I.R.C. Section 2642(c)(2) Trusts

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.


As the Bush tax cuts are set to expire next year, many high-net-worth individuals are gifting their $5.12 million gift tax exemptions ($10.24 million for married couples) before year end. And to protect their children (and more remote descendants) from creditors, ex-spouses and estate taxes, most grantors are making their gifts to generation-skipping trusts.

Assuming the grantor has no generation-skipping tax (GST) exemption available after making such gifts, what opportunities are available for making gifts to grandchildren or great-grandchildren? I.R.C. Section 2642 provides for an annual exclusion from the GST for non-taxable gifts (within the $13,000/$26,000 annual gift tax exclusion) made to grandchildren or more remote descendants. Such gifts are not treated as generation-skipping transfers and do not reduce the grantor’s $5.12 million GST exemption.

But what about the grantor that wishes to make gifts to grandchildren (or lower generations) in trust to protect the beneficiaries from their inability, their disability, their creditors and their predators, including ex-spouses? Fortunately, special rules exist for gifts in trusts for the benefit of grandchildren and more remote descendants. I.R.C. Section 2642(c)(2) provides that for the $13,000/$26,000 GST exemption to apply, the trust must meet these requirements:

1. The trust must be for the benefit of a single beneficiary;

2. During the life of such beneficiary, no portion of the principal and income of the trust may be distributed to or for the benefit of any person other than such beneficiary; and

3. If the trust does not terminate before the beneficiary dies, the assets of the trust must be includible in the gross estate of the beneficiary.

It is possible to have the trust continue for the lifetime benefit of the grandchild, provided the trust’s assets are includible in the grandchild’s estate. This can be accomplished by giving the grandchild a testamentary general power of appointment in the trust agreement. In addition, by making the trust a “grantor” trust for income tax purposes, the grantor will be responsible for paying the trust’s income taxes, thereby allowing the trust to compound income tax free. In essence, the grantor’s payment of the trust’s income taxes is essentially a tax-free gift to the beneficiary of the trust.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.