requesting relief, the taxpayer must follow the procedures for requesting a private letter ruling. In determining whether there has been substantial compliance, all relevant circumstances will be considered, including evidence of intent contained in the trust instrument and such other factors as the Secretary of the Treasury deems appropriate. 11 F. Inclusion Ratio All generation-skipping transfers are taxed at a flat rate equal to the maximum estate and gift tax rate multiplied by the inclusion ratio. IRC 2602, 2641. When a transferor allocates GST Exemption to a transfer, he reduces the inclusion ratio of the property or trust involved in the transfer and, therefore, reduces the tax rate. Therefore, it is not technically correct to state that an allocation of GST Exemption exempts particular property or a particular trust from the GST Tax. Rather, the allocation of GST Exemption reduces the tax rate (potentially to zero) that continues to apply to the property or trust as a whole. 1. Computation of the Inclusion Ratio--the Applicable Fraction. The inclusion ratio is defined as 1 minus the applicable fraction. IRC 2642(a)(1); Treas. Regs. 26.2642-1(a). In general, the applicable fraction is a fraction, the numerator of which is equal to the GST Exemption allocated to the trust or direct skip involved and the denominator of which is the value of the property in the trust (or which is the subject of the direct skip), less any federal estate tax and state death taxes actually recovered from the trust and minus any charitable deduction property. IRC 2642(a)(2). 11 This provision is contained in EGTRRA 2001 which, as modified by TRA 2010, will not apply after 2012.

20 (a) Example. T transfers $100,000 to a newly created irrevocable trust providing that the trust income is to be paid to T s child, C, for life, remainder to GC. On a timely filed gift tax return, T allocates $40,000 of his GST Exemption to the transfer. The applicable fraction with respect to the trust is.40, computed as follows: GST Exemption Allocated = $40,000 =.40 Value of Trust $100,000 The inclusion ratio for the trust is.60, computed as follows: Inclusion = 1 Applicable = 1 -.40 =.60 Ratio Fraction Assuming a top estate tax rate of 35 percent, the tax rate applied to the taxable termination occurring at C s death is 21%, computed as follows: GST Tax = Maximum Estate and = 35% x.60 = 21% Rate Gift Tax Rate x Inclusion Ratio Accordingly, if the value of the trust at C s death is $600,000, a GST Tax in the amount of $126,000 will be due ($600,000 x 21%). See Treas. Regs. 26.2642-1(d), Example 1. 2. Recomputation of the Applicable Fraction Upon Addition To Trust. (a) In general. Section 2642(d)(1) provides that the applicable fraction must be recomputed upon a transfer of property to an existing trust. In general, the numerator of the new applicable fraction is the sum of the amount of GST Exemption currently being allocated to the trust, plus the "nontax portion" of the trust and the denominator of the new applicable fraction is the value of the trust principal after the new transfer to the trust. The recomputation is expressed by the following formula: New Applicable Fraction = (GST Exemption Allocated + "Nontax Portion") ([Value of property transferred less charitable ded. property] + value of all property in the trust immediately after the new transfer). For purposes of the above formula, the "nontax portion" of the trust is the product of the value of all property in the trust immediately before the new transfer and the applicable fraction for the trust. (b) Example. In 1995, T created a trust for the life of C, remainder to GC which he funded initially with $100,000 and allocated GST Exemption of $40,000 on

21 a timely filed gift tax return. Therefore, at inception, the trust has an applicable fraction of.40 and an inclusion ratio of.60. In 1996, T adds another $50,000 to the trust when the trust had a value of $110,000 before the addition. Therefore, the "nontax portion" of the trust is $44,000 (i.e., $110,000 x applicable fraction of.40). If T allocates no GST Exemption to the trust, the new applicable fraction will be ($44,000)/[$110,000+$50,000]) = $44,000/160,000 =.275 and the inclusion ratio will be.725. Thus, in order to cause an inclusion ratio of zero for the trust, T would be required to allocate $116,000 of GST Exemption at the time of the new transfer, as shown in the computation below. Nontax portion of trust = $44,000 New Applicable Fraction = ($44,000+$116,000)/$160,000 = ($160,000/$160,000) = 1 Inclusion Ratio = 1-1 = 0. (c) Similar recomputation rules apply if additional exemption is allocated to the trust which does not effectively revoke a prior allocation of exemption. See Treas. Regs. 26.2642-4(a), (b), Examples 1, 2 and 3. (d) NB: The recomputation rules become significantly more complicated if GST Exemption is allocated at a time when it could apply as both a timely allocation and a late allocation. See generally the examples contained in Treas. Regs. 26.2642-4(b), Examples 3 and 4 and footnote 4 of this outline. G. Splitting Trusts to Cause a Zero or One Inclusion Ratio 1. The Case for "Pure" Inclusion Ratios. Ideally, a trust should have an inclusion ratio of either zero or one and not any number between zero and one. For example, suppose T leaves $2,000,000 at death to a trust permitting distributions to C and GC for the life of C, remainder to GC. Suppose T has only $1,500,000 of GST Exemption remaining. If the choice is available, T's Executor should divide the trust for C and GC into two trusts, one funded with $1,500,000 and one funded $500,000. T's Executor would allocate T's $1,500,000 GST Exemption to the first trust, causing an inclusion ratio of zero and would allocate no GST Exemption to the second trust, causing an inclusion ratio of one. This kind of planning would present the following advantages. (a) Without the division of trusts, the single trust would have an inclusion ratio of.25, meaning that, assuming a top rate of 45%, an 11.25% GST Tax would be imposed each time a distribution from the trust was made to GC and upon the termination of the trust at C's death. By the same token, each time a distribution is made to C from the trust, a portion of T's GST Exemption is wasted. (b) With a division of trusts, all distributions to GC can be made from the zero inclusion ratio trust and all distributions to C can be made from the one inclusion ratio trust.

