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Probate & Property

Nov/Dec 2023

A Guide to Reconstructing GST Exemption Allocations and Calculating the Inclusion Ratio of a Trust

Carol G Warley, Abbie Everist, Amber M Waldman, and Tandilyn Cain

Summary

  • A trust’s inclusion ratio can change over time, as it is affected by the allocation of the transferor’s generation-skipping tax (GST) exemption.
  • As with most areas of the tax law, modern GSTT has changed since its enactment.
  • Automatic allocation of a transferor’s GST exemption occurs regardless of whether the transfer is reported on a gift tax return.
A Guide to Reconstructing GST Exemption Allocations and Calculating the Inclusion Ratio of a Trust
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Understanding the inclusion ratio of a trust is crucial for effective estate planning. The inclusion ratio determines the portion of a trust’s assets that will be subject to generation-skipping transfer tax (GSTT) upon a triggering event. Generally, a trust is subject to GSTT when there is a taxable termination under section 2612(a) or a taxable distribution under section 2612(b). A taxable termination occurs when there is a termination of a non–skip person’s interest in the trust resulting in only skip persons remaining as beneficiaries. This may occur at death or due to lapse of time, exercise or release of power, disclaimer, or termination of a trust. A taxable distribution occurs when there is a distribution of property to a skip person or termination of a trust.

A trust’s inclusion ratio can change over time, as it is affected by the allocation of the transferor’s generation-skipping tax (GST) exemption, the timing of transfers to the trust, and the timing of certain triggering events such as the death of a beneficiary. To fully understand the inclusion ratio of a trust, you must ask several questions and recreate the history of transfers made to the trust.

  1. When was the trust created?
  2. When were transfers made to the trust?
  3. Is it a GST Trust?
  4. Did transfers to the trust qualify for the GSTT annual exclusion?
  5. Was any GST exemption allocated to the trust?
  6. Were there any general powers of appointment?
  7. Has there been a qualified severance?
  8. When does the statute of limitations close on the inclusion ratio?

Introduction to Case Study

A new client engages you to review their existing estate plan. You start by reviewing the GST status of her 1984 life insurance trust. The history of this trust is as follows:

  • The trust was created on September 1, 1984, for the benefit of the grantor’s descendants.
  • The trust is a GST Trust under section 2632(c)(3)(B).
  • The trust was funded with $1,000,000 on October 1, 1984. The transferors made a gift-splitting election on their 1984 gift tax returns. There were no withdrawal rights granted to any trust beneficiaries.
  • The transferors made additional gifts to the trust on October 1, 1999, of $1,000,000 and on October 1, 2002, of $100,000. Gift-splitting elections were made on the 1999 and 2002 gift tax returns. There were no withdrawal rights granted to any trust beneficiaries.

When was the trust created?

The current form of GSTT was enacted in 1986 and generally applies to direct skip transfers and indirect skip transfers made to irrevocable trusts after September 25, 1985. Transfers made to a trust on or before this date are exempt from GSTT and are deemed to have an inclusion ratio of zero. The regulations under section 2601 provide guidance for determining if a trust qualifies, and if so, it will typically be referred to as a “Grandfathered” trust for GSTT purposes. The regulations further provide that if additions or deemed contributions are made after this date, then a pro rata portion of the trust’s assets will be subject to GSTT, unless an allocation of GST exemption is made. Appreciation or accumulated income from the Grandfathered portion of a trust will not be considered an addition that affects the trust’s inclusion ratio. Although it may be simple to determine if additions were made to the trust, deemed contributions may not be as straightforward. The release, exercise, or creation of certain powers of appointment can be treated as a deemed contribution that compromises the trust’s Grandfathered GSTT exempt status. Additionally, if certain modifications are made to a Grandfathered trust, the trust can lose its exempt status. There are modification safe harbors provided in the regulations under section 2601. Planners should be mindful of these rules when working with Grandfathered trusts to avoid causing unintended exposure to the GSTT.

Case Study

Because this trust was irrevocable as defined in Treas. Reg. § 26.2601-1 on September 25, 1985, the portion of the trust funded on October 1, 1984, is exempt from the GSTT. The portion of the trust funded in later years will need to be looked at separately, and additional questions will need to be answered before the inclusion ratio can be determined as it relates to those transfers.

