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PostedHow nonresidents avoid generation-skipping transfer tax
Phil Hodgen
Attorney, Principal
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A reader of my November, 2008 article in California CPA Magazine (hi, David) called me and asked a question about the article. He wanted to clarify a generation-skipping transfer tax question.I didn't have the space in the article to cover all of the nooks and crannies on the subject of estate taxation for cross-border families. And if there's anything that has nooks and crannies, it's the Internal Revenue Code. And one of the cranniest nooks is the generation-skipping transfer tax.The question, simply put, is how you can make a foreign trust that later becomes a U.S. trust into a generation-skipping transfer tax exempt trust if you don't allocate generation-skipping transfer tax exemption to it. [Ha! You call that a simple question? On what planet? ed.](Warning. Highly technical stuff follows. Causes brain damage.? You can read this charming little essay or you can skip this and go visit Internal Revenue Code Section 2663 and its progeny in the Treasury Regulations.)U.S. citizens funding dynasty trusts--estate or gift taxStart with normal U.S. estate tax planning for U.S. citizens. We'll work around to noncitizens and foreign trusts. Trust me.Let's say your goal is to set up a dynasty trust--a trust that will hold assets for multiple generations. You don't want an estate tax haircut as wealth passes from grandfather to child to grandchild to great-grandchild. As long as the assets stay inside the trust, that result is generally achievable.The problem is getting the assets into that trust in the first place. Once the assets are inside the trust, we're home free--that piece of real estate can stay in the family for generations without any estate tax.There are only two ways for a U.S. citizen to get assets into such a trust:
- by dying (which means that first you pay the estate tax and whatever is left over goes into that trust), or
- by making a lifetime gift (which means you have to pay gift tax).
The term “direct skip” means a transfer subject to a tax imposed by chapter 11 or 12 of an interest in property to a skip person. Section 2612(c)(1).The generation-skipping transfer tax will apply when money goes to a "skip person." This is:
a natural person assigned to a generation which is 2 or more generations below the generation assignment of the transferor. Section 2613(a)(1).Grandchild is a "natural person."? Grandchild is 2 or more generations younger than the grandfather.? But the grandfather is not a "transferor."? And if the grandfather isn't a "transferor" then the whole definition falls apart because there is no starting point to define the number of generations.? So Grandchild can't be a "skip person."Therefore, because grandfather is not a "transferor", the grandchild can't be a "skip person".Since the gift is made to someone who is not a "skip person", the transfer can't be a generation-skipping transfer. And the generation-skipping transfer tax can't apply.An even easier answerLet's look at the definition of a "direct skip" again. It's a transfer that is subject to a tax imposed by chapter 11 (estate tax) or chapter 12 (gift tax) AND that transfer is made to a skip person.When a nonresident makes a gift of cash from a foreign country to a U.S. citizen, that transfer is not subject to gift tax.So even if the grandchild was a "skip person" the transfer would not be a "direct skip." Which means that the transfer would not be subject to the generation-skipping transfer tax, because the transfer wasn't subject to the gift tax.Now let's add trusts into the mixSo far I've been talking about the grandfather making a direct gift of cash to the grandchild.What if the grandfather instead set up an irrevocable trust for the benefit of the grandchild? The same result would exist:? no generation-skipping transfer tax.Because the post is so long already I won't go into the "kneebone connected to the thigh bone, the thigh bone connected to the hip bone" explanation.In brief, though, the distribution from the trust would either be a "taxable distribution" or a "taxable termination".? But since these definitions require that the recipient be a "skip person", we're safe--the grandfather isn't a transferor, so the grandchild isn't a "skip person."Internal Revenue Code Section 2663OK.? So you want the easy way out.? You don't want my explanation, eh?Go to Section 2663.? That's where the application of the generation-skipping transfer tax to nonresidents is dealt with.And go straight to Treasury Regulations 26.2663-2(b) which says that the generation-skipping transfer tax only applies if the original transfer (a straight gift or a transfer to a trust) was originally subject to U.S. estate or gift tax.Moral of the storyA nonresident noncitizen may fund an irrevocable trust with non-U.S. assets without fear of the generation-skipping transfer tax.