22 (c) With a division of trusts, the two trusts can be invested differently. Presumably, the zero inclusion ratio trust would be invested for growth, since all appreciation on that trust escapes estate and GST Tax at C's death. On the other hand, the one inclusion ratio trust might be invested for income to provide for distributions to C during C's lifetime. (Note that distributions directly to the service providers for GC's health and education could also be made from the one inclusion ratio trust without a GST Tax being imposed.) (d) A "mixed" inclusion ratio trust requires the filing of a GST Tax Return (gift tax return) each time a taxable distribution is made. This can add unnecessary delay and expense to the administration of the trust. 2. When Will Trusts Be Treated as Separate for GST Tax Purposes? It is not possible to make an allocation of GST Exemption over only a portion of a trust. Therefore, in order to create pure inclusion ratios of either zero or one, it is often necessary to sever a trust into two trusts (or to treat a trust as two trusts), one with an inclusion ratio of zero and the other with an inclusion ratio of one. However, a single trust will only be recognized as multiple trusts for GST Tax purposes under the following rules. (a) GST Exemption must be allocated to entire trust. If property is held in trust, the allocation of GST Exemption must be made over the entire trust. Treas. Regs. 26.2632-1(a). (b) Separate Share Rule. A single trust will be treated as separate trusts if it consists solely of separate and independent shares for different beneficiaries. Treas. Regs. 26.2654-1(a)(1). Example: T creates an irrevocable trust providing that one-half of the income is to be paid to T s son, C, and one-half of the income is to be paid to T s grandson, GC for 10 years. At the end of the 10 year period, the trust principal is to be distributed equally between C and GC. The trust will be treated as separate trusts for GST Tax purposes, and T may allocate his GST Exemption differently as between the two trusts. (c) Separate Share Must Exist From Inception of Trust. However, a portion of a trust is not a separate share unless that separate share exists at all times after the creation of the trust. Id. Example: T creates an irrevocable trust providing the Trustee with the discretionary power to distribute income and principal among T s children and grandchildren. The trust provides that when T s youngest child attains age 21, the trust will be divided into separate shares for each of T s children, with each such share held in further trust for such child for life, remainder to such child s children. The separate shares which come into existence when T s youngest child attains age 21 are not recognized as separate trusts for GST Tax purposes because the shares did not exist at the inception of the trust. Therefore, any allocation of T s GST Exemption to the trust, either before or after T s youngest child attains age 21, will apply to the whole trust. Treas. Regs. 26.2654-1(a)(5), Example 8.

23 (d) Pecuniary Payment from a Trust Can Be Treated as a Separate Share. A right to receive a mandatory payment of a pecuniary amount at the death of a transferor from a trust that is included in the transferor s gross estate or from a testamentary trust will be treated as a separate share if either (x) the Trustee is required to pay appropriate interest to the person under Regs. 26.2642-2(b)(4)(i); or (y) if the pecuniary amount is payable in kind on the basis of value other than the date of distribution value of assets, the Trustee is required to allocate assets to the pecuniary payment in a way that fairly reflects net appreciation and depreciation in the value of the fund available to pay the pecuniary amount. Example: T creates a revocable trust providing that, at T s death, $500,000 is payable to T s spouse, with the balance payable to T s grandchildren. The trust instrument provides that the bequest to T s spouse may be satisfied in non-cash assets at their values for federal estate tax purposes and does not require the Trustee to allocate assets to the bequest which fairly reflect net appreciation and depreciation in the entire revocable trust. The $500,000 bequest to T s spouse will not be treated as a separate share for GST Tax purposes and, therefore, any allocation of T s GST Exemption must be made over the entire revocable trust rather than only over the property passing to the grandchildren. Treas. Regs. 26.2654-1(a)(5), Example 4. (e) Multiple Transferors to a Single Trust. If there are multiple transferors to a single trust, the portions of the trust attributable to different transferors are treated as separate trusts for purposes of the GST Tax. Treas. Regs. 26.2654-1(a)(2). Spouses using gift splitting are treated as separate transferors regardless of from whom the property was actually contributed. Treas. Regs. 26.2652-1(a)(5). 3. When can a trust be severed to create separate trusts for GST Tax purposes. (a) If the separate share rule applies under b through e above to treat a separate share as separate trusts for GST Tax purposes, any such separate share may be divided at any time into separate trusts to reflect that treatment. Treas. Regs. 26.2654-1(a)(3). (b) If a trust is included in the transferor's gross estate or created under the transferor's will, a severance of the trust into two trusts will be recognized for GST Tax purposes if: i. The trust is severed pursuant to a direction contained in the governing instrument; or ii. The trust is severed pursuant to an authorization contained in the governing instrument or pursuant to local law, and the terms of the each of the new trusts provide in the aggregate for the same succession of interests and beneficiaries as provided in the original trust; the severance occurs (or the local law reformation proceeding is commenced) prior to the date prescribed for filing the federal estate tax return (including extensions) for the transferor's estate; and