When were transfers made to the trust?

As with most areas of the tax law, modern GSTT has changed since its enactment, which makes understanding when transfers were made to a trust important for determining a trust’s inclusion ratio. In addition to the September 25, 1985, date, there are other key dates that planners should be familiar with to understand how transfers made during certain years may be treated differently than under current law. For example, many planners are aware that under current law, there are different requirements for applying the gift tax and GSTT annual exclusions. Until 1988 the requirements for both annual exclusions mirrored each other. Only transfers made after March 31, 1988, are subject to the more narrow requirements discussed in depth below.

An amendment to the Tax Reform Act of 1986 also created an exception referred to as a “Gallo” trust, which is exempt from GSTT. A Gallo trust is for the benefit of a single grandchild and will have an inclusion ratio of zero if funded with up to $2,000,000 before January 1, 1990, as long as it has not been modified beyond what is permitted in the Grandfathered trust safe harbor regulations under section 2601. This exception is found only in the amendment to the 1986 Act and is not found in the Internal Revenue Code or Treasury regulations.

In 2001, section 2632(c)(1) was added, and certain indirect skip transfers made after December 31, 2000, will have an automatic allocation of GST exemption to the extent the transferor has remaining exemption available. A taxpayer can elect in or out of automatic allocation rules, so having a complete copy of the taxpayer’s gift tax returns is necessary to confirm whether any elections were made.

Case Study (con’t)

The dates of the transfers matter because of the different rules in place over the period this trust has been in existence.

  • October 1, 1984—Current GSTT was not in place. This trust meets the requirements to be considered irrevocable as of September 25, 1985, and the portion of the trust funded on or before this date will have an inclusion ratio of zero. It will be necessary to confirm no modifications have been made that would compromise its Grandfathered status.
  • October 1, 1999—Automatic allocation rules were not in place. You reviewed the gift tax return and determined that there was no manual allocation of the transferors’ GST exemptions to this transfer.
  • October 1, 2002—Automatic allocation rules were in place and the transferors’ GST exemptions would have been allocated unless an affirmative election was made to opt out of an automatic allocation by the taxpayer on a timely filed gift tax return. You reviewed the gift tax returns and determined no opt-out election was made.

Is it a GST Trust?

A “GST Trust” is defined broadly in section 2632(c)(3)(B) as a trust that could have a generation-skipping transfer. The statute then describes six exceptions to this definition, most of which relate to certain rights or powers held by non–skip persons. If relying on the application of an automatic allocation, these exceptions should be reviewed carefully because an automatic allocation of available GST exemption will occur only if an indirect skip is made to a GST Trust. These rules apply to transfers made after December 31, 2000.

The exceptions to the definition of a GST Trust can be difficult to navigate, and many planners prefer to make an affirmative election to have the automatic allocation rules apply to a trust or not apply. This election is provided under section 2632 and must be made on a timely filed gift tax return. An election can be made to treat a trust as a GST Trust even if its terms would not otherwise meet the definition. Similarly, a taxpayer may also make an election out of GST Trust treatment if the trust’s terms meet the definition and an automatic allocation is not desired.

Case Study (con’t)

Because this trust does not fall under any of the exceptions in section 2632(c)(3)(B) of the Code, it is a GST Trust and the transferors’ GST exemptions were automatically allocated to any transfers made to the trust after December 31, 2000. The clients’ gift tax returns should still be referenced to determine whether a GST election was made on a timely filed return.

Did transfers to the trust qualify for the GSTT annual exclusion?

The current GST annual exclusion rules apply to transfers made after March 31, 1988. For a short period of time before April 1, 1988, there were fewer restrictions on whether a transfer would qualify for the GSTT annual exclusion. Under current law, in order for a trust to qualify for the GSTT annual exclusion under section 2642(c), it must be a trust that is considered a direct skip trust. If a transfer qualifies for the GSTT annual exclusion, that portion of the transfer would be exempt from the GSTT. For a gift to a trust to qualify for the GSTT annual exclusion, it must meet the following requirements:

  1. The gift must be made to a trust, which is for the benefit of one skip person individual.
  2. If the skip person beneficiary were to pass away before the trust terminated, the assets of the trust would be included in that skip person’s estate.
  3. The gift must be a present interest gift.

