GST trap for the unwary.

• Author: Bakale, Anthony
• Position: Generation-skipping transfer tax

Practitioners must exercise extreme care when preparing gift tax returns for clients making gifts in trust.

Example: Husband H and wife W make a gift to a newly created trust. The trust indenture provides that the trustee may make discretionary distributions of income and principal to the donors' child and grandchild, the only two trust beneficiaries. Each trust beneficiary is given a right of withdrawal or Crummey power, so that the gift in trust is eligible for the annual gift tax exclusion. The gifted amount totals $100,000 (before gift-splitting) and H and W wish to split gifts.

As a practitioner preparing Form 709, U.S. Gift and Generation-Skipping Transfer Tax Return, for H and W, it is critical to properly report the gift for both gift tax and generation-skipping transfer (GST) tax purposes.

Reporting the transaction for gift tax purposes is fairly straightforward and understood by most practitioners. The $100,000 gift is reported on Part 1 of Form 709, Schedule A. The gift-splitting election is made in Part 3 of Schedule A, resulting in each spouse's total gift amount being reported at $50,000. The total gift amount is then reduced by annual exclusions of $20,000 ($10,000 for each donee), resulting in taxable gifts of $30,000 for each spouse. The resultant gift tax is then offset by the unified credit (assuming it has not been previously used) and no gift taxes are due with the returns.

Many practitioners, however, overlook reporting this transaction for GST tax purposes. Specifically, because the gift in trust was made for the benefit of both skip (grandchild) and nonskip (child) persons, the practitioner and his clients must make an express allocation of GST tax exemption to exempt the transfer from future GST tax. An automatic allocation of the donors' GST tax exemption to the gifts does not occur, because nonskip persons have an interest in the trust (Sec. 2613(a)(2)). The consequences of not making an affirmative allocation of GST tax exemption can be disastrous.

For instance, if an allocation of GST tax exemption is not made when the gift tax return is originally filed and the fair market value of the trust assets grows from the initial $100,000 to $5 million, at which time the child dies, a taxable termination has occurred for GST tax purposes, because only the grandchild remains as a trust beneficiary (Sec. 2612(a)(1)(A)). The entire $5 million of trust property is subject to GST tax at 55%, totaling $2,750,000.

The entire...