24 the new trusts are funded on a fractional basis or on a non-pro rata basis if funding is based on either the fair market value of the assets on the date of funding or in a manner that fairly reflects net appreciation and depreciation in the assets from the date of death until the date of funding. (c) EGTRRA 2001 Qualified Severance Rules. Prior to EGTRRA 2001, if an irrevocable trust had a fractional inclusion ratio, a division of the trust into two trusts, one with a zero inclusion ratio and one with a one-inclusion ratio, was generally not permitted except for trusts funded at the transferor s death. Effective for severances occurring after December 31, 2000, IRC 2642(a)(3) permitted a qualified severance of a single trust into two or more trusts if (1) the single trust was divided on a fractional basis and (2) the terms of the new trusts, in the aggregate, provided for the same succession of interests of beneficiaries as was provided in the original trust. If the trust had a fractional inclusion ratio, the severance would be respected for generationskipping transfer tax purposes only if the single trust were divided into two trusts, one of which received a fraction of the total assets equal to the applicable fraction of the single trust immediately prior to the severance. In such a case, the trust receiving such fractional share shall have an inclusion ratio of zero and the other trust shall have an inclusion ratio of one. The qualified severance rule is contained in EGTRRA 2001; pursuant to TRA 2010, this rule will no longer be available after December 31, 2012. The severance must be reported on Form 706GS(T) Generation Skipping Transfer Tax Return for Termination, with Qualified Severance written on the top of the form and a Notice of Qualified Severance attached. The return and attached notice is due on April 15 of the year following the year during which the severance occurred or by the last day of the period covered by an extension of time, if an extenson of time is granted, to file such form. Treas. Regs. 26.2642-6(e)(1) (8/1/2007). 12 H. The ETIP Rule 1. In general. Any allocation of GST Exemption to property subject to an "estate tax inclusion period" or "ETIP" is not effective until the termination of the ETIP. Treas. Regs. 26.2632-1(c)(1). An ETIP is defined as the period during which, should death occur, the value of transferred property would be includible (other than by reason of section 2035) in the gross estate of the transferor or the transferor's spouse. Treas. Regs. 26.2632-1(c)(2). (a) The ETIP rule does not apply to reverse QTIP trusts. Treas. Regs. 26.2632-1(c)(2)(C). (b) A Crummey withdrawal power held by a spouse will not cause an ETIP to arise if the withdrawal power is limited to the greater of $5,000 or 5% of the trust corpus and if the power terminates no later than 60 days after the transfer to the trust. 12 The rules described above are repealed effective January 1, 2013 as a result of EGTRRA 2001 s sunset provision (as modified by TRA 2010).