Case Study (con’t)

This trust is for the benefit of multiple skip and non–skip persons. Also, there are no withdrawal rights, so transfers to this trust are not present interest gifts. Therefore, transfers to this trust would not qualify for the GSTT annual exclusion. An example of a transfer that would qualify is as follows:

  • In 2023, transferor made a gift of $17,000 to a trust for the benefit of their grandchild.
  • The trust agreement gives the grandchild a testamentary general power of appointment over the trust assets.
  • The trust agreement gives the grandchild the right to withdraw the 2023 contribution to the trust.

Was any GST exemption allocated to the trust?

Under current law, each taxpayer is given a lifetime GST exemption that can be allocated to transfers during life or at death. Allocation of the taxpayer’s GST exemption shields transfers from the GSTT. Only the transferor can allocate GST exemption to the transfer. Generally, when a gift-splitting election is made on a gift tax return, each spouse is treated as a transferor over one-half of all transfers on the gift tax return for GSTT purposes.

Generally, a transferor will not allocate his GST exemption to a trust that he expects will benefit only non–skip persons, saving it for other planning that is intended to benefit skip persons. There are many ways that a taxpayer can allocate his GST exemption to a trust.

Automatic Allocation

Automatic allocation of a transferor’s GST exemption occurs regardless of whether the transfer is reported on a gift tax return. A transferor’s GST exemption is first automatically allocated to any direct skips under section 2632(b). Then, the deemed automatic allocation of GST exemption to indirect skips under section 2632(c)(1) allows the transferor’s GST exemption to be allocated automatically to certain transfers made after December 31, 2000. For indirect skips, an automatic allocation occurs only if the trust is a GST Trust under section 2632(c)(3)(B).

The deemed automatic allocation rules are intended to serve as a safety net. For example, if a transfer to a trust that is a GST Trust and is intended to ultimately benefit skip person beneficiaries was not reported on a gift tax return, it would automatically be protected from the GSTT. However, the well-intended rules also could cause unintended consequences. For example, if a trust is by definition a GST Trust, but the trust will never benefit a skip person due to non–skip persons depleting the trust, the automatic allocation rules could cause a waste of the transferor’s available GST exemption.

Taxpayers are able to elect to affirmatively opt in or opt out of these rules on a timely filed gift tax return. Ideally, it is best to determine whether or not the transferor wants the automatic allocation rules to apply to a trust when reporting the initial transfer to the trust. Although these rules are a helpful safety net in some scenarios, relying on the automatic allocation rules is not recommended.

There are also automatic allocation rules at death under section 2632(e). The taxpayer’s unused GST exemption is first allocated to direct skips occurring at the individual’s death. Second, the unused GST exemption is allocated pro rata to any trusts of which the decedent is the transferor and from which a taxable distribution or taxable termination might occur at or after the individual’s death. If the taxpayer affirmatively allocates on Schedule R of the estate tax return, the automatic rules for indirect skips will not apply.

Manual Allocation

Before January 1, 2001, the transferor’s available GST exemption had to be manually allocated to transfers (other than direct skips) on the transferor’s gift tax return. Taxpayers may still manually allocate on a timely-filed gift tax return if there was no automatic allocation because the trust did not meet the definition of a GST trust or an opt-out election was made. The taxpayer’s unused GST exemption can also be manually allocated at death on Schedule R of his estate tax return. When manually allocating a GST exemption, consider using formula language so that the allocation is adjusted upon changes to values.

Late Allocation

Late allocation of the transferor’s GST exemption is available when an existing trust is not exempt from the GSTT and the taxpayer wishes to allocate his available GST exemption to that trust based on current values. Under Treas. Reg. § 26.2642-2(a)(2), an election can be made to treat the allocation as having been made on the first day of the month during which the late allocation is made. The allocation is not effective until a gift tax return reporting the allocation is actually filed with the IRS prior to the end of that same month. The late allocation is considered effective on the date of filing. This election is not effective with respect to the valuation of a life insurance policy if the insured individual passes away prior to the effective date.

Although a late allocation is typically seen as an available remedy for a missed allocation of GST exemption, it is also a planning opportunity in depressed markets. Assets a taxpayer gifted to a trust in one year might have significantly declined in value before the time that the gift tax return for that year is due. If trust assets have significantly declined in value, opting out of an automatic allocation of GST exemption on the timely filed gift tax return for the year of the gift and subsequently making a late allocation of GST exemption immediately after the deadline for filing the gift tax return may result in the transferor using less of his GST exemption.

