Congress Should Impose a Two-Generation Limit on the GST Exemption: Here's Why
Lawrence W. Waggoner
University of Michigan Law School
July 15, 2010
U of Michigan Public Law Working Paper No. 205
In 1986, Congress enacted the federal Generation-Skipping Transfer Tax (GST Tax). The purpose of the tax was to supplement the federal estate and gift taxes. When private wealth shifts from generation to generation or bypasses a generation without incurring federal estate or gift taxes, the GST Tax steps in and fills the void.
When Congress adopted the GST Tax, it added a provision known as the GST Exemption. The GST Exemption allows trust settlors to create trusts of a certain value without incurring a GST Tax. The maximum amount originally exempted was $1 million ($2 million for a married couple), but over time, Congress increased the maximum amount to $3.5 million ($7 million for a married couple).
When Congress originally fashioned the GST Exemption, the duration of private trusts was controlled by state law — the Rule Against Perpetuities. The Rule Against Perpetuities was then undergoing reform in the states, but the reforms retained the basic durational limit of a life in being plus 21 years or a close equivalent that has been part of Anglo-American law for centuries. Presumably relying on state law, Congress failed to place its own durational limit on trusts that qualify for the GST Exemption.
The state-law perpetuity landscape has now changed. Interstate competition for trust business has taken hold. In order to attract trust business for local banks and other institutional trustees, legislatures in several states have repealed or modified their state perpetuity rule to allow trust settlors to create GST-Exempt trusts that can last forever or for several centuries. An empirical study has established that the wealthy are creating GST-Exempt perpetual or near-perpetual trusts in large numbers in these trust-friendly states. Considerable private wealth is pouring into such trusts from out-of-state settlors, thereby escaping federal transfer taxation for centuries and in some cases forever.
In this essay, the author makes the case for Congress to impose a two-generation limit on the GST Exemption. Without such a limit, private wealth will continue to pour into GST-exempt trusts that can last forever or for several centuries. The loss of tax revenue will become more and more significant as time goes along, undermining the integrity of the generation-skipping transfer tax and the federal transfer tax system as a whole.
The matter is timely because the GST Tax is in abeyance this year, but returns in 2011. Two questions that Congress seems poised to resolve later this year are what the rate and maximum exemption will be when the tax returns and whether the tax will be reinstated for this year. As part of its 2010 tax bill, Congress should also close the loophole in the GST Exemption by providing that a trust loses its exemption once the trust continues beyond the death of the youngest beneficiary who is no more than two generations younger than the trust settlor. A two-generation limit would be consistent with the policy of the GST Tax, which focuses on taxing private wealth as it shifts from generation to generation or bypasses a generation without incurring federal estate or gift taxes. Coincidentally, a two-generation limit would also be consistent with the perpetuity rule recently adopted by the American Law Institute, which requires a trust to terminate no later than the death of the youngest beneficiary who is no more than two generations younger than the trust settler.
Number of Pages in PDF File: 7
Keywords: Generation-skipping transfer (GST) tax, exemption, trusts
JEL Classification: K10
Date posted: July 17, 2010 ; Last revised: July 21, 2010