25 Treas. Regs. 26.2632-1(c)(2)(B). This is a change from the Proposed Regulations which may allow greater use of traditional, single-life insurance trusts as generationskipping vehicles. (c) Property is not deemed to be includible in the gross estate of the transferor or his spouse if the possibility that it will be included is so remote as to be negligible, i.e., if there is less than a 5 percent probability that the property would be so included. Treas. Regs. 26.2632-1(c)(2)(A). 2. Purpose and Example. The purpose of the ETIP rule was to prevent leveraging of GST Exemption through retained interest transfers, such as a QPRT. For example, in the absence of the ETIP rule, T could transfer his $500,000 residence into a QPRT, retaining the right to live in the residence for, say, 10 years, remainder to a generation skipping trust for T's children and grandchildren. Due to T's retained interest the value of the taxable gift might be only $250,000, thereby allowing T to remove a $500,000 asset from the GST Tax system at an "exemption cost" of only $250,000. The ETIP rule prevents this kind of planning by suspending the effectiveness of T's allocation of GST Exemption until the termination of the ETIP which, as discussed below, would be the expiration of the 10 year term of the trust. 3. Termination of the ETIP. The ETIP terminates on the first to occur of the following four events: (a) The death of the transferor; (b) The time at which no portion of the property would be includible in the transferor's gross estate (without regard to IRC 2035); (c) The time of a generation-skipping taxable transfer, but only with respect to the property involved in the generation-skipping transfer; and (d) In the case of an ETIP arising by reason of an interest held by the transferor's spouse, the first to occur of (i) the death of the spouse and (ii) the time at which no portion of the property would be includible in the spouse's estate (without regard to IRC 2035). Note: Under the Final Regulations for IRC 2632(c), a transferor may elect out of the automatic allocation rules for transfers subject to an ETIP at any time prior to the due date of a federal gift tax return for the calendar year during which the ETIP closes regardless of whether any transfer was made in the calendar year in which the ETIP closes. VI. INCLUSION RATIO FOR CHARITABLE LEAD ANNUITY TRUSTS A special rule applies to determine the applicable fraction (and, therefore, the inclusion ratio) for a charitable lead annuity trust (CLAT). Under Treas. Regs. 26.2642-3, in determining the applicable fraction for a CLAT, the numerator is the "adjusted GST Exemption" and the denominator is the value of all property in the trust

26 immediately after the termination of the charitable lead annuity. The "adjusted GST Exemption" is defined as the amount of GST Exemption allocated to the trust increased by an amount of interest equal to the interest that would accrue if the GST Exemption were invested at the interest rate assumed by the IRS in computing the value of the charitable lead annuity, compounded annually, for the actual period of the charitable lead annuity. The amount of GST Exemption allocated is not reduced even if it is ultimately determined that a lesser amount of GST Exemption would have produced a zero inclusion ratio. In Rev. Procs. 2007-45 and 2007-46, issued July 16, 2007, the IRS issued sample trust provisions for inter vivos and testamentary CLATs, including sample provisions with suggested language to utilize when a skip person is a remainder beneficiary. VII. TAX BASE, COMPUTATION AND REPORTING A. Taxable Terminations The GST Tax on taxable terminations is imposed on a "tax-inclusive" basis, that is, the taxable amount includes the GST Tax itself. IRC 2622. In this respect, the GST Tax on taxable terminations is similar to the estate tax. For example, suppose both T and his son, C are in the top estate tax bracket, assumed to be 55% for this example. T transfers $1,000,000 to a generation-skipping trust for C, remainder to GC, but allocates no exemption to the transfer. At C's death, a GST Tax of $550,0000 would be imposed. Similarly, if T had bequeathed the $1,000,000 outright to C, at C's death an estate tax of $550,000 would be due. Liability for the GST Tax on a taxable termination falls upon the Trustee. IRC 2603(a)(2). B. Taxable Distributions Although the statute states that the GST Tax on a taxable distribution is imposed upon the "amount received" by the transferee, the tax is effectively imposed on a tax-inclusive basis because the transferee is liable for the tax. IRC 2621, 2603(a). Thus, like the GST Tax on taxable terminations, the tax base for taxable distributions is tax-inclusive. C. Direct Skips The GST Tax on direct skips is imposed only on the amount received and the transferor is liable for the tax. IRC 2623, 2603(a)(3). Therefore, the GST Tax on direct skips is imposed on a tax-exclusive tax base. However, if the transferor does pay the GST Tax on the direct skip, the tax paid is considered to be an additional taxable gift by the transferor. IRC 2515. For example, assuming a GST rate of 45%, if T makes a $1,000,000 gift to GC and allocates no GST Exemption to it, a $450,000 GST Tax is due. In addition, a gift tax will be imposed on the transfer of $1,470,000 by T. Assuming a 45% gift tax, the gift tax due would be $652,500, resulting in total transfer taxes of $1,102,500.

27 Note that if T had wished instead to provide a net $1,000,000 to GC via a taxable termination trust, T would have to fund the trust with $1,818,182. The $1,818,182 would have been subject to an initial gift tax of $818,182, and at C's death the $1,818,182 in the trust would be subject to a taxable termination tax, resulting in a net to GC of $1,000,000. Thus, to make this transfer of $1,000,000, it would take $2,454,545. VIII. GST TAX ON TRANSFERS BY NON-RESIDENT ALIENS (NRAs) Under the proposed regulations, it was possible for a transfer of non-u.s. situs property by an NRA (which would not be subject to gift or estate tax) nonetheless to be subject to GST Tax. The final regulations indicate that transfers by NRAs will be subject to GST Tax only if they are subject to U.S. estate or gift tax. Treas. Regs. 26.2663-2(b). IX. THE EFFECTIVE DATE RULES In general 1. All transfers after 10/22/86. The GST Tax applies to all generationskipping transfers made after the date of enactment, October 22, 1986, subject to the exceptions noted at VII.A.3 below. 2. Lifetime Transfers after 9/25/85. In addition, the GST Tax applies to lifetime transfers occurring after September 25, 1985. 3. Exceptions. The GST Tax does not apply to: (a) Transfers from trusts which were irrevocable on 9/25/85, to the extent not made out of principal added after that date or out of income on principal added after that date. (b) Transfers under wills and revocable trusts in existence on 10/22/86 if the decedent died before 1/1/87. (c) Transfers from a person under a mental disability to change the disposition of his property on 10/22/86, if he did not regain competence before death. (d) "Gallo exclusion" transfers to a grandchild of the transferor made before 1/1/90, up to $2,000,000 per grandchild. X. DYNASTY TRUSTS A. Dynasty Trusts in general. A Dynasty Trust is a trust designed to be effectively perpetual, thus benefiting many generations. Such a trust is designed to obtain the greatest benefit from the donor s applicable exemption amount and lifetime exemption from the Generation-Skipping Transfer Tax.

28 B. Trust situs. In most of the 50 states, trusts are subject to the Rule Against Perpetuities. The Rule Against Perpetuities provides that a trust must terminate twenty-one years after the death of the last person who was alive at the creation of the trust. When the Rule Against Perpetuities requires that a trust terminate, the trust property comes into the hands of the then living beneficiaries and becomes subject to transfer taxation in their estates and to their creditors. Several states, including Alaska, Arizona, Colorado, Delaware, Florida, Illinois, Idaho, Maryland, Maine, New Jersey, Ohio, Rhode Island, South Dakota, and Wisconsin, have effectively abolished their version of Rule Against Perpetuities. C. Division of the Dynasty Trust. The trust should eventually divide along family lines, and should continue to divide as each family line gets larger. This will allow for the appointment of trustees who are more familiar with the needs of each family line. This should also reduce the risk of family conflicts. Most Dynasty Trusts provide that the initial trust will divide at the deaths of the first generation, and the trustee may also direct the trustee to divide the trust at any earlier time. At that time, a new subtrust will be created. Each subtrust typically has a Beneficiary who is the head of the family line for whom the new trust is created. Each trust is for the benefit of one Beneficiary and his or her descendants. Each trust divides into new trusts when the Beneficiary dies. As the client s descendants get older, they will likely gain increasing responsibility over the administration of the trust established for their own family line. The client may wish to provide that each Beneficiary will become co-trustee of his or her trust upon reaching certain ages. However, as discussed below in the Flexibility section, the clients can change these provisions (including the ages at which the Beneficiary would acquire these rights) at any time. D. Distributions. In general, there are two possible standards for the distribution of trust property in a Dynasty Trust: (1) the trustee may make distributions for the beneficiary s health, education, support, and maintenance, and (2) the trustee may make distributions in his discretion. A trustee who is also a beneficiary may only make distributions pursuant to the first, more limited, standard. This limitation on the scope of the trustee s discretion is necessary to keep the trust property out of the trustee s taxable estate (when the trustee is also a beneficiary), but the trustee s discretion is still broad enough to cover most, if not all, of the distributions that a client would want to make if he were able to control the distribution of trust property. An independent trustee may also make distributions under the second, broader standard.

29 Although the first, limited, standard permits a trustee who is also a beneficiary to make distributions, there are certain disadvantages to including this standard in a Dynasty Trust. For example, because this standard is a more objective one, it can invite litigation in which beneficiaries sue the trustee to force a distribution they believe is required for their health, support, or education. In addition, creditors of the beneficiaries may be able to force the trustees to make distributions for the creditor s benefit, on the theory that it is part of the support of the beneficiary. Thus, there are advantages and disadvantages of this distribution standard further. However, if the client wishes his descendants to be able to act as sole trustees, it will probably be necessary to include this more limited standard. E. Incentives. The client may also include incentive provisions that instruct the trustee to be conservative in distributions and encourage the beneficiaries to remain self-supporting. The client may wish to simply make a statement of his intent to that effect, or may include a variety of more rigid incentive provisions (e.g., a provision in the trust requiring the trustee to match the earnings of the beneficiary by making an annual distribution to the beneficiary equal to his earned income). F. Flexibility. Flexibility in a Dynasty Trust is absolutely necessary, because the trust is essentially perpetual. 1. Succession Plans The first generation could be given the power in the Dynasty Trust to create plans of succession for the trustees of the trust. With some necessary restrictions (for tax reasons), this power would allow them to remove and replace trustees. These plans can be very detailed, and can essentially amend the trustee succession provisions currently in the trust. For example, they could change the ages at which a beneficiary becomes a trustee. Subject to the clients consent, beneficiaries might have the power to create their own plans of succession for the trustee. 2. Trust Protector A Dynasty Trust may provide that the trust may be amended by a special fiduciary known as a Trust Protector. This fiduciary can be given very broad (or very narrow) powers to change the terms of the trust. Using these powers, the Trust Protector can amend the trust to take into account any future changes in the tax laws, for example. In addition to certain amendment powers, the trust document might give the Trust Protector the ability to change the trust situs (for example, to move it to another jurisdiction if advisable). 3. Powers of Appointment

30 A Dynasty Trust can provide additional flexibility by virtue of testamentary powers of appointment granted to the grantor s spouse (if she is a beneficiary) and the clients descendants. The spouse s power often permits her to appoint any portion of the trust to a charity or to one or more of the grantor s descendants, either directly or in a trust for the descendants benefit. The testamentary powers held by the client s descendants ordinarily apply only to the property held in their own subtrusts. Thus, if a beneficiary concludes that the trust is no longer serving his or her family s interests, he or she can exercise that power of appointment by will to make the Beneficiary s share of the trust pass to the Beneficiary s chosen appointees (either directly or to separate trusts for their benefit, with terms chosen by the beneficiary). 4. Adding Beneficiaries The Trust Protector is often given the power to add charities as beneficiaries of the trust. This power adds a great deal of flexibility, but also vests a great deal of power in the Trust Protector. XI. HEALTH AND EDUCATION TRUST A. General description. A Health and Education Trust (or HEET ) is a perpetual trust with many of the same characteristics as a Dynasty Trust. However, it is a Dynasty Trust that is not exempt from generation-skipping tax. B. Non-exempt Dynasty Trust. Because the trust is not exempt from GST tax, it is potentially subject to a confiscatory 45% GST Tax. This tax would normally be incurred in only in two situations: 1. Taxable termination. As discussed above, a taxable termination would normally occur at the death of the last member of the second generation. 2. Taxable distribution. A taxable distribution could occur if the HEET made a distribution to any skip person.

31 C. Avoiding Taxable Terminations The tax is imposed only when all non-skip beneficiaries are gone. To avoid this, the HEET includes a perpetual non-skip beneficiary: a charity is an income and principal beneficiary (usually receives at least one-half of annual income). D. Avoiding Taxable Distributions Direct distributions from the HEET for health and education are exempt from tax (i.e., distributions that would qualify for the med-ed exclusion if they were made directly by a donor). Other distributions are permissible, but will be taxed if not to nonskip person. Rather than make a distribution, the HEET could also make the capital of trust available in the form of loans and direct equity investments (the Family Bank or Family VC Fund ). XII. The Impact of the Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010 (referred to in this outline as TRA 2010) on Generation Skipping Planning and Compliance A. Brief Summary of TRA 2010 s Transfer Tax Provisions out rule. 1. For 2010 decedents, the Act creates a default rule and an opt a. Under the default rule: i. The estate tax rate is 35 percent. ii. The estate tax exemption is $5 million. iii. The estate s assets received a stepped up basis equal to their fair market value as of the date of death (or the alternate valuation date) under the rules of IRC sec. 1014. TRA 201, sec. 301(a). iv. Section 2664 of the Code, which repealed the GST tax, is itself repealed; instead, the GST tax applies but at a zero percent rate and with a $5 million GST exemption. b. Under the opt out rule, the decedent s executor can elect out of the default rule, with the following results: i. The estate tax does not apply to the estate.

32 ii. The estate is subject to the modified carryover basis rules of Code sec. 1022. Those rules are as follows: (A) With respect to property acquired or passing from the decedent, such property is subject to carryover basis rather than a stepped up basis at death. (B) The executor may elect to add up to $1.3 million of additional basis to such assets. (C) With respect to such property passing to a surviving spouse or to a trust which would qualify as QTIP property for the surviving spouse, the executor may elect to add up to another $3 million of additional basis. (D) The executor is required to file Form 8939 (the carryover basis report ) detailing the allocation of additional basis to the estate assets by the due date of the decedent s final income tax return. IRC sec. 6075(a). iii. The GST tax continues to apply to the estate, but with a zero percent rate and a $5 million GST exemption. In addition, section 301(c) of TRA 2010 provides, in substance, that, notwithstanding the opt out election, the decedent will continue to be treated as the GST transferor of the estate assets for purposes of 2652(a)(1) of the Code. This appears to have the following impact on 2010 decedents: (A) It no longer appears possible to fund testamentary dynasty trust with unlimited amounts of assets without the imposition of a current or future GST tax. Under EGTRRA 2001 prior to the enactment of TRA 2010, the estate of a decedent dying in 2010 was not subject to the estate tax. Therefore, at least arguably, when a 2010 decedent transferred assets to a dynasty trust, the trust had no transferor for GST tax purposes and distributions from the trust could never be subject to GST tax, as described in the footnote below. 13 13 The transferor is the person who transfers property and with respect to whom such property was most recently subject to tax under Chapter 11 (estate tax) or Chapter 12 (gift tax). IRC sec. 2652(a)(1). If the estate tax did not apply to the decedent s estate, the property transferred by him at death was not subject to an estate tax under chapter 11 and, therefore, the decedent fails to meet the definition of the term transferor under code section 2652(a)(1). If a trust has no transferor then it is impossible for the trust to have beneficiaries who are skip persons because a skip person is a person assigned to the second or more remote generation below the transferor. And, finally, if a trust has no skip persons as beneficiaries, distributions from the trust can never be taxable distributions, taxable terminations or direct skips for GST tax purposes.

