Generation-skipping transfer tax: its bite is worse than its bark!

• Author: Pratt, David A.

It is no secret that Chapter 13 of the Internal Revenue Code of 1986, as amended,[1] other wise known as the generation-skipping transfer (GST) tax, contains one of the most complex set of rules in the Internal Revenue Code. Indeed, a few years ago the American Institute of Certified Public Accountants prepared a proposal to substantially modify the GST tax law in order to eliminate tax traps that may cause massive liabilities for taxpayers and their advisors.[2] Perhaps the best quotation regarding the GST tax is the following: "[T]he GST tax is a deceptive and deadly tax with which to reckon. It strikes without warning. Furthermore, its calculations are so inhumanely convoluted that the GST tax can send estates into a black hole of confusion from which no lawyer can extract them--or so it seems."[3]

Simply stated, the GST tax rate is the maximum federal estate tax rate,[4] which currently is 55 percent.[5] The tax is imposed on transfers of property made from one generation to another generation which is two or more generations below the transferor's generation (e.g., a transfer of property from a grandparent to a grandchild).[6] Accordingly, the cost of making a mistake in this area of the Code can be significant.

This article discusses some of the GST tax provisions that may apply to those trusts commonly used as part of an estate plan that is designed to reduce estate and gift tax exposure. In most cases, these provisions are apparent, but in some, they are not. The authors hope that the article is used by practitioners as a checklist for each estate plan to ensure that the complex provisions regarding GST tax have been properly addressed.

When is GST Tax Exemption Allocated?

Every individual has a $1,030,000 GST tax exemption.[7] In general, the allocation of GST tax exemption can exempt all or a portion of a GST from GST tax. In order to exempt a GST from GST tax, the exemption must be properly allocated and there are specific rules regarding such an allocation.[8]

If a gift is made to a skip person,[9] any unused portion of the individual's GST tax exemption is automatically allocated to the transferred property.[10] With respect to gifts made to a nonskip person[11] during life, GST tax exemption is allocated on Schedule C (the GST tax schedule) of a federal gift tax return (Form 709).[12] If GST tax exemption is allocated on a timely filed federal gift tax return, the value of the property transferred is used to determine the amount of exemption that is allocated.[13] A gift tax return is timely filed if it is filed by the due date of the return, including extensions actually granted.[14] If GST tax exemption is allocated on a late federal gift tax return, the value of the property as of the date the return is filed is used to determine the amount of exemption is allocated.[15] There is also a convenience rule which allows a taxpayer to elect to use the value of the trust's property as of the first day of the month the late return is filed instead of the value as of the date the return is actually filed.[16]

An example should illustrate how important it is to allocate GST tax exemption on a timely filed gift tax return. Assume that taxpayer gifts internet stock to a perpetual irrevocable gifting trust, of which the beneficiaries are the taxpayer's descendants, and that the trust will continue for the longest period allowed under law, subject to the rule against perpetuities. On July 1, 1997, the stock has a value of $500,000, and on July 1, 1999, the stock has a value of $2,000,000. If taxpayer allocates $500,000 of his GST tax exemption on a timely filed federal gift tax return, all distributions from the trust to skip persons, at any generation, will be exempt from GST tax.

On the other hand, if taxpayer fails to allocate GST exemption on a timely filed gift tax return, the value of the trust's property on the date the late return is filed must be used to allocate the exemption. In this example, if a return is filed on July 1, 1999, the taxpayer will not have a sufficient amount of GST tax exemption to allocate and all future distributions from the trust to skip persons will be subject to GST tax. Because only $1,010,000[17] of exemption will be available to allocate, approximately 50 percent of each distribution will be subject to GST tax.

How is GST Tax Exemption Allocated?

In addition to allocating GST tax exemption on a timely filed basis, the exemption should be allocated properly. In general, the allocation must clearly identify the trust to which the allocation is being made, the amount of the GST tax exemption allocated to it, and if the allocation is late or if an inclusion ratio[18] greater than zero is claimed, the value of the trust's assets at the effective date of the allocation.[19]

Schedule C of Form 709, the federal gift tax return, is not very clear with respect to the form of the notice of allocation. In fact, the schedule itself does not include a form for the notice. While line 5 of Part 2 of Schedule C states, in bold, that a notice of allocation must be attached, and also refers to the instructions regarding such a notice, many taxpayers have failed to include the required notice and, instead, attempted to allocate exemption to a trust on another place on Schedule C of the gift tax return.[20]

The IRS has been very lenient in some private letter rulings regarding an improper allocation of GST tax exemption, provided that the taxpayer has substantially complied with requirements of the regulations regarding the allocation.[21] In each of these rulings, the taxpayer relied on Hewlett Packard Company, 67 T.C. 736 (1977), acq. in result, 1979-1 C.B. 1. which held that elections may be held to be effective where the taxpayer complies with the essential requirements of a regulation even though the taxpayer failed to comply with certain procedural directions therein.

Practitioners should review a client s prior gift tax returns to determine whether prior allocations of GST tax exemption were done properly. In cases where it is unclear, the practitioner should consider advising the client to request a private letter ruling before any additional...