Retroactive Allocation

Section 2632(d) provides for retroactive allocations under certain circumstances intended as a remedy for untimely deaths. The transferor can retroactively allocate GST exemption on a chronological basis to any previous transfer(s) to a trust if the following facts apply:

  1. A non–skip person has an interest or a future interest in a trust to which any transfer has been made and
  2. Such person

a. is a lineal descendant of a grandparent of the transferor or of a grandparent of the transferor’s spouse or former spouse,

b. is assigned to a generation below the generation assignmen of the transferor, and

c. predeceases the transferor.

The retroactive allocation is reported on a timely gift tax return for the calendar year of the non–skip person’s death. The amount of GST exemption that can be allocated is the amount available immediately before the non–skip person’s death. The value used for the retroactive allocation is the value of the transfer on the date it was originally made. Even though the original date-of-transfer value is used, the allocation is deemed to have occurred immediately before the death, not as of the original date of transfer.

GST Exemption Allocation Summary

The below reference chart was prepared in collaboration with Julie Miraglia Kwon based on her lecture “Generation-Skipping Transfer Tax: Exploring the Nooks and Crannies” given to the American Bar Association Real Property, Trust and Estate Law Section on April 18, 2023. She explained that two important concepts should be considered in allocating GST exemption: (1) valuation of the allocation and (2) effective date of the allocation.

Case Study (con’t)

The 1984 transfer was exempt from the GSTT and has an inclusion ratio of 0.000. No GST exemption was allocated to the 1999 transfer to this trust, so that portion of the trust is fully subject to the GSTT. Because it is a GST Trust, however, automatic allocation of the transferors’ GST exemptions occurred for the 2002 transfer to the trust. Because the trust has a mixed inclusion ratio, the taxpayer could consider a late allocation of GST exemption if he is concerned about paying GSTT as a result of transfers to skip persons.

Were there any general powers of appointment?

A general power of appointment over a trust’s assets can change the identity of the transferor, which presents both planning opportunities and pitfalls. An individual must be the transferor to allocate available GST exemption. A right of withdrawal over a portion of a trust’s assets is also considered a general power of appointment, and seemingly simple Crummey withdrawal rights can lead to GSTT issues. The regulations under section 2652 provide that the lapse of a withdrawal right in excess of $5,000 or 5 percent of trust assets will cause the power holder to be deemed to have transferred the excess amount to the trust for GSTT purposes.

To avoid this consequence, withdrawal rights are commonly drafted to avoid the lapse of the power to the extent it is greater than $5,000 or 5 percent of trust assets. This creates what is commonly referred to as a hanging Crummey power, and this portion of the withdrawal right remains in existence. A hanging Crummey power can cause estate tax inclusion.

Case Study (con’t)

The trust agreement will need to be reviewed to confirm that no general powers of appointment exist that could cause a change to the transferors for GSTT purposes. There are no withdrawal rights available to the trust’s beneficiaries, so there is no need to determine whether hanging withdrawal rights will cause estate inclusion and changes to the transferors.

Has there been a qualified severance?

Some trust agreements include language that will trigger a severance automatically if an inclusion ratio is other than 0.000 or 1.000. If the trust does not contain that type of language, however, a qualified severance may be necessary. When a trust has an inclusion ratio other than 0.000 or 1.000, the trustee may be interested in doing a qualified severance under section 2642(a)(3)(B) and Treas. Reg. § 26.2642-6(e). A qualified severance divides the trust into two or more trusts so that the resulting trusts either have an inclusion ratio of 0.000 and are exempt from GSTT or have an inclusion ratio of 1.000 and are nonexempt from GSTT. Administering a trust with an inclusion ratio other than 0.000 or 1.000 can be complicated, time consuming, and expensive for the trustee. When the trust is severed into trusts that are either GST exempt or GST nonexempt, it can be much simpler to administer.