33 (B) Construction of GST formula bequests under wills of 2010 decedents will continue to be problematic. If the language of the bequest gives an amount equal to my unused GST exemption, the bequest would appear to be $5 million (for a decedent who has used no GST exemption during life). On the other hand if the language of the bequest gives that amount which will produce no GST tax, the bequest arguably could be of the entire estate. iv. The Act does not specify a due date for making the opt out election. It simply says that the election is to be made at such time and in such manner as the IRS shall prescribe. TRA sec. 301(c). One might assume that the due date would be the same as the due date for the estate tax return under the default rule (see c below). c. For decedents dying before December 17, 2010, TRA 2010, sec. 301(d) extends various due dates as follows: (i) The Act extends the due date for the estate tax return and for the payment of the estate tax until September 19, 2011. The Act did not extend the time for filing the carryover basis report. Accordingly, that report continues to be due on the due date for the decedent s final income tax return. (ii) The Act extends the time for making disclaimers until September 19, 2011. (iii) The Act extends the due date for filing a return reporting a generation skipping transfer made in 2010 under Code sec. 2662 until September 19, 2011. This would include a return to make a timely allocation of GST exemption (or to opt out of the automatic allocation of GST exemption) to a direct skip or taxable termination, but apparently would not include a return to allocate (or opt out of automatic allocation) to an indirect skip since an indirect skip is not a generation skipping transfer. 2. Also for 2010: a. The gift tax exemption is $1,000,000. b. The GST exemption is $5,000,000. 3. For 2011 and 2012: a. The estate, gift and GST tax rate is 35 percent.

34 b. The estate, gift and GST tax exemption is $5 million. 1014. c. Estates are subject to the step up in basis rules of Code sec. d. There is portability of estate and gift tax exemptions between spouses. Note that the GST exemption is not subject to the portability rules. 4. For 2013 and future years (unless Congress changes the law): a. The estate and gift tax exemption reverts to $1,000,000. inflation. b. The GST exemption reverts to $1,000,000, indexed for c. The top transfer tax rate increases to 55 percent. GST tax sunset. d. The helpful provisions of EGTRRA 2001 relating to the B. Generation Skipping Planning and Compliance After TRA 2010 1. Zero Percent Rate. Section 2664, which had provided that the generation skipping tax would not apply to generation skipping transfers made in 2010, is eliminated. Instead, section 302(c) of TRA 2010 now provides that, for 2010 only, the GST tax rate is zero percent. a. What is the difference between section 2664 stating that the GST tax will not apply to generation skipping transfers in 2010 and TRA sec. 302(c) stating that the GST tax will apply, but at a zero percent rate? The key difference is that section 302(c) makes clear that the transferor move-down rule shall apply to generation skipping transfers made in 2010. This eliminates an issue that had been presented by former section 2664, as shown in the following example: b. Suppose T died in 2010. His will made a bequest of assets to a trust for the benefit of T s grandchildren and more remote descendants. Compare the tax results of T s transfer to the trust: (i) under old section 2664 of the Code, and (ii) under TRA 2010. i. Under Old Section 2664 (prior to TRA 2010). Under old section 2664 of the Code, there would have been no GST tax on T s transfer to the trust because the GST tax did not apply to generation skipping transfers in 2010. Less clear,

35 however, was the GST impact of a distribution to the grandchild in a year after 2010. A taxable distribution is a distribution from a trust to a skip person. IRC 2612(b). Therefore, if the grandchild is a skip person, the distribution is taxable. A skip person is a person assigned to the second or more remote generation below the transferor. IRC 2613(a). The transferor is the decedent in the case of any property subject to the tax imposed by chapter 11 and the donor in the case of any property subject to the tax imposed by chapter 12. The property transferred to the trust was clearly subject to the tax imposed by chapter 12 (the gift tax), so the donor is the transferor. Therefore, generally speaking the distribution from the trust to the grandchild would be a taxable distribution. However, an exception applies to relieve the distribution from tax if the transferor move down rule of IRC 2653(a) applies. Under that section, if (a) there is a generation skipping transfer of any property and (b) immediately after such transfer such property is held in trust then for purposes of applying chapter 13 to subsequent transfers from the trust, the trust will be treated as if the transferor of such property were assigned to the 1st generation above the highest generation of any person who ha an interest in such trust immediately after the transfer. Applying these principles to the example under pre-tra 2010 law yielded the following results: A. The original gift of property to the trust would appear to be a generation skipping transfer in that it appears to meet the definition of a direct skip. A direct skip is a transfer of property subject to estate or gift tax to a skip person. The transfer is subject to gift tax and the trust would be a skip person because all of its beneficiaries are skip persons. B. Immediately after the transfer, the property continues to be held in trust. C. Therefore the requirements of the transferor move down rule appear to be met and any transfers from the trust to grandchildren should not be treated as taxable distributions. (Note, however, that transfers from the trust to great grandchildren or more remote descendants would be taxable distributions.) D. However, under pre-tra 2010 law, it was possible that the transferor move down rule simply did not exist during 2010, by reason of section 2664 of the Code. Recall that, under section 2664 of the Code, this chapter

36 [chapter 13 of the Code] shall not apply to generationskipping transfers after December 31, 2009. If chapter 13 in its entirety simply did not apply in 2010, then perhaps the transferor move-down rule did not apply either. ii. Under TRA 2010. Under TRA 2010, it is clear that the generation skipping transfer tax applies to transfers made in 2010. It is simply applied with a zero percent rate. As such, the transferor move down rule is clearly available and, therefore, a distribution to a grandchild from a direct skip trust funded in 2010 will not attract a GST tax. Note, however, that a distribution to a great-grandchild or more remote descendant would attract a tax because such individuals would continue to be skip persons even after application of the transferor move down rule. This presents a planning opportunity for estates of 2010 decedents. For example, if the estate passes to a child who does not need the entire inheritance, the child could consider disclaiming the assets to grandchildren or to trusts for their benefit. TRA 2010 provides an extended period for making such disclaimers, at least for purposes of federal disclaimer law. 2. Temporary $5 Million Exemption. For 2010, 2011 and 2012, the GST exemption is $5 million. a. For 2010 outright direct skip gifts and taxable terminations, generally it will make sense to opt out of automatic allocation of GST exemption. Exemption allocated to such transfers in 2010 could be a waste of exemption. b. For 2010 direct skip transfers in further trust, it may make sense to opt out of automatic allocation of GST exemption. For example, suppose T made a direct skip transfer to a trust for the benefit of his grandchildren and more remote descendants in 2010. If an opt out election is made, the transferor move-down rule will protect future distributions from the trust to the grandchildren from GST tax in the future. Distributions from the trust to great grandchildren and more remote descendants, however, would not be protected. Accordingly, the transferor (or his executor) will need to consider the purpose of the trust, and the likelihood of distributions to skip person beneficiaries in determining whether or not to opt out of automatic allocation of exemption. c. It is now possible to allocate GST exemption to 2010 transfers to indirect skip trusts. This was not possible prior to TRA 2010. d. Given that the $5 million GST exemption may be available only for 2010, 2011 and 2012, planners should consider advising clients to allocate exemption to existing trusts now. For example, a client may have created a QPRT or GRAT in the past which has transferred assets to a long-term trust. Consider making a late allocation of GST exemption to such trust during 2011 or 2012 to lock in the exemption amount before it plummets in 2013.

37 3. No Portability. While the estate and gift tax exemptions are portable between spouses, the GST exemption is not. Accordingly, married clients who wish to make full use of their combined GST exemptions should ensure that (a) their estate planning documents segregate the GST exempt amount of each spouse into an appropriate trust and (b) each spouse has assets in his or her name at least equal to the $5 million GST exemption. 4. Temporary Extension of EGTRRA 2001 s Helpful GST Compliance Provisions. The many helpful provisions of EGTRRA 2001 relating to the GST tax, including the automatic allocation rules for indirect skip transfers, the qualified severance rules and the availability of 9100-style relief for failure to make a timely allocation of GST exemption are extended through December 31, 2012. Given that these rules are available only through December 31, 2012, planners should review client files before December 31, 2012 with the following in mind: ratios. a. Consider filing qualified severances for trusts with mixed inclusion b. Consider making a 9100-style application for missed allocations of GST exemption. c. Consider retroactive allocations of GST exemption in appropriate circumstances. d. Warn clients of the possible demise of the automatic allocation rules as of January 1, 2013 and the need to file gift tax returns making an affirmative allocation of exemption for 2013 and future years. 11029\12\2588756.1

VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # (000-000-0000) Fax # (000-000-0000) E-Mail Address I will be attending: Generation Skipping Transfer Tax (GSTT) Planning TELESEMINAR December 22, 2011 Early Registration Discount By 12/15/11 Registrations Received After 12/15/11 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER December 15, 2011 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Credit Card (American Express, Discover, MasterCard or VISA) Amount: Credit Card # Cardholder Exp. Date