Case Study (con’t)

Because this trust has a mixed inclusion ratio, it is a good candidate for a qualified severance. As shown at the bottom of the next page, the inclusion ratio of the trust is 0.346. This means that 34.6 percent of the trust is subject to the GSTT. The trustee can sever 34.6 percent of the trust into a GST nonexempt trust with an inclusion ratio of 1.000 and 65.4 percent of the trust into a GST exempt trust with an inclusion ratio of 0.000. The trustee could intentionally make distributions from the nonexempt trust to the non–skip beneficiaries and deplete it before it goes on to skip persons. The trustee could use the exempt trust for the benefit of skip person beneficiaries. This would ensure the transferors’ GST exemptions were used efficiently. If the transferors have additional GST exemption in the future because of inflationary increases, they could choose to make a late allocation to the nonexempt trust portion to protect those assets from the GSTT.

When does the statute of limitations close on the inclusion ratio?

Although it is common to report the allocation of GST exemption on a gift tax return, adequate disclosure of the transfer on a gift tax return does not start the statute of limitations with respect to the inclusion ratio of a trust (unless all transfers to the trust were direct skips, which have a different rule). Under Treas. Reg. § 26.2642-5, the inclusion ratio of an indirect skip trust is generally not final until the later of

  • The expiration of the period for assessment with respect to the first GST tax return filed using that inclusion ratio or
  • The expiration of the period for assessment of federal estate tax with respect to the estate of the transferor, even if an estate tax return is not required to be filed.

This means the inclusion ratio of a trust is not final until the transferor passes away and a GST tax return is filed. For trusts with somewhat uncertain inclusion ratios other than zero, the trustee may want to consider making a taxable distribution and have the recipient pay a small amount of GSTT after the transferor passes away. This would report the inclusion ratio on a GST tax return and start the statute of limitations to achieve finality with respect to that inclusion ratio.

Case Study Conclusion

Let’s calculate the inclusion ratio of the trust in our case study. This calculation is simplified, as we have two transferors for GSTT purposes due to the gift-splitting elections made on the gift tax returns. For purposes of this illustration, we have combined the two shares even though, for GSTT purposes, two trusts exist. We have used an illustrative growth rate of about 4 percent.

First, we have the October 1, 1984, transfer of $1,000,000. Because this transfer was made before the enactment of the current GSTT, it is Grandfathered pursuant to Treas. Reg. § 26.2601-1(b). The inclusion ratio for this first transfer is 0.000. This Grandfathered portion is treated as if the transferor had allocated the GST exemption to the transfer for purposes of the inclusion ratio calculation.

Next, we have the October 1, 1999, transfer of $1,000,000. The taxpayer and spouse did not affirmatively allocate any of their GST exemption on the 1999 gift tax return, so no GST exemption was allocated to this transfer. Assuming that the pre-transfer value of the trust’s assets is $1,800,000, the inclusion ratio is calculated as follows:

Applicable fraction: ($1,800,000 [current value of Grandfathered portion]/$2,800,000 [trust value after transfer]) = 0.643;

Inclusion ratio: 1 – 0.643 = 0.357.

Lastly, we have the October 1, 2002, transfer of $100,000. Although the taxpayer and spouse did not affirmatively allocate any of their GST exemption on the 2002 gift tax return, the deemed allocation rules under section 2632(c)(1) applied because this is a GST Trust within the meaning of section 2632(c)(3)(B) and no opt-out election was made. Therefore, $50,000 of the taxpayer’s GST exemption and $50,000 of the spouse’s GST exemption was automatically applied to the transfer. If the pre-transfer value of the trust assets is $3,200,000, the inclusion ratio is calculated as follows:

Applicable fraction: ($2,157,600 [current value of Grandfathered portion of $2,057,600 + $100,000 of GST exemption allocated to this transfer]/$3,300,000 [trust value after transfer]) = 0.654;

Inclusion ratio: 1 – 0.654 = 0.346.

Thus, 34.6 percent of the trust is subject to the GSTT. If you recommend a qualified severance to your client, the trust could be divided into a GST exempt portion with an inclusion ratio of 0.000 and a GST nonexempt portion with an inclusion ratio of 1.000 for ease of administration and distribution planning purposes.

Conclusion

There are remedies available beyond the scope of this article to mitigate unexpected GSTT concerns. These include section 9100 relief and timely allocation relief under Revenue Procedure 2004-46. As you can see, reconstructing a trust’s inclusion ratio can be complicated, and there are many factors to consider. Going through this process can open the door to many planning opportunities and chances to provide significant value for